Update on ABACUS

Read the “synthetic, synthetic CDO” post first if you haven’t already.

The reasonable counterargument, for example here, is that because these are derivatives, there logically speaking must have been someone on the other side of the trade from the buyers, and the buyers should have known that — who that is doesn’t need to be disclosed. I think this is true to a degree, but not to the degree that Goldman needs it to be true.

Take an ordinary synthetic CDO. Back in 2005-2006, a bank might create one of these because it knows there is demand on the buy side for higher-yielding (than Treasuries) AAA assets. To do this, the CDO has to sell CDS protection on its reference portfolio to someone. That someone could in the first instance be the bank. But then the bank’s “short” position goes into its huge portfolio of CDS, which may overall be long or short the class of securities (say, subprime mortgage-backed securities) involved.The bank is constantly hedging that portfolio via individual transactions with other clients or other dealers, so there’s no one-to-one correspondence between the long side of the new CDO and any specific party or parties on the short side.

Let’s say for the sake of argument that the bank, prior to the new CDO, was exactly neutral on this market. The new CDO makes it a little bit short. So the bank will go out and hedge its position by finding someone else to lay the short position onto. But first of all, there’s a good chance it will divide up the short position and hedge pieces of it with different people. Those people may be buying the short position not because they want the subprime market to collapse; they might be partially hedging their own long positions in that market. Second, there’s an even better chance that it won’t sell off exactly the short position it just picked up from the CDO; it will buy CDS protection on a bunch of RMBS that are similar to the ones it just sold CDS protection on (which ones will depend on what the market is interested in), so in aggregate it comes out more or less the same.

So ultimately the “short” side of the CDO gets dispersed between the bank’s existing CDS portfolio and the broader market. So yes, there must be a short interest out there that is exactly equivalent to the long interest. But there doesn’t have to be a party or even an identifiable set of parties who have exactly the short side of the new CDO and want it to collapse, let alone a party that helped structure the CDO because it wanted to be on the short side. There’s a big difference between the market as a whole and one hedge fund.

Now, are things different with a synthetic synthetic CDO, as I have called it? Maybe. The pro-Goldman argument would be that ABACUS was so highly structured — basically, each tranche was a single complex derivative with a long side and a short side — that the long investors must have realized that there was a single party, or a small number of parties, on the other side. But that doesn’t necessarily hold. Just like a synthetic CDO, Goldman could have whipped this thing together because it thought it could sell it, and Goldman could have planned to hedge it the usual way — partially with its inventory and partially through a lot of small transactions dispersed throughout the market.

As always, I draw on Steve Randy Waldman.

98 responses to “Update on ABACUS

  1. You just had to know this was coming.

    New York Post:

    Goldman Sachs may soon settle its fraud case with the Securities and Exchange Commission, opting to end the legal fight rather than endure a repeat of the public flogging it received Tuesday in Washington, sources familiar with the matter told The Post.

    So all of the smoke coming out of Levins and McCaskills ears were simply for dramatic effect. How many times have we seen this scenario play out? A slap on the wrist, a hefty fine that’s probably already covered with a synthetic derivative, and a probable no admission of any wrong doing statement to boot.
    Yes Mr. President, this is real change we can believe in and Washington moves on without the accountability required by the people and without missing a beat life lurches forward. Move on people, nothing much to see here that we haven’t seen many times in the past. This is just business as usual.

  2. The reasonable counterargument, for example here, is that because these are derivatives, there logically speaking must have been someone on the other side of the trade from the buyers, and the buyers should have known that — who that is doesn’t need to be disclosed.

    I just love this quote I’ve been seeing in a few places:

    As I reminded my undergraduates the other day, caveat emptor is a legal principle, not a business plan.

    http://economistsview.typepad.com/economistsview/2010/04/caveat-emptor-is-not-a-business-plan.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+EconomistsView+%28Economist%27s+View+%28EconomistsView%29%29

    We can see how advanced kleptocracy has become when a legal defense is not only a business plan but a basic meme of political discourse and of how “civilization” is allegedly supposed to be constituted.

    The hideous fact is that we’re infested by feral barbarians.

  3. The issue is not that somebody (even a single somebody) was on the other side of the trade. The issue is that the same somebody originated the idea of creating the instrument, actively participated in its construction, and was not revealed to the buyers.

    At least, that is my reading of the SEC’s allegations.

  4. Isn’t the case really about whether Goldman withheld material info? The rest (about how sophisticated someone is, or whether someone knew someone was short) is irrelevant. In fact, it is a smokescreen. As you wrote, “there doesn’t have to be . . . a party that helped structure the CDO because it wanted to be on the short side”.

    Goldman did not apparently tell the investors this. If it is material (I would say yes), then Goldman messed up.

  5. Regarding Paulson’s participation in the construction of the transaction, it’s also possible to argue that – regardless of how the underlying securities were chosen – ACA chose the securities as it had full discretion to completely replace every security on the list. So even though some securities remained on the list, ACA knowingly chose to keep them. This is separate from the legal charges of misrepresentation, which I will leave to the lawyers here.

    As far as hedging risk, there is a difference between hedging underlying names and hedging the tranche itself. I believe one source of confusion is that the ABACUS transaction was a “funded” synthetic, meaning investors paid money that was used to purchase underlying collateral. If I understand correctly, the investment vehicle then issued a credit-linked note to investors that pays the yield on the collateral plus the synthetic tranche spread.

    Imagine if the CDO was “unfunded” (an example would be the standardized corporate tranches based on the investment grade CDX index). The investor would essentially be left selling tranche protection (another way to say it is the bank buys protection from the investor). The bank can hedge this tranche protection in two ways. 1) Hold the risk and delta hedge against the names in the underlying portfolio (all this means is the value of the tranche is sensitive to changes in the value of the underlying names – the bank will need to adjust its single name positions to stay hedged); or 2) pass the tranche risk on to an interested hedge fund(s) (the hedge fund buys the tranche protection sold by the investor). The second method is obviously more convenient, assuming there are parties that are willing to take on opposite positions. The key distinction to remember here is that there is a difference between the underlying single name CDS protection and tranche protection. You could consider the tranche protection an option on the “expected loss” of the underlying CDS portfolio.

    So from this perspective, it seems to me that it would be reasonable for ACA and IKB to assume there would be someone buying protection on ABACUS tranches. Whether it’s GS or Paulson isn’t relevant.

    Again, I am leaving aside the legal issue of misrepresentation as the law depends on specific disclosure rules.

    The greater issue, it seems to me, is how these transactions are captured on the bank balance sheet (tying into the whole question of bank size, as I assume Thirteen Bankers discusses – sorry, haven’t gotten it yet, missed your book signing in New Haven!).

    You can find a few more thoughts on synthetic CDOs at notestoself.posterous.com

  6. William Peterson

    It seems to me that a useful way of thinking about the Abacus deal is to use the analogy of a bet on a horse race. If I bet on a particular horse to win, I am long that horse, and the bookmaker is taking a short position – he would like the horse to lose (or the security to fail). He will probably limit his short position by taking out bets with other bookmakers (this is known as ‘laying off’ in UK racing terminology), so ultimately the short position corresponding to my original long position is widely dispersed.

    If the short position is not dispersed in this way, or if the bookmaker has a mechanism (something like a naked CDS) for taking out an even larger short position, then he has a strong incentive to fix the outcome of the race by doping my horse to fail. This is a tempting option, as it’s much easier than it would be to fix the race so that a particular horse wins (a race has many losers, but only one winner). Similarly, it’s much easier to bankrupt a company than to ensure success.

