In a post 8 days ago I said the Goldman Sachs SEC case was foolish and wouldn't stand up in court. I also surmised that it would likely be settled instead. Various news reports indicate that this is now likely to occur. The SEC isn't dumb, this case won't go to court but the settlement will not likely occur until after the President signs the financial reform bill which is currently in reconciliation. As politics go, this saga was a shrewd move by the White House but somewhat disconcerting in that it was intended to capitalize on the relative naivete of the typical voter or CNN watcher. Perhaps the best takeaway from the whole episode is just how clueless Senators are, Sen. Levin takes the cake in my opinion.
A few readers asked about a better explanation of the synthetic CDO, how it's built and why I wrote that the case was a farce. It's probably best to explain this in steps.
1) Goldman Sachs acted as a market maker for this transaction. A market maker's job, simply put, is to match a buyer and seller in the market place. Occasionally in the finance world this requires that market maker take one side of the transaction. For instance, assume investor A wants to sell 100K shares of General Electric at $16 per share and hires Goldman Sachs to do this. Goldman Sachs finds investor B who wants 90K shares at $15.90. A and B settle on a price of $15.95, B buys 90K shares, and Goldman buys the other 10K to facilitate the transaction. It will then sell these other 10K shares to another investor. The market maker's central role is to find a counter-party to the trade desired by their client, Investor A. They could care less about the price as long as it is fair according to similar market transactions. This is very different from a fiduciary. Most people are familiar with that term in reference to a real estate agent hired by a buyer. The fiduciary must act only in the best interests of their client, the buyer. For those of you who have been part of a real estate transaction, it goes without saying that the agent can not be a fiduciary for both the buyer (seeking to minimize the price) and the seller (maximizing the price). This then is a very different role than one played by Goldman Sachs as a market maker and logically follows that you can not be both market maker and fiduciary.
2) John Paulson, a now famous hedge fund manager with a negative view of the housing market in 2006/7, came to Goldman Sachs and requested to short (bet against) the housing market through the use of a synthetic CDO. As explained below, a synthetic CDO is a zero sum transaction where two parties with opposite views on an underlying asset (the housing market in this case) construct a legal wager through the use of credit default swaps. A credit default swap is very similar to your standard home/life insurance policy, for a yearly fee the purchaser gets insurance which pays out if the underlying mortgages default or some other credit event occurs (downgrade, etc...) instead of a fire/earthquake/tornado or death. As an example, Jeff Greene, who is now running as a Democrat for the Florida Senate seat, had the same view as Paulson and purchased $1 billion in credit default swaps (insurance on mortgage bonds) for a yearly fee of $12 million betting that the bonds would default (source: The Greatest Trade Ever.) Greene apparently made about $500-800 million through this investment strategy, quite the payoff.
3) Goldman hired ACA, an investment management firm, to select the assets (mortgage bonds) that the synthetic CDO "referenced." (In keeping with our home insurance policy example, ACA was responsible for choosing the house and the occupants which is what determines the risk of fire). Paulson had a hand in choosing these as well, but the final approval authority was ACA. As I explained below, this is not unusual if you think of any other wager. You would not bet on a horse race without knowing the participants, distance, surface type and so on. For a successful bet to take place, both parties must agree to all the terms. Only the fool hardy would blindly accept the conditions first proposed by the opposing bettor, children on playgrounds instinctively know this. ACA had to keep Paulson happy otherwise he would walk away from the transaction which would cause it to collapse since it requires two parties, one short and one long.
4) ACA and Goldman then found parties to take the other side of the bet. These large banks, IKB and ABN (as well as Goldman), sold Paulson the credit default swaps. The banks agreed to pay him if a default occurred while Paulson paid them a yearly fee.
5) The bonds defaulted soon afterward and Paulson made a fortune (around $1 billion according to various news reports.)
This is a very simple explanation of what happened. The SEC's complaint centers around Goldman allowing Paulson to have a say in the mortgage bonds which were used and whether the banks were informed of this. An impartial observer would conclude that banks must have known there was a party shorting the transaction and that the other party must have agreed to the underlying mortgage bonds. To me, a non-lawyer, this about as ridiculous an accusation of fraud as you could make.
Showing posts with label GS. Show all posts
Showing posts with label GS. Show all posts
Monday, May 24, 2010
Sunday, May 16, 2010
Goldman Sachs SEC Case
I wrote this in an email to someone else a few weeks ago, but thought it would make a good post. Most people are probably familiar with the civil fraud case brought against Goldman Sachs by the SEC. This presentation given by a professor at Stanford last month is a useful explaination of the other side of the story - that the SEC brought a highly partisan case against an unpopular firm with little probability of succeeding. Now faced with proving this to an educated judge/jury, a far more likely outcome is that the SEC accepts the futility of this lawsuit and negotiates a Wall Street wide settlement comprised of new (and much needed) rules on derivatives and as well as some meaningless amount of money (like $20B, sounds like a lot to voters but not much when you spread it across dozens of parties).
