Thursday, December 24, 2009

Goldman Sachs Responds to NY Times on Synthetic CDOs

Background: The New York Times published a story on December 24th primarily focused on the synthetic collateralized debt obligation business of Goldman Sachs. In response to questions from the paper prior to publication, Goldman Sachs made the following points.

As reporters and commentators examine some of the aspects of the financial crisis, interest has gravitated toward a variety of products associated with the mortgage market. One of these products is synthetic collateralized debt obligations (CDOs), which are referred to as synthetic because the underlying credit exposure is taken via credit default swaps rather than by physically owning assets or securities. The following points provide a summary of how these products worked and why they were created.

Any discussion of Goldman Sachs’ association with this product must begin with our overall activities in the mortgage market. Goldman Sachs, like other financial institutions, suffered significant losses in its residential mortgage portfolio due to the deterioration of the housing market (we disclosed $1.7 billion in residential mortgage exposure write-downs in 2008). These losses would have been substantially higher had we not hedged. We consider hedging the cornerstone of prudent risk management.

Synthetic CDOs were an established product for corporate credit risk as early as 2002. With the introduction of credit default swaps referencing mortgage products in 2004-2005, it is not surprising that market participants would consider synthetic CDOs in the context of mortgages. Although precise tallies of synthetic CDO issuance are not readily available, many observers would agree the market size was in the hundreds of billions of dollars.

Many of the synthetic CDOs arranged were the result of demand from investing clients seeking long exposure.

Synthetic CDOs were popular with many investors prior to the financial crisis because they gave investors the ability to work with banks to design tailored securities which met their particular criteria, whether it be ratings, leverage or other aspects of the transaction.

The buyers of synthetic mortgage CDOs were large, sophisticated investors. These investors had significant in-house research staff to analyze portfolios and structures and to suggest modifications. They did not rely upon the issuing banks in making their investment decisions.

For static synthetic CDOs, reference portfolios were fully disclosed. Therefore, potential buyers could simply decide not to participate if they did not like some or all the securities referenced in a particular portfolio.

Synthetic CDOs require one party to be long the risk and the other to be short so without the short position, a transaction could not take place.

It is fully disclosed and well known to investors that banks that arranged synthetic CDOs took the initial short position and that these positions could either have been applied as hedges against other risk positions or covered via trades with other investors.

Most major banks had similar businesses in synthetic mortgage CDOs.

As housing price growth slowed and then turned negative, the disruption in the mortgage market resulted in synthetic CDO losses for many investors and financial institutions, including Goldman Sachs, effectively putting an end to this market.

And from the Business Insider's Henry Blodget:

Is it really a scandal? If you view Wall Street the old-fashioned way, yes: The firm sold its clients a product and then bet against it. This allowed Goldman to make money two ways instead of just one: Product origination fees and trading profits, all at its clients' expense.

If you take a more realistic view of Wall Street, however, this is just an everyday reality. Wall Street firms like Goldman sit between buyers and sellers, and they also buy and sell on their own behalf. Every single transaction these firms conduct entails a conflict of interest: Everyone is always making bets, and someone is always winning and losing them. It's just not obvious until later which party that is.

The way we suspect Goldman viewed its behavior in the housing scenario above is as follows:

  • Clients are desperate for products with which to bet on the housing market
  • We can help our clients by creating those products and get paid handsomely for doing so.
  • We're negative on the housing market, so we can use the products bet against the housing market. If we're right, we'll make some money there, too.

Don't forget that the buyers of Goldman's CDOs were among the most sophisticated investors in the world. These investors were paid to analyze the housing market and make smart investment decisions based on that analysis. The investors did their analysis and concluded that the housing market was going to go up. Goldman did its own analysis and came to the opposite conclusion. But it was at least relatively a fair fight.

Don't forget that the clients who bought the CDOs may have turned around and sold them to someone else 30 seconds after buying them. We're not talking about mom-and-pop buy-and-hold investors here. We're talking about institutions who often roll their portfolios over several times a month. We're also talking about institutions that were making an absolute killing going long the housing market--so much so that they were desperate for more products with which to continue making the same bet.

Don't forget also that these particular CDOs were likely a tiny percentage of the total products that Goldman sold to these clients over the period in question. Many of the other products Goldman sold the same clients may have performed superbly, making the clients boatloads of money. When all of the clients' dealings with Goldman are netted out, the clients may have done very well.

Don't forget that, in this instance, Goldman was not hired to manage money for its clients. Goldman in this case was acting as a product dealer. The products Goldman sold allowed clients to bet on or against the housing market (by going short or long). The products appear to have worked the way they were supposed to.

Don't forget that everything is obvious in hindsight. Goldman could have been wrong about the housing market, and its clients could have been right. In that case, we wouldn't be talking about a scandal. We would be talking about how Goldman got greedy and made dumb bets.

So is it a scandal?

If Goldman's traders and salespeople had secret information about the housing market that they did not share with clients, yes, it's a scandal. That's called intentionally screwing your clients, and Goldman deserves to be strafed for it.

If Goldman was merely creating products to address market demand and then using those products itself, however, it's inevitable. As long as brokerage firms are allowed to have proprietary trading desks (which we certainly don't need to allow), there will always be cases in which firms bet against some of their clients. To think otherwise is just being naive,

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