    For this reason the racing authorities in honest jurisdictions try to limit the extent to which gamblers can take ‘naked short’ positions: in particular those who can easily influence the outcome of the race (owners, trainers and jockeys) are absolutely prohibited from doing this. However the racing equivalent of ‘financial innovation’, in the form of Internet betting exchanges (rather like OTC derivative markets), has made it much harder for them to do this.

    In the Abacus deal it seems entirely plausible to assume that the long investor did not know that the holder of the short interest had no plan to disperse his risk, and therefore stood, as an individual, to make very substantial gains from the security’s failure. It also seems plausible to assume that the long investor did not realise that the short interest had the ability, as well as the incentive, to influence the outcome.

    GS may argue that a sophisticated investor should take these possibilities into account – the caveat emptor principle. But this sort of information about potential transactions does not come for free – if gamblers need to know what the net position of the bookmaker is, and whether the bookmaker can fix the race, before making a bet the market is likely to disappear. In any case the GS defense clearly implies that all short positions should be publicly observable: with current transparency rules about CDS this is not even theoretically the case.

    Two final points which I have not seen made elsewhere. Firstly, ever since capitalist enterprise began, less informed investors have used the fact that entrepreneurs typically have a substantial long interest in their company as both a signal and an incentive device. If instead entrepreneurs and corporate executives can surreptitiously, but legally, short this interest then it is very hard to see how traditional capitalism can continue to operate.

    Secondly, the whole ‘invisible hand’ tradition in Economics assumes that markets work in such a way that individual actions lead to socially desirable outcomes. But if modern financial markets allow individuals to make large private benefits by setting up operations which are designed to fail, and to impose considerable costs (bankruptcy, foreclosure) on society by doing so, this whole line of argument collapses.

  7. I am facinated by CDO’s, CDO’s squared,and CDO’s cubed.
    And they remind me of nothing more than convoluted diagrams of perpetual motion machines from the middle ages.
    I will dispense arguing that they misprice risk and cause mis-allocation of resources.

    If these types of financial instruments are so great, why are we in the midst of the greatest financial disaster since the Great Depression.

    You may be able to buy insurance in the event the world blows up, but who is going to be around to pay you?

  8. I disagree that IKB and ACA could not have reasonably known that there was another counterparty that wanted to go short the subprime market. With deals of this kind the argument that everything is hedged piece by piece does not really hold: CDS’ on ABS’ or not like CDS’ on corporate names in terms of availability and liquidity, so if you’ve got $1bn to do you’d better do them from the outset, and you also better don’t really on too much dynamic and proxy hedging: for the former the market might just disappear right under you when you need it, and for the latter you probably dont like the basis risk.

    However, this is besides the point. Given the model uncertainty – and the possibility to arbitrage rating models – it is important whether or not the portfolio has been selected by a long interest or by a short interest. In one case you as a long investor have a fighting chance that AAA means what it says on the tin and that indeed you are taking a fair bet with someone who just has a different view.

    However, if the short side is in charge of portfolio selection and has access to all the rating agency models, then there is a real risk that the ratings gets “arb’d” and AAA is not really AAA.

    It is for this reason that the information that Paulson (a) had a short interest, and (b) made proposals regarding and had a veto right on the portfolio composition is important information to the long counterparty, and it could be argued that Goldmann was morally – and possibly legally, we’ll see about that – obliged to disclose not that there was a short side (this is obvious) but that the short side had a significant say in the structuring of the deal.

    http://wp.me/pTAkP-5c

  9. Feral they may be and barbarians as well but they are well tutored or so they seem to this simple soul.

    Isn’t it a marvel how the CDOs and CDSs function so the economy can distribute capital efficiently to the various sectors and enterprises where needed.

    Ultimately the low interest rates that created the frothy housing bubble first supplied a financial sector with abundant funding that it couldn’t distribute along traditional routes, thanks to moribund US manufacturing. At another level pension funds and savers wanted returns beyond the miserable rates banks were offering thanks to the easy money. The sorcerer’s apprentices residing on Wall Street solved that by unleashing a flurry of CDOs and CDSs.

    The euro zone is the latest benefactor of the GS whipsaw treatment, first they re-structure Greek debt to get them into the euro zone, then when the bill comes due their pals, the rating agencies, downgrade Greece. How heavily is GS betting against Greece? When will someone throw a noose around these serial banksters? Never, clearly they own the constabulary.

  10. I would just point out that the ratings arb was really set up for the long investors. That’s why so many investors sold mezzanine protection – it provided the most spread per unit ratings risk. It isn’t really accurate to say that the long investors had no access to ratings models or that they had no shot. And they still know what the underlying credits are, which is the most important piece of information. This, of course, brings us back to fundamental analysis vs. taking a rating at face value. So while Paulson had input, I think it’s more accurate to say ACA had the veto power.

    I agree, however, that ABS CDS is not the same as corporate CDS in terms of liquidity. But this obviously just reinforces the argument that the only viable hedge would be to pass the position on to a hedge fund.

    Just for the record, I cannot believe I am defending Goldman. Would a lawyer please let us know if there is a black and white take on the whole misrepresentation thing? Everything I’ve read so far seems entirely like opinion with no reference to the law.

  11. This post is a lot closer to reality than the previous analyses of Synthetic CDOs.

    The issue is not who was short or long in a zero sum derivative like this. The issue will probably come down to (from least likely to more likely)

    1. Were there any issues in how the ratings were assigned. Were they ‘shopped’ and were any lines crossed in massaging the rating of the security. In my limited knowledge (second hand) of the ratings agencies, one didn’t need to ask for advice on how to get to any specific rating, or push the analysts for ratings. The agencies did it on their own to try and win business. The agencies provided their models to any potential issuer, and the security was generally constructed in advance to meet certain ratings criteria – the agencies were so captive that they opened the kimono at the front end of the rating process, so you knew what you would get without much back and forth required.

    2. Was Goldman aware of any material information on the reference portfolio that was not provided to ratings agencies or buyers of the CDOs. There were lots of perspective on housing at the time – would there be a soft landing, a hard crash… would prices simply go flat. Would homeowners get a bailout… Simply having a positive or negative view as a firm would not be a material piece of information. Think about other more liquid zero sum products – Spot/Forward/Swap currency trades. An institutional investor comes in and wants to go long Euro, short USD. Goldman might be extremely ‘short’ Euro right now. The institutional investor who asks to buy 100M Euro is still provided the trade for a price, no questions asked, no perspective shared. Goldman might hold the other side or go sell off that USD exposure. There could be miles of emails calling euro ‘shitty’ or ‘crappy’ or whatever you want, which are not material. Knowing that Paulson wants to short it is not material. Back to the CDO issue, I believe the only potential problem here is if Goldman knew that the rating should be lower due to defaults or delinquencies that aren’t made available to or shared with the ratings agency or investors.

    3. Were there representations made outside of the offering circular that were different from what was in the offering circular. Did Fabrice or other sales people make misrepresentations (*omissions* about Paulson or other short perspectives within Goldman on the trade are not misrepresentations in a product like this…) about Paulson’s intentions/positions to ACA and buyers. Did reps for Goldman represent Goldman as having a perspective on the long or short side of the transaction (i.e. provide advice or induce people to buy as opposed to just market-make).

    This last point is most likely in my mind. Especially with the statements that Goldman is making regarding Fabrice being young/immature and the distance they have been putting

  12. Quite. Am I missed something here?

  13. Is this the part where Goldman comes to the table, in their mind ready to give a 100 cents on the dollar settlement and Mary Schapiro says “No! No! No! Just give us 60 cents on the dollar and we’ll call it old bygones!! What is F-ing the U.S. taxpayer between to old friends like us??”

  14. http://wp.me/pTAkP-5D

    “I would just point out that the ratings arb was really set up for the long investors.