I personally am unconvinced that Goldman's behavior was illegal in any sense, though the social utility of a synthetic CDO escapes me. While their actions do not look good to mainstream America, people always look bad when they are right and the majority is wrong and looking for a fall guy. If the argument is that market makers in illiquid complex securities should have some fiduciary responsibility to buyers and sellers, then I might find that an interesting point of debate. But unfortunately for the SEC, the law has very different definitions of a fiduciary and market maker, simply put a fiduciary has to act in the client's best interests while a market maker just has to offer a fair market price. I would love to see the flip side of this “fraud” prosecuted wherein investor A mis-prices their securities and through a market maker sells them to investor B whose opinion proves instantly correct resulting in profits, i.e. arbitrage. Should the market maker then be required to inform the participant of the relative wisdom of his decisions prior to executing the order? Of course not, the investor is responsible for evaluating assets prior to buying or selling them.
ACA was the final authority on securities in the portfolio and as much as the SEC would like you to believe otherwise, they had to have approved every single asset in the portfolio. Furthermore, the short position would have to be permitted some input in the formation of portfolio since this was a synthetic collateralized debt obligation (CDO), a zero-sum game where shorts must equal longs. Synthethic CDOs only mirror the performance of other assets, in this case CDOs (click through for explanation of a CDO) comprised of mortgage backed securities (MBS). To grossly oversimplify, this is analogous to wagering on a football game. Two parties each wager $100 and the bets perfectly offset (A bets $100 that team X loses, B bets $100 that team X wins), neither the existence of the bet nor the possibility that Mike Dikta is person B affects the outcome of the actual game. In a similar fashion, who is long or short the synthetic CDO is immaterial, it won't affect the performance of the underlying CDO in any manner. It would make no sense for the person on the short (losing) side of the bet, either football or synthetic CDO, to not care about the identity of the underlying team (bond). No sane investor would give Goldman their money and just tell them to short a random pool of securities. The SEC probably scored some brownie points with its political masters, but the judge/jury that presides over this will have slightly more cognitive ability than your average NY Times reporter or MSNBC talking head.
On a side note, I find it much more disturbing that the Moody’s employee, Eric Kolchinsky, believes a seller or buyer’s identity to be material to the valuation of the asset. That seems to be his argument when he says that he would have rated them differently if he had known that John Paulson would short these. I am frankly appalled that Senators, or at least their staffers, did not recognize the outrageous nature of this statement immediately. For the investing illiterate, imagine that when you purchase a home, the home inspector sizes you up before the inspection. He concludes that you are either very knowledgeable about carpentry, electricity, and plumbing or that you have not a clue. If you are the former, you get a detailed inspection, the latter (95% of all home buyers) just get charged a fee and receive an inspection which is significantly less rigorous. Moody's is supposed to be an impartial observer, evaluating the assets with the same degree of concern regardless of the parties involved. When Kolchinksy attests that he would have paid closer attention to the deal had he know that Paulson held the short position, he is implying that the quality of his work as rater depends on his perception of the investor. It could alternatively mean that Kolchinsky did not understand that a synthetic CDO requires a short investor, but I will go out on a limb and surmise that while he is apparently not a bright individual, he can not possibly be that oblivious. I do personally think Kolchinsky isn't very bright, and offer as evidence his own statement as well as the fact that Paulson's investing prowess wasn't well known until a year after these deals occurred in early 2007. In other words, Kolchinsky is wrong to think Paulson's identity matters, and even less believable for thinking that he would have used it at that time. Be that as it may, if I ever invested in a deal that was rated by Kolchinsky's team, I would begin considering a civil fraud suit against Moody's for any deal that blew up on me.
Interestingly enough, Sen. Levin questioned Daniel Sparks, head of Goldman Sachs' mortgage desk, on this very subject and Mr. Sparks expressed astonishment that a Moody's employee would say something like that. Senator Levin was lost in the sauce (not just at the moment, the entirety of his performance during the panel leads me to question his ability) and the whole episode floated well over his head as well as those of the reporters in the room. It is equally troubling that Pulitzer prize winning reporters don't pick up on this as the real story. Moody's and S&P are the largest rating agencies in the world, and in any given week their credit upgrades/downgrades are responsible for more market movement than the mortgage desk at Goldman Sachs. If they are not competent enough to do their job on a synthetic CDO, what about whole countries like the PIIGS (Portugal, Ireland, Iceland, Greece, and Spain)?