    Fully agree – but it did help the shorts: because of the rating arb, investors were willing to write protection cheaper than it would have been the case otherwise (or at all, for that matter)

    “It isn’t really accurate to say that the long investors had no access to ratings models or that they had no shot. And they still know what the underlying credits are, which is the most important piece of information. This, of course, brings us back to fundamental analysis vs. taking a rating at face value.

    This is not at all what I was saying – what I was saying was that with the shorts selecting the portfolio, the AAA was even less AAA than it would have been had the longs chosen the portfolio. Whether IKB and ACA should have done their own fundamental analysis is a completely different question – but there was an interesting take on that question in the blogoshphere which I have referred to here.

    “So while Paulson had input, I think it’s more accurate to say ACA had the veto power.

    I guess we can agree they both had – with any of Paulson, ACA, and IKB saying no the deal would not have happened it seems

    “Would a lawyer please let us know if there is a black and white take on the whole misrepresentation thing? Everything I’ve read so far seems entirely like opinion with no reference to the law.

    I am not a lawyer, but quite a bit of enough interaction with them… My take would be that most likely it was not illegal, but that we wont really know unless there is precedent established. And of course if Goldman settles there will be no precedent established….

  15. I gave my Book Review of “13 Bankers” today. It’s not a masterpiece, but I would say I covered the bases better than the flippant and myopic Louis Uchitelle review in NYT (among others). You can see my review of “13 Bankers” here:

    http://grahambrokethemold.blogspot.com/2010/04/book-review-kwak-and-johnsons-13.html

  16. The U.S. taxpayer. Who else?? We’ll probably pay the Greece bill when Merkel shows she’s too damned intelligent to fall for their cry baby routine for the candy bar at the grocery check out line.

  17. David Petraitis

    Russ, I love the “feral barbarians” bit … I will be quoting it! 8)

    On the points made by James about the mismatching of long and short sides on a synthetic, he is of course correct that the buyer of the long side does not necessarily know if there are one or many sellers of the short side, or if the bank is doing this internally.

    In the case of Abacus the long side was created, pre-marketed, packaged and then sold by the GS team *so that* John Paulson could match it short.

    That is precisely vampire squid behavior.

  18. David Petraitis

    “If entrepreneurs and corporate executives can surreptitiously, but legally, short [their] interest …”

    Interesting point was made in a good paper by William K. Black “Epidemics of ‘Control Fraud’ Lead to Recurrent, Intensifying Bubbles and Crises”

    Here:

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1590447

    He makes the point that in some cases CEO can and HAVE done exactly that. Specifically where their own compensation could be positively gamed even while the company was insolvent, there is a perverse incentive for this behavior.

  19. Do you think there is a “materiality” difference (that a reasonable buyer would want to know) between a synthetic CDO with one short or many dispersed shorts? Rather, do you think it only turns on the participation in the selection process?

    Personally, I would want to know whether the product I’m buying was 1) conceived by one person (concealed by dealer) who is 100% sell side and 2) participating in selection. But, to me, #1 is important. Material or duty triggering? I don’t know. But, I would say absolutely IF the sell side knew my identity and I didn’t know theirs while this inequality was maintained by the dealer.

    To me, #1, alone, is important because it creates no “checks and balances” on #2. Had I known Paulson was 1B on the other side, I would probably start asking questions to ACA and GS that would ultimately pull me into the selection process at least to check for influence. I could do DD on Paulson, as well. Did Paulson know the identity of the buy-side without it being both ways?

    If so, even minus Paulson’s participation in selection, it creates questions of fairness and incentives, doesn’t it?

  20. Excellent read,and analysis. :^)

  21. If I’m the CDO buyer, I would want to know if I’m in a horse race with a dispersed market or a poker match with one person. If it is a poker match, I’d want knowledge of identities to be zero or both ways. If someone is hosting this game, I’d want to know if someone paid them to get me to the table so they could see me and I couldn’t see them.

    If, as James wrote, the buy side isn’t necessarily under the single short assumption…. you could argue it’s akin to being invited to a horse track and ending up in a poker match with loaded cards. Your opponent is concealed. You are not. The dealer is paid to keep it this way. The invitation and the role of this party is very important.

    I would have to know more about the average buyers assumptions in this market and market norms too, which I’m learning here, thank you.

  22. Has anyone read news about the identities of the buyers at these banks, IDK and Amro? Have they made any comments? I would like learn about their expectations, assumptions and experience. I think that’s very important from a regulatory standpoint and incentives too. As a shareholder of a bank, I don’t want one or two people at my bank to have the power to lose 1B on a single transaction to one man. That’s a situation ripe for dangerous outcomes.

    From a general standpoint, we must consider this area ripe for potential fraud and conspiracy where everyone does well except the shareholder of the bank. Is anyone talking about this? I would demand my bank have an immediate review process on derivatives that implicated a committee on the board and perhaps outside review.

  23. Not relevant to this thread, but Ezra Klein is beginning to come around to Johnson’s way of thinking about the resolution problem: http://voices.washingtonpost.com/ezra-klein/2010/04/the_problem_of_international_a.html

  24. It’s painful to say, but financial reform just died a horrible death: Jim Cramer just shouted to his lemmings, “all’s clear to buy financial stocks.”

    This feels like 2007 all over again- Wall Street, Larry Summers, and Tim G. just completed Operation Whitewash (the crisis never happened), and pulled it off.

    Absolutely disgusting.

  25. Brad Thrasher

    As I stated at the outset of SEC v. GS et al the issue is a more precise definition of where fiduciary duty ends and caveat emptor begins. This is the duty of Congress, not the courts.

    As for the needed legislation I draw first from the metaphor, your right to swing your arm ends precisely where my nose begins.

    As to settlement proposals the SEC could best serve the nation by squeezing GS until such time as proper legislation is signed by the President.

  26. This proposed amendment might be a way to stop a lot of the abuses.

    http://brown.senate.gov/imo/media/doc/SAFEBankingAct.pdf

  27. Barry Ritholtz says SEC has nailed its case against Goldman Sachs. See here.

  28. Golly, if only IKB and ACA Capital had been allowed to look at the underlying portfolio of subprime bonds before being forced at gunpoint to put $1bln at risk on them. /sarc

    Frankly most of the issues raised above and in comments are red herrings that miss the mark wildly. I’ll move past the usual misconceptions about the supposedly huge difference between ‘synthetic’ and non-synthetic (organic?) transactions and just ask: who cares who ‘selects’ a portfolio if you get to see it before buying it? Or are people somehow under the impression that the portfolio was a secret to the buyers? Is that how people think this market worked? secret-surprise CDOs?

    Thought experiment, here’s a portfolio of stocks: (Google, Apple, Home Depot). Say I name a price X, ok now, do you want to buy it at X, yes or no? Perhaps you could come up with an answer. If so, does that answer somehow change if I go on to tell you the portfolio was chosen by a Wall Street genius? By a 5-year-old child? By an axe murderer? And if so, why on earth why? Whoever ‘selected’ the portfolio, it is what it is, and you’re looking right at it. It’s on the piece of paper you’re about to sign. Is the buyer not expected to do his own, er, thinking before dropping a billion dollars on a portfolio staring him right in the face?

    The issue of whether the buyers would/should have known/thought there was ultimately one or many counterparties shorting the other side achieves, miraculously, even more irrelevance. I cannot see how/why that should matter one iota to any rational buyer. In a derivative, if you buy something, the other side is short that thing, period. Yes maybe they pass that short through to others, or maybe they don’t. Maybe those others are few, maybe they are many. Maybe if you traced every single leg of the risk to its ultimate root (note: this is not possible, even in principle) you’d find three shorters, or one, or a zillion holding that risk. Tell me: so what? How does any of that affect an intelligent person’s valuation of a trade on its merits? Leaving aside counterparty risk (which is not at issue here), if you price a trade under the impression there are many dispersed entities out there ultimately carrying the short risk of that trade, and then you find out it’s only Paulson, and you change your valuation because of learning that, then you don’t know what you’re doing. Not relevant.

    Ultimately this is a story about idiotic buyers failing to evaluate the thing they were buying. They did this in a grab for spread, throwing money at anything with a “AAA” label. If you don’t like this overvaluation of “AAA” CDOs then put the blame where it belongs: on the arb’able risk-capital rules which made them so overvalued, and which incentivized the proliferation of CDOs in the first place. But actually, also blame the idiots at that German bank who bought this garbage piece of paper. At least a little? Is that too much to ask?

  29. Cool stuff tippygolden! A tip of the hat. :-)

    “Mainstream Media Doesn’t Know Sh*t About Securities Law”

    I’ve worked in “Media” all my life. : -o

  30. Wall Street has been called a casino. I think “rigged casino” would be more accurate.

  31. Are you speaking of Franklin Raines, former CEO of of the GSE, Fannie Mae, who buried losses so that he could collect huge bonuses estimated to be $90 million? As far as I can remember, he spent not one day in jail, unlike Dennis Kozlowski and his buddy at Tyco who received stiff jail sentences for taking “unauthorized” compensation/bonuses.

  32. “People are going off a cliff and we’re not really doing anything about it,” said Andrew Stettner, deputy director of the National Employment Law Project.

    http://www.calculatedriskblog.com/

  33. While I agree with you generally, I would want to know if your portfolio was picked by Serge Brin or Steve Jobs. But Paulson, who was a relative unkown at the time, is not equivalent to such insiders.

  34. I think most of what you say in totally accurate…for two people trading behind computer screens. But, the whole argument falls apart when you insert an intermediary making representations and omissions.

    THAT is what you have here. Your post reads as if GS was invisible, did not exist, wasn’t there, wasn’t relied upon. Just making trades. If so, why didn’t GS just introduce the buyers to Paulson and put them in a room. Oh…they couldn’t do that. But, they could tell Paulson who the buyers were. That’s rigged. As the Wapo wrote tonight about the criminal referral..

    “Under civil law, the SEC doesn’t have to prove Goldman set out to defraud investors — only that it did. But criminal law would require that prosecutors show that Goldman maliciously planned to mislead its investors.”

    Did they plan to mislead? I think they planned to mislead one and not the other.

    GS created the product, and nothing like a basket of Google and Apple, where far more less is required, for example, ACA’s. That’s where the argument rounds right back to the complicated nature of the product, who’s your client and who’s relying on whom for their best interests.

    Many people think GS set out to ‘trick’ their client. Didn’t Tourre say at one point, in a meeting, this is “surreal”? Had money exchanged hands yet? Doubt it. Sounds tricky to me.

    It sounds like Goldman and supporters think GS should be able to have clients to earn income but owe no duties to them. I think you’ll need more money to be that invisible.

  35. Two things:

    1. Us there any reason to think IKB would have cared to know it was paulson on the other side. I know of none. He was a nobody.

    2. I don’t think IKB and ABN AMRO were Goldman’s clients. They were the underwriter for the deal, not fincial advisors to the investor, which is where I think a lot of the commentary gets off track.

  36. Here is a interesting definition:

    A synthetic CDO is a speculative contract, created from credit default swaps, and then divided up and sold as revenue generating bonds. A synthetic CDO destroys capital. It is inherently a negative sum game. There is winner, a loser in equal amount, and fees are taken off by the investment banks.

    The contradiction is synthetic CDOs (destroyers of capital) are sold as bonds (financial instruments that create capital.)

    See here 4:55 into video

  37. Yes…

    SAFE BANKING ACT OF 2010 
    Senate 3241 / House Resolution 5159 
     

    http://kaufman.senate.gov/imo/media/doc/SAFE%20Banki­ng%20Act%2020101.pdf

    We need to get this Act passed, unadulterated. It doesn’t cure all the problems of the financial system (e.g. derivatives), but it is an excellent and meaty start to banking reform.

    ~ ~ ~ ~ ~

    Please email or call your Senators and Representative.

    http://www.contactingthecongress.org/

  38. Nice analogy. Good points.

  39. Let’s pray the SEC doesn’t settle.

  40. I apologize for the duplicate post, but it was a pertinent response to a post earlier in the thread. I’m reposting it with hope that more people will take 10 minutes to voice their support of this bill.

    SAFE BANKING ACT OF 2010
    Senate 3241 / House Resolution 5159

    http://kaufman.senate.gov/imo/media/doc/SAFE%20Banki­ng%20Act%2020101.pdf

    We need to get this Act passed, unadulterated. It doesn’t cure all the problems of the financial system (e.g. derivatives), but it is an excellent and meaty start to banking reform.

    ~ ~ ~ ~ ~

    Please email or call your Senators and Representative.

    http://www.contactingthecongress.org/

  41. Tippy,
    Terrific stuff you got there. Here’s a connected story to the SEC case by Justin Blum and David Glovin over at Bloomberg. Pay special attention to the quote from Blankfein on “unethical behavior” and see where you rank that on the believability scale. Cross your fingers.

    http://www.bloomberg.com/apps/news?pid=20601087&sid=azKt1pYdWUAU&pos=3

  42. Yes, opinions the man (Barry Ritholtz) gives are provocative, particularly about the misdirected media analysis of Goldman. But it’s awfully hard to hear it through all the foul-mouthed rage. Fury doesn’t help the credibility of arguments.

  43. But, the whole argument falls apart when you insert an intermediary making representations and omissions.

    Whether someone made misrepresentations is a legal issue that will be sorted out. I’m not sure what the evidence will show. The post above (and most of the comments) is not confined to those charges however, it attempts to make points about the nature of the transaction itself. Those points are mistaken.

    Your post reads as if GS was invisible, did not exist, wasn’t there, wasn’t relied upon. Just making trades. If so, why didn’t GS just introduce the buyers to Paulson and put them in a room.

    Why would they. Why should it matter. You haven’t addressed my point that it shouldn’t matter to a buyer who ‘selected the portfolio’. The buyer can and should look at the actual dang portfolio. Do they like it or not and for what price. What on earth did Paulson have to do with anything. What on earth would knowing about Paulson have changed.

    You are now just making up ad hoc rules. Those rules have nothing to do with the reality of how derivatives trading works. Whenever an interest-rate swaps desk does a trade to pay fixed on $100mm, chances are there’s another trade or set of trades they do around that time to receive fixed (at a slightly higher rate, the difference being the bid-offer) on about $100mm. That is how market-making works. Do you think every time this happens they take the two counterparties and ‘put them in a room’? What the heck? Why? Do you think the two counterparties want or need this to evaluated whether the swap rate they were quoted is fair? This is nonsense on stilts.

    Why would IKB or ACA Capital have to have been ‘in a room’ with Paulson? How would that have helped them? What would they need Paulson to do exactly? Take his index finger and point at the portfolio that was already laid out in the docs that they already had?

    This is very basic. I’m not even saying ‘caveat emptor’ here. I’m just saying they should have known what the heck they were buying. All these criticisms are premised not only on them not knowing a damn thing about what they were buying, but on the idea that they shouldn’t have been expected to, and that it was rational for them to buy/not buy solely on the basis of who was on the other side. This makes no sense whatever.

    Oh…they couldn’t do that. But, they could tell Paulson who the buyers were. That’s rigged.