I personally am unconvinced that Goldman's behavior was illegal in any sense, though the social utility of a synthetic CDO escapes me. While their actions do not look good to mainstream America, people always look bad when they are right and the majority is wrong and looking for a fall guy. If the argument is that market makers in illiquid complex securities should have some fiduciary responsibility to buyers and sellers, then I might find that an interesting point of debate. But unfortunately for the SEC, the law has very different definitions of a fiduciary and market maker, simply put a fiduciary has to act in the client's best interests while a market maker just has to offer a fair market price. I would love to see the flip side of this “fraud” prosecuted wherein investor A mis-prices their securities and through a market maker sells them to investor B whose opinion proves instantly correct resulting in profits, i.e. arbitrage. Should the market maker then be required to inform the participant of the relative wisdom of his decisions prior to executing the order? Of course not, the investor is responsible for evaluating assets prior to buying or selling them.
ACA was the final authority on securities in the portfolio and as much as the SEC would like you to believe otherwise, they had to have approved every single asset in the portfolio. Furthermore, the short position would have to be permitted some input in the formation of portfolio since this was a synthetic collateralized debt obligation (CDO), a zero-sum game where shorts must equal longs. Synthethic CDOs only mirror the performance of other assets, in this case CDOs (click through for explanation of a CDO) comprised of mortgage backed securities (MBS). To grossly oversimplify, this is analogous to wagering on a football game. Two parties each wager $100 and the bets perfectly offset (A bets $100 that team X loses, B bets $100 that team X wins), neither the existence of the bet nor the possibility that Mike Dikta is person B affects the outcome of the actual game. In a similar fashion, who is long or short the synthetic CDO is immaterial, it won't affect the performance of the underlying CDO in any manner. It would make no sense for the person on the short (losing) side of the bet, either football or synthetic CDO, to not care about the identity of the underlying team (bond). No sane investor would give Goldman their money and just tell them to short a random pool of securities. The SEC probably scored some brownie points with its political masters, but the judge/jury that presides over this will have slightly more cognitive ability than your average NY Times reporter or MSNBC talking head.
On a side note, I find it much more disturbing that the Moody’s employee, Eric Kolchinsky, believes a seller or buyer’s identity to be material to the valuation of the asset. That seems to be his argument when he says that he would have rated them differently if he had known that John Paulson would short these. I am frankly appalled that Senators, or at least their staffers, did not recognize the outrageous nature of this statement immediately. For the investing illiterate, imagine that when you purchase a home, the home inspector sizes you up before the inspection. He concludes that you are either very knowledgeable about carpentry, electricity, and plumbing or that you have not a clue. If you are the former, you get a detailed inspection, the latter (95% of all home buyers) just get charged a fee and receive an inspection which is significantly less rigorous. Moody's is supposed to be an impartial observer, evaluating the assets with the same degree of concern regardless of the parties involved. When Kolchinksy attests that he would have paid closer attention to the deal had he know that Paulson held the short position, he is implying that the quality of his work as rater depends on his perception of the investor. It could alternatively mean that Kolchinsky did not understand that a synthetic CDO requires a short investor, but I will go out on a limb and surmise that while he is apparently not a bright individual, he can not possibly be that oblivious. I do personally think Kolchinsky isn't very bright, and offer as evidence his own statement as well as the fact that Paulson's investing prowess wasn't well known until a year after these deals occurred in early 2007. In other words, Kolchinsky is wrong to think Paulson's identity matters, and even less believable for thinking that he would have used it at that time. Be that as it may, if I ever invested in a deal that was rated by Kolchinsky's team, I would begin considering a civil fraud suit against Moody's for any deal that blew up on me.
Interestingly enough, Sen. Levin questioned Daniel Sparks, head of Goldman Sachs' mortgage desk, on this very subject and Mr. Sparks expressed astonishment that a Moody's employee would say something like that. Senator Levin was lost in the sauce (not just at the moment, the entirety of his performance during the panel leads me to question his ability) and the whole episode floated well over his head as well as those of the reporters in the room. It is equally troubling that Pulitzer prize winning reporters don't pick up on this as the real story. Moody's and S&P are the largest rating agencies in the world, and in any given week their credit upgrades/downgrades are responsible for more market movement than the mortgage desk at Goldman Sachs. If they are not competent enough to do their job on a synthetic CDO, what about whole countries like the PIIGS (Portugal, Ireland, Iceland, Greece, and Spain)?
Subscribe to:
Posts (Atom)