    ‘rigged’? Why didn’t IKB walk away then? You know, by looking at the actual portfolio which was right there in the docs for them to look at? And why did ACA wrap the super-senior? I’m still scratching my head trying to figure out who you think forced all these guys to go long this portfolio and hid its contents from them in the process.

    GS created the product, and nothing like a basket of Google and Apple, where far more less is required, for example, ACA’s.

    What? garbled

    You’re right it’s not like the simple basket I used as a simplified example. That is how simplified examples work. You haven’t explained (at least not in any way I can parse) how it’s materially different, in a way that matters.

    That’s where the argument rounds right back to the complicated nature of the product, who’s your client and who’s relying on whom for their best interests.

    If the product was ‘too complicated’ for IKB or ACA then maybe they should not have participated in the trade. Nobody forced them to! It’s true that GS should ‘know their client’, of course their (quite unassailable) position was that these were institutional investors already involved in this market who met the test of being sophisticated enough (granted in retrospect, there’s an argument that in practice they weren’t :)

    And as for who’s relying on whom for their best interests, you seem to misunderstand the role of market makers. Whoever IKB or ACA (or Paulson!) might or might not have been ‘relying on for their best interests’, the one entity we know they weren’t (and shouldn’t have been) is…GS.

    Many people think GS set out to ‘trick’ their client.

    I suspect, indeed, that they set out to sell a trade for more than they bought it. THE HORROR

    It sounds like Goldman and supporters think GS should be able to have clients to earn income but owe no duties to them.

    ‘be able to have clients to earn income’ = ???

    You speak as if GS had captive clients whom they could order to sign contracts. “We think we have the right to have clients to give us income, so we force you to sign this trade, but we’re not going to do anything for you”, says Goldman to IKB. That’s really your position? Is that what you think Goldman’s business model is? How exactly does that work?

    Goldman’s role in this market was/is to make markets, provide liquidity, facilitate trades, match buyers and sellings. That is exactly what they did. Everyone understands Paulson wanted to go short and was looking for someone to go short against. When seems unappreciated here is that apparently IKB wanted to go long! That is what they wanted. GS matched up the two. That is precisely what they ‘owe’ to their clients as market makers. The clients – both of them – were telling them ‘we think it is in our best interest to do this trade’. Paulson thought it was in his best interest to be short. IKB thought it was in their best interest to be long. A market-maker is supposed to help facilitate the transaction – which was, in fact, serving those clients’ best interests, as stated by the clients themselves. Goldman is not supposed to argue with one or the other. That is just not how anything works, everyone’s made-up rules here aside.

  44. While I agree with you generally, I would want to know if your portfolio was picked by Serge Brin or Steve Jobs.

    Agreed, if there’s insider knowledge involved that could change the equation obviously…as you say, that’s not the case here

  45. Well it’s fair to speak of IKB as a client because they bought the bond from GS (or, their SPV anyway..). ABN Amro only came into the equation b/c they acquired RBS, which had acquired ACA (something like that), and ACA, a different arm of ACA, had wrapped the super senior as part of the deal. But would think both IKB and ACA could be termed clients, sure.

    In both cases they were evidently clients who wanted to go long-risk on this portfolio. I’m hard-pressed to understand how/why some people here can imply that Goldman should have essentially argued with that desire of theirs. Or is it that Goldman should have just unilaterally charged a lower price? In either case, that is not how anything works….

  46. Consider the interest-rate swap. It is inherently a negative sum game. There is a winner, and a loser in equal amounts (if interest-rates go up, the floating side of the swap gains value so the fixed-payer wins and the floating-payer loses), and fees are taken off by the investment banks, i.e. the bid-offer spread.

    So, therefore, interest-rate swaps must destroy capital. Right?

  47. Meanwhile consider the bond. If I, a company, issue a bond, and you buy it, but a few years later it loses value (because I had a ratings downgrade, say), and I can buy it back more cheaply, then I was the winner and you were the loser; I got more cash than I paid back. If on the other hand my credit rating stays the same but interest-rates go down, then you were the winner and I was the loser – your bond gained value from what you paid in cash for it, and I’m suffering for the same reason by having to pay above-market interest rates. Meanwhile surely the underwriter took out a fee when I issued the bond…

    Winners, losers, a fee. Therefore, bonds destroy capital too. What doesn’t ‘destroy capital’?

  48. Then why the secrecy and omission toward one side of your SPV transaction – not the other – why the intrigue – if the buyer ‘wouldn’t have cared’?

  49. I’m not a huge fan of vulgarity either. But the thing is, there is absolutely nothing wrong/false about what Ritholtz said there. In fact Ritholtz is saying things that need to be brought more into the light, but aren’t because the reporters at NYT and DealBook are more concerned about the condition of their nails than getting this story right.

    Yes, Ritholtz is a little vulgar, but you know when you’re watching your country go down the toilet, lose its morals, and the guys at Goldman Sachs steal and quickly suck up all the long-term capital assets of this country, saying “we provide liquidity for the market and we are ‘marketmakers’ Mr. And Mrs. Sucker Written on Your Forehead (aka American taxpayers)” if you’re a TRUE American you might feel the need to utter a couple curse words.

  50. “You haven’t addressed my point that it shouldn’t matter to a buyer who ‘selected the portfolio’. The buyer can and should look at the actual dang portfolio. Do they like it or not and for what price.”

    To your prior point, there doesn’t seem to be much standardization, so the law applies on a case-by-case basis. So, if the law rules that GS can’t omit – then, doesn’t that answer your question about all parties in similar situations? Doesn’t that change your theory of “duty” owed to whom and ultimately change the nature of all CDO’s as you see it? This is how it goes down. Laws apply principals and if anyone’s confused as to the nature of a particular ‘thing’ – like a CDO, it gets cleared up. Duties owed, etc.. The debate seems to get frothy because bankers don’t see what other people see and vice versa. As to the legal principals – which just apply behavioral norms over centuries- I agree with other people on this interaction.

    “You are now just making up ad hoc rules. Those rules have nothing to do with the reality of how derivatives trading works”

    -I don’t think I’m making up the rules. I think the market makers/participants are. I’m applying my common sense and notion of conflict of interests to this situation. Then, you go on to talk about interest rate swaps. But – wait- that’s a different situation entirely.

    “Why would IKB or ACA Capital have to have been ‘in a room’ with Paulson?”

    He didn’t need to be. But, the market maker/participant owed equal duties of disclosure, in my opinion.

    “Why didn’t IKB walk away then? You know, by looking at the actual portfolio which was right there in the docs for them to look at?”

    IKB was dumb. But, your victim’s stupidity is not a defense for fraud or material omissions ESPECIALLY if IKB proves they relied on GS and ACA to have their backs. Hey – some people outsource their due diligence. Dumb? Maybe. But- I think this makes it worse for GS, actually.

    “You’re right it’s not like the simple basket I used as a simplified example. That is how simplified examples work. You haven’t explained (at least not in any way I can parse) how it’s materially different, in a way that matters”

    I don’t think you need a selection agent for Google and Apple as you might rely on one for a relatively new and more complicated asset. I think asking for a selection agent supports that. I think it makes the omissions more material.

    “If the product was ‘too complicated’ for IKB or ACA then maybe they should not have participated in the trade. Nobody forced them to!”

    What if they answer, “well, that’s why we work with you, GS… your expertise”. That argument is sort of walking into trouble, isn’t it?

    “Goldman’s role in this market was/is to make markets, provide liquidity, facilitate trades, match buyers and sellings. That is exactly what they did.”

    You think that’s what they did. If that’s what happened – no problem. Obviously there’s a problem.

    Look, Sonic, you started by writing… “Whether someone made misrepresentations is a legal issue that will be sorted out. I’m not sure what the evidence will show.”

    OK, if the court sorts it out against GS, which you leave room for, then the legal nature of these contracts will not be what you’re suggesting, then or now. If you’re “not sure what the evidence will show” – what’s your deal with the vigorous defense? Even allowing for the possibility the evidence could show ANYTHING against GS undercuts your argument. Your argument is – GS is immune from any duty to either side of the trade, isn’t it?

  51. Do you think what we learned in Senate hearing was more or less vulgar than Barry Ritholtz’s article?

  52. William Peterson

    “You haven’t addressed my point that it shouldn’t matter to a buyer who ‘selected the portfolio’. The buyer can and should look at the actual dang portfolio. Do they like it or not and for what price.”

    One point I tried to make in my original post about the horserace is that this sort of information-gathering on the components of a complex security is very costly. A long investor may be quite rational in also wishing to have information about the identity and opportunities available to the short side – this is a valuable and cheap signal. If I am offered a trade which implies selling a large put option on the equity of a corporation it is quite rational for my decision to be influenced by the identity of the buyer – I might be willing to sell to a ‘neutral’ party, but not to the corporate CEO.

    Unfortunately if CDS and similar derivatives allow the issuer to conceal this information, or to ‘game’ this signal by misrepresenting their true economic interest, the long investor is left with a choice between costly information gathering and not investing at all – the market (which has economic value because it reallocates risk effectively) will collapse.

    A further point (relevant to many RMBS, though probably not here) is that in many cases the portfolio selector can vary the contents of the portfolio after the long investor has bought (for example, to replace mortgages which have paid off), In this case it is essential that the selector has the same incentives as the long investor. If the selector is short he is in exactly the same position as my hypothetical crooked jockey. In this case a system in which the investor can not know the identity, and the position, of the portfolio selector is inherently a rigged casino. And, once people realise what is going on, rigged casinos attract few gamblers.

  53. William Peterson

    One point I tried to make in my original post about the horserace is that this sort of information-gathering on the components of a complex security is very costly. A long investor may be quite rational in also wishing to have information about the identity and opportunities available to the short side – this is a valuable and cheap signal. If I am offered a trade which implies selling a large put option on the equity of a corporation it is quite rational for my decision to be influenced by the identity of the buyer – I might be willing to sell to a ‘neutral’ party, but not to the corporate CEO.

    Unfortunately if CDS and similar derivatives allow the issuer to conceal this information, or to ‘game’ this signal by misrepresenting their true economic interest, the long investor is left with a choice between costly information gathering and not investing at all – the market (which has economic value because it reallocates risk effectively) will collapse.

    A further point (relevant to many RMBS, though probably not here) is that in many cases the portfolio selector can vary the contents of the portfolio after the long investor has bought (for example, to replace mortgages which have paid off), In this case it is essential that the selector has the same incentives as the long investor. If the selector is short he is in exactly the same position as my hypothetical crooked jockey. In this case a system in which the investor can not know the identity, and the position, of the portfolio selector is inherently a rigged casino. And, once people realise what is going on, rigged casinos attract few gamblers.

  54. One point I tried to make in my original post about the horserace is that this sort of information-gathering on the components of a complex security is very costly. A long investor may be quite rational in also wishing to have information about the identity and opportunities available to the short side – this is a valuable and cheap signal.

    Sorry, if it’s too ‘costly’ for you to look at the 82 or so bonds in the portfolio you’re about to invest in, you shouldn’t be.

    [put option] I might be willing to sell to a ‘neutral’ party, but not to the corporate CEO.

    That has to do with inside information (already addressed), not a factor in this case

    Unfortunately if CDS and similar derivatives allow the issuer to conceal this information, or to ‘game’ this signal by misrepresenting their true economic interest,

    There’s no possible way to ‘game’ the fact that when IKB went long, someone was going short. This was not ‘hidden’ from them, because it’s not possible to ‘hide’ that fact which is inherent in the nature of the transaction.

    the long investor is left with a choice between costly information gathering and not investing at all – the market (which has economic value because it reallocates risk effectively) will collapse.

    If you’re so correct about it being too costly for long CDO investors to look at portfolios they’re buying, then maybe the CDO market should collapse. In any event, at the time of this transaction it hadn’t, and IKB bought. The indictment of Goldman people have here is premised on the notion that IKB couldn’t be bothered to look at the portfolio. That is a quite astonishing premise by which to attempt to indict Goldman rather than IKB.

    in many cases [in RMBS] the portfolio selector can vary the contents of the portfolio after the long investor has bought

    Indeed, there are managed CDOs, so in those cases knowing who the Portfolio Manager is, is important. But that is not the case with Abacus, it was static, and ACA was not the Portfolio Manager, merely the ‘Selector’.

  55. So, if the law rules that GS can’t omit

    Can’t omit what? Identity of someone they had lined up as a short on the other side? Let me know if/when the law actually rules that….

    Then, you go on to talk about interest rate swaps. But – wait- that’s a different situation entirely.

    Why. How are they different in a way that is important to this discussion. They are derivatives, they are swaps, they are synthetic. You can’t just say ‘different situation entirely’, you have to explain how.

    But, the market maker/participant owed equal duties of disclosure, in my opinion.

    ‘Disclosure’ of someone they had lined up on the other side? It’s your ‘opinion’ that they ‘owed’ this to IKB? Well that’s nice. But your opinion is not based on anything in law.

    IKB was dumb. But, your victim’s stupidity is not a defense for fraud or material omissions ESPECIALLY if IKB proves they relied on GS and ACA to have their backs

    What fraud and material omissions exactly have been shown. And what do you mean ‘relied on GS and ACA to have their backs’. GS ‘had their backs’ – they showed them the portfolio. So IKB looked at the portfolio. Or didn’t they?

    Hey – some people outsource their due diligence. Dumb? Maybe. But- I think this makes it worse for GS, actually.

    Now the buyer ‘outsourced their due diligence’ to the seller? And this puts the seller at fault? Ridiculous

    I don’t think you need a selection agent for Google and Apple as you might rely on one for a relatively new and more complicated asset.

    My point is you don’t need one for either. In both cases, if you have the portfolio right there in your hands, you can and should evaluate that portfolio on its merits.

    OK, if the court sorts it out against GS, which you leave room for, then the legal nature of these contracts will not be what you’re suggesting,

    Not quite. There are some specific charges against GS (whether they misled IKB into thinking Paulson held equity, etc) that may or may not be proven. But that has nothing to do with the bigger-picture (incorrect) points some here have tried to make about CDOs.

  56. William Peterson

    I don’t think the specific issue about whether Goldman is ‘guilty’ or IKB ‘stupid’ are really crucial (though I believe both statements to be true). The point I have been trying to make is that in certain cases allowing agents to hold market positions which they can conceal from others is very destructive to market capitalism. This is because it makes well-established and inexpensive procedures for signalling beliefs about quality, and aligning the interests of informed and less-informed agents, completely misleading and ineffective.

    A second analogy may be helpful here. At one level, a mugger who robs someone at gunpoint is involved in a zero-sum transaction – it appears there is no consequence for aggregate wealth. But a legal system which allows muggers to operate freely is wealth-destroying, since all honest individuals are forced to take expensive anti-mugging precautions, or hide away in gated communities (ie withdraw from the market).

    Those of us who are not derivative traders, but whose wealth has been badly damaged by what has happened to the global economy since 2007 (as a UK taxpayer, I have ended up paying for some of the losses incurred on this deal), are perfectly entitled to question whether the casino is fair . If we decide that it isn’t we will take our money away – and that will be really bad for genuine entrepreneurs.

  57. Jimmy,

    You’re making this much too complicated.

    Goldman’s long client assumed that someone was short on the synthetic CDO.

    Goldman KNEW that Goldman was short on the synthetic CDO.

    Goldman’s client assumed that Goldman had developed the synthetic CDO, in the case of John Paulson.

    Goldman KNEW that John Paulson had developed the synthetic CDO and Goldman KNEW Paulson’s position on the synthetic CDO.

    Goldman’s client assumed that it had the proper information.

    Goldman KNEW that it had all of the information: the client’s position, Paulson’s position, Paulson’s creation of the synthetic CDO, and Goldman’s position.

    Goldman also KNEW the position of other Goldman clients (Michael Burry comes to mind) in the synthetic CDO and/or sub-prime market.

    Goldman KNEW. Goldman’s client assumed.

    Quants are complicated. Greed is easy.

  58. Simplify it to the breaking point:

    CDS are insurance contracts. Insurance begets moral hazard. Thus insurance needs heavy regulation.

    All the gambling comparisons are very enlightening: Nothing gets financed here. These are purely speculative positions. Gambling is heavily regulated and taxed for a reason.

  59. Bankers insist their OTC derivative operations disburse risk, but in fact what they do is increase risk, exponentially. Because we have an ignoramus Congress which does not yet begin to understand this, all their prattling nonsense about ‘reform’ leaves the problem untouched. The SEC case against Goldman is horses**it. It will be settled for chump change. The crime is allowing these instruments to exist and multiply. Their existence made collapse of the mortgage market simply inevitable.

  60. What exactly about this Ritholtz rant impresses you? The fact that he’s a lawyer? That he swears? Where’s the beef?

  61. Don’t confuse them with intelligence.

  62. That’s a good point about “wanted returns beyond the miserable rates banks were offering thanks to the easy money” – I hadn’t thought about that. So not only did the low interest rates drive “irrational exuberance” toward housing, but forced all the money out of safer instruments and into riskier but “better performing” investments, thus creating a feedback effect and adding more fuel to the fire…

    Hey, but Alan “Atlas Shrugged” Greenspan admitted he was “wrong”, so it’s all ok.

  63. Barry’s not exactly right. The 10b-5 claim requires intent to defraud, i.e. scienter, i.e. “mens rea.” That is the culpable mental state. Of course it can be inferred, but having been long “if true” this transaction is probabtive of the lack of intent to defraud. The claim under § 17a of the Securities Act is another matter. All that’s required is a material misstatement of omission.

  64. Right, “client” in the sense of “customer who bought something from” but not in the sense of “relying on GS for investment advice.” I’m not sure if that makes a difference, but I think the distinction gets lost.

  65. You probably knew this already, or would if you give it a minute, but casinos are rigged. That’s how they stay in business. Ditto for insurance companies.

  66. I think the intrigue only comes from the post hoc analysis. Do we know whether GS told Paulson who was taking the long position? Was there some reason for him to care?

  67. “To your prior point, there doesn’t seem to be much standardization, so the law applies on a case-by-case basis. So, if the law rules that GS can’t omit – then, doesn’t that answer your question about all parties in similar situations?”

    In the briefest of paraphrases, the law says Goldman can’t “make material mistakens or omissions.” Which is why the question is whether Paulson’s identity was material. I haven’t seen anyone state a reason why it was. Instead, the focus tends to be the bare fact that there was a short side, which is inherent in the transaction.

    The other alleged omission is that the short had a handle in picking the portfolio, which Sonic is arguing can’t be materials because the contents of the portfolio was specifically disclosed.

    You, on the other hand, seem simply to want to generalize and ignore the details. Perhaps that is because you don’t know enough to discuss more specifically (fair enough) or perhaps that is because you aren’t really interested in any analysis because you have already reached your view without it.

  68. Ugh. Mistatements. Not mistakens.

  69. William Peterson

    Of course casinos are rigged, in the sense that the house typically has a known built-in advantage (eg in roulette they take the money on both red and black if the wheel comes up zero). What they don’t do (unless the mob has REALLY taken over) is fix the outcome of the wheel after the bets have been placed.

  70. “The other alleged omission is that the short had a handle in picking the portfolio, which Sonic is arguing can’t be materials because the contents of the portfolio was specifically disclosed.”

    Really? It “can’t” be material? Why hide it? If not, why did Khuzami file suit? Obviously, it’s being viewed as a material omission by the SEC and most people I know. I doubt GS will sit on jury as much as they’d like that. So far, most arguments, like yours start with a conclusion that “it can’t be material” and tell us why, but you never explain the desire on GS’s part not to disclose. Or Bear Sterns refusal to do these deals for Paulson, as reported in the press. But, as you know the Senate exhibits show much more. Is the defense – “this secret we’re withholding from our clients is not material”

    Tough spot to be in.

    If it’s not material, disclose it, avoid getting lawsuits filed against you by SEC and clients. If your conclusion IS correct, then GS are terrible risk managers of their own liabilities. They keep unnecessary secrets that generate legal action?

  71. A bit off topic. What if we limit the size of derivatives?

    The Wall Street Pirates would not get some of benefits of the size of the contract they can offer. The not so great americans who do want to bet against the rest will perhaps actually have to bet on banking insurance instead of failure of the rest of us.

    What if as would have happened 50 years ago the pending failure of a local bank would likely have brought sadness instead of the more probably cheers?
    Do that by allowing a local large for here bank to be American and compete. Not Wall Street Pirating for Profit and compete.

    As for jamie DEMON let him take his bank to Somalia.
    One of will survive without the other.

  72. To me, it doesn’t even seem to be relevant information whether there was one person short, or a broader group each partially short or making their own hedges on similar products. The investors on the long side of ABACUS were still able to see what the underlying assets were behind this “synthetic synthetic.” They were able to analyze exactly what would happen to their position of mortgages or CDSs X, Y, and Z went belly up.

  73. You started from the presumption that it was “hidden.” Instead, ask your self (as GS likely did), do we need to tell them? The answer is certainly no. So much for the “why hide it” line of conspiracy. I’m sure they also did not disclose who provided ACA’a coffee, or which anti-virus software they used on incoming emails.

    Look, the point is, “they didn’t say it” is hardly evidence of materiality. Many, many things are not said (they can’t be). So if you want to continue this discussion, please explain why “Paulson is on the short side” was something that the long wanted to know at the time. In doing so, please remember that no one knew who Paulson was at the time.

    Look, I know one of the SEC lawyers on the complaint. He is both a great guy and very, very smart. But I just don’t see the cased here.

  74. Bonds are issued and the money borrowed by the issuer is invested in the economy (eg, in a private business, to build public infrastructure).

    IIUC the cash a protection buyer stands to gain, in a synthetic CDO, is withheld from the economy. This on top of destroying capital.

  75. The SEC case against Goldman Sachs gets more interesting. If the government wins its case it will be the “opening salvo” in what has been described, circumspectly, as the “Securities Lawyers Full Employment Act of 2010″. If the government loses its case against Goldman Sachs there will be further public outrage to fuel the drive for financial reform.

  76. What Markvoch said. There is no such rule as having to tell someone who goes long-risk buying something from you that you have lined up someone on the other side to go short-risk. That is a rule you have made up post facto. It is not an actual rule. Moreover, such a rule would make completely no sense in derivatives trading. Sorry to keep coming back to this example, but try to imagine an interest-rate swaps desk having to tell every single fixed-receiver that someone else was on the other side paying-fixed, and who it was. It is ridiculous, and not even relevant info.

    It also doesn’t seem to occur to you or anyone else here that Paulson may not have wanted his giant short position widely known, and that he had a right to expect GS not to disclose it. By what principle exactly have you decided that IKB had a right to know the size and nature of Paulson’s investment? None, of course, other than a desire to find something wrong with what GS did.

  77. Sorry, meant “what AJ said” obviously :)

  78. William Peterson

    Are you claiming that anyone holding a large short poosition must be entitled to conceal it from other market participants (and presumably also from regulators)? If so, how do you stop CEOs shorting their own company, and then intentionally destroying it (which I, and I suspect most people, would regard as an exceptionally undesirable form of fraud). If on the other hand you accept that there are situations in which such positions must be revealed, then it is at least conceivable (in view of Paulson’s role in structuring the CDO) that this was one of them.

  79. Not quite. One person short, as opposed to a broader group, would mean a different risk profile in counterparty risk (ability to sustain the payment). But that is really not the point.
    The key point is that the short participated in the selection of the pool. That is a major issue which a reasonable person would expect disclosure (But then it would likely impact the pricing thereof).
    Another information which should be (but usually not) considered by the buyers is the total CDS exposure against the underlying MBS. In many cases the derivates are magnitude times that of the underlying securities making it possible to manipute the underlying securiies. One hedge fund purchased and made good all the underlying securities therebyt making a killing on the long side of the CDS. But then GS cried foul and ligitated.

  80. One person short, as opposed to a broader group, would mean a different risk profile in counterparty risk (ability to sustain the payment). But that is really not the point.

    In fact, it’s completely not the point at all. IKB bought a piece of paper issued by Goldman’s SPV (they were not facing Paulson) so there was never really an issue of counterparty risk. James Kwak above, and some commenters, are trying to make the claim that IKB would have an interest in or right to know (for the life of me, I know not why) who was short the other side of the risk beyond that, i.e. from SPV -> Goldman -> Paulson (or whoever), and that it would matter whether it was one or many ultimate short risk holders. That information would have had no relevance whatsoever to IKB’s counterparty exposure, which again, regardless of who Goldman lined up on the short side, still would have consisted of holding a piece of paper issued by the Abacus vehicle.

    The key point is that the short participated in the selection of the pool. That is a major issue which a reasonable person would expect disclosure (But then it would likely impact the pricing thereof).

    The pool is the pool. Long-risk value on the pool depends on the properties of the pool, which can be ascertained, estimated, modeled, or whatever, by looking at the names in the pool and analyzing them. Knowing who selected the pool does not affect the pricing, unless you’re doing it wrong. I can’t believe how many times i have had to point this out.

    Another information which should be (but usually not) considered by the buyers is the total CDS exposure against the underlying MBS

    That is a better and more interesting point, but still points towards the fact that the long-risk buyer could have and should have checked out the pool before buying. Which they had every ability and opportunity to do, since they, like, knew what the pool was and all.

  81. William, I agree there are times when positions must be disclosed, especially to regulators. If you believe this was one of them, feel free to explain why. In actual practice, I have found that clients don’t exactly appreciate you blabbing about their holdings to others who have no right to know it, for no good reason. But again, if you think there is some reason Goldman should have done this, some law compelling Goldman to do this, feel free to cite it.

  82. There is a difference between “value” and “price”. That the short selected the pool does not affect the underlying “value”, but certainly impacts the price due to buyers’ perspective. It happens every day everywhere.

  83. Also, risk of concentration, remember AIG.

  84. Well in that sense the buyer’s mood, or their trading book’s prior contents, or their marital situation, or their network connectivity, or their favorite sports team’s record, or whether it’s 4:15 on a Friday afternoon before a 3-day weekend, can affect the price of something. But people here are arguing (if they’re saying anything of import) that knowing about Paulson and the identity of Paulson was material information relevant to the deal’s value. And as you and I have now agreed, it was not.

  85. Let’s not get lost in the weeds of detail here. (After all, that’s exactly the effect that the artificial complexity of these products was designed to produce.)

    Warren told Barry to leave Lloyd alone, and so our elites have sent the signal that CEOs have impunity.

    The SEC investigation is, therefore, only about expendable underlings, and not about accounting control fraud, which, by definition, happens at the executive level. Our system works!

  86. I would be interested to learn exactly how/why does the protection buyer ‘withhold’ the protection payments he receives ‘from the economy’.

  87. “This is not at all what I was saying – what I was saying was that with the shorts selecting the portfolio, the AAA was even less AAA than it would have been had the longs chosen the portfolio. Whether IKB and ACA should have done their own fundamental analysis is a completely different question – but there was an interesting take on that question in the blogoshphere which I have referred to here.”

    I guess I just place more weight on ACA’s responsibility here as the institution selling its credit-picking prowess. And given how poorly all these products performed, it’s a moot point that some of the underlying products were less AAA than others. Paulson could have saved himself some time agonizing over credit selection. Nevertheless, I hear what you are saying…

  88. I’m not sure how to address a straw-man that equates legal, consensual transactions to muggings. One of these things is not like the other…

    That some of your wealth has been damaged as a UK taxpayer strikes me as a legitimate grievance you have against your government, for bailing out RBS/ABN Amro/etc. I would support you in that grievance. This has nothing to do with Goldman.

    Indeed, I encourage you to ‘take [your] money away’ – including, from your government, by opposing bailouts and higher taxes. Or is that not where you were headed?

    best

  89. Agreed, you could argue that even the transactions we are debating here are less rigged than casinos since it’s impossible to really know the odds.

  90. William Peterson

    I think Paulson’s short position should have been revealed becuase of his role in structuring the offering. If he had played no part in this then (apart from the possibility of manipulating the underlying security, not relevant here) I cannot see any harm in anonymity.

    I think we now agree on what we disagree about.

  91. William Peterson

    There are two ways you can run a capitalist system. In one ‘caveat emptor’ applies to most transactions, and I must always take precautions to ensure that I am not cheated. (A transaction which is apparently mutually agreed can still be rather like a ‘mugging’ if the one side misrepresents the quality of the good, or fixes the outcome after the contract has been signed). This is what you could call ‘libertarian capitalism’ – minimal state regulation of contracts, so that every individual must protect their own position, and the devil take the hindmost.

    The alternative form of capitalism implies some degree of regulation and intervention to prevent greed from undermining the trust which I and many other believe are essential if the system is to operate effectively. It’s possible that in such a system financial operators will not be quite so well paid – but most other people might well prefer it.

    Incidentally, had the UK government not bailed out RBS it would have been the depositors who bore the losses – not the bankers who made the mistakes. So that is not where I was heading. Whoever loses, it seems perfectly reasonable to think about better ways of preventing banks and those who run them from the consequences of their self-interest and stupidity.

  92. Hmm. Well I can only say I speak from direct firsthand experience when I say that we are very, very, very far indeed from a system that could be even remotely characterized as involving ‘minimal state regulation’. (And ironically, though it’s tangential to this point, I should point out that it is state regulation alone which created the incentive to structure CDOs in the first place.)

    As for who takes losses, I can only say I do not think that bailing out banks is a likely to prove an effective means of preventing them from the consequences of their own stupidity.

  93. tippygolden

    I’m not talking about the money the protection buyer receives.

  94. tippygolden

    In the Abacus deal, the protection sellers (ABN and IKB) did not have $1 billion in collateral. The German and British taxpayers ended up paying for ABN and IKB’s losses.

  95. Sonic Charmer:
    There is no need to disclose Paulson’s identify. His specific identity is irrelevant. There should simply be a fair disclosure along the line of “ACA, with input from one or more CDS shorts (protection buyers), selected the reference pool….”. No need to disclose names, just the process. But then, don’t you believe that the buyers would beat down the price or simply passed on the deal. It is therefore quite material.