Tuesday, April 27, 2010

A Short History of Derivative Security Markets

By Ernst Juerg Weber, University of Western Australia - UWA Business School

Abstract: Contracts for future delivery of commodities spread from Mesopotamia to Hellenistic Egypt and the Roman world. After the collapse of the Roman Empire, contracts for future delivery continued to be used in the Byzantine Empire in the eastern Mediterranean and they survived in canon law in western Europe. It is likely that Sephardic Jews carried derivative trading from Mesopotamia to Spain during Roman times and the first millennium AD, and, after being expelled from Spain, to the Low Countries in the sixteenth century. The first derivatives on securities were written in the Low Countries in the sixteenth century. Derivative trading on securities spread from Amsterdam to England and France at the turn of the seventeenth to the eighteenth century, and from France to Germany in the early nineteenth century. Circumstantial evidence indicates that bankers and banks were at the forefront of derivative trading during the eighteenth and nineteenth centuries.

Download paper here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1141689

Monday, April 26, 2010

The Mysterious "Fed Staffers" document that stalled the Dodd bill

Courtesy of the Financial Times here are four pages of "Fed staff" comments on the Dodd financial reform bill: av.r.ftdata.co.uk/files/2010/04/Senate-Ag-bill-comments-april-24-2010-FED.pdf.

According to the Times:
It details seven areas where derivatives-related reform needs a comprehensive re-draft — a re-draft that might have the handy side-effect of helping Wall St banks avoid having to spin off their derivatives operations.

Gillian Tett and Paul Krugman on the "murky world" of credit ratings

The FT's Gillian Tett welcomes last week's publication of the rating agency emails:

Another week, another bout of e-mail embarrassment. Goldman Sachs shot into the spotlight 10 days ago, after the Securities and Exchange Commission accused the bank of fraud and released e-mails written by Fabrice Tourre, a trader, describing the financial products he created as useless “monstruosities” (sic).

A senate committee released a fresh batch of documents at the weekend, including e-mails from senior Goldman officials crowing that the bank could make “serious money” from America’s mortgage disaster. These will be debated in Washington on Tuesday.

But these have not been the only electronic howlers. A senate committee last week released e-mails from Standard & Poor’s and Moody’s which revealed something long suspected but never proven: that from 2005 the rating agencies faced growing pressure to cut corners in how they rated complex credit instruments in order to win lucrative business from banks....

It is fascinating, almost touching, stuff. Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working. But by 2007 they, like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also in a strange, geeky silo, into which few non-bankers ever peered...

There are two important lessons. One is that what went wrong in finance was fundamentally structural, as an entire system spun out of control It might seem tempting to lash out at a few colourful traders but that is a sideshow: what is needed is systemic reform that removes conflicts of interest.

The second lesson is that the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense.

And in the NY Times, Paul Krugman:

What those [rating agency] e-mails reveal is a deeply corrupt system. And it’s a system that financial reform, as currently proposed, wouldn’t fix.

The rating agencies began as market researchers, selling assessments of corporate debt to people considering whether to buy that debt. Eventually, however, they morphed into something quite different: companies that were hired by the people selling debt to give that debt a seal of approval.

Those seals of approval came to play a central role in our whole financial system, especially for institutional investors like pension funds, which would buy your bonds if and only if they received that coveted AAA rating.

It was a system that looked dignified and respectable on the surface. Yet it produced huge conflicts of interest. Issuers of debt — which increasingly meant Wall Street firms selling securities they created by slicing and dicing claims on things like subprime mortgages — could choose among several rating agencies. So they could direct their business to whichever agency was most likely to give a favorable verdict, and threaten to pull business from an agency that tried too hard to do its job. It’s all too obvious, in retrospect, how this could have corrupted the process.

And it did. The Senate subcommittee has focused its investigations on the two biggest credit rating agencies, Moody’s and Standard & Poor’s; what it has found confirms our worst suspicions. In one e-mail message, an S.& P. employee explains that a meeting is necessary to “discuss adjusting criteria” for assessing housing-backed securities “because of the ongoing threat of losing deals.” Another message complains of having to use resources “to massage the sub-prime and alt-A numbers to preserve market share.” Clearly, the rating agencies skewed their assessments to please their clients.

These skewed assessments, in turn, helped the financial system take on far more risk than it could safely handle. Paul McCulley of Pimco, the bond investor (who coined the term “shadow banks” for the unregulated institutions at the heart of the crisis), recently described it this way: “explosive growth of shadow banking was about the invisible hand having a party, a non-regulated drinking party, with rating agencies handing out fake IDs.”

So what can be done to keep it from happening again?

The bill now before the Senate tries to do something about the rating agencies, but all in all it’s pretty weak on the subject. The only provision that might have teeth is one that would make it easier to sue rating agencies if they engaged in “knowing or reckless failure” to do the right thing. But that surely isn’t enough, given the money at stake — and the fact that Wall Street can afford to hire very, very good lawyers.

What we really need is a fundamental change in the raters’ incentives. We can’t go back to the days when rating agencies made their money by selling big books of statistics; information flows too freely in the Internet age, so nobody would buy the books. Yet something must be done to end the fundamentally corrupt nature of the the issuer-pays system.

An example of what might work is a proposal by Matthew Richardson and Lawrence White of New York University. They suggest a system in which firms issuing bonds continue paying rating agencies to assess those bonds — but in which the Securities and Exchange Commission, not the issuing firm, determines which rating agency gets the business.

I’m not wedded to that particular proposal. But doing nothing isn’t an option. It’s comforting to pretend that the financial crisis was caused by nothing more than honest errors. But it wasn’t; it was, in large part, the result of a corrupt system. And the rating agencies were a big part of that corruption.

Saturday, April 24, 2010

E-Mails Show Goldman Boasting as Meltdown Unfolds

Original posted on U.S. Senator Carl Levin's website:

“Investment banks such as Goldman Sachs were not simply market-makers, they were self-interested promoters of risky and complicated financial schemes that helped trigger the crisis,” said Sen. Levin. “They bundled toxic mortgages into complex financial instruments, got the credit rating agencies to label them as AAA securities, and sold them to investors, magnifying and spreading risk throughout the financial system, and all too often betting against the instruments they sold and profiting at the expense of their clients.” The 2009 Goldman Sachs annual report stated that the firm “did not generate enormous net revenues by betting against residential related products.” Levin said, “These e-mails show that, in fact, Goldman made a lot of money by betting against the mortgage market.”

The four exhibits released today are Goldman Sachs internal e-mails that address practices involving residential mortgage-backed securities and collateralized debt obligations (CDOs), financial instruments that were key in the financial crisis.

In one of the e-mails released today, Mr. Blankfein stated that the firm came out ahead in the mortgage crisis by taking short positions. In an e-mail exchange with other top Goldman Sachs executives, Mr. Blankfein wrote: “Of course we didn't dodge the mortgage mess. We lost money, then made more than we lost because of shorts.”

In a second e-mail, Goldman Sachs Chief Financial Officer David Viniar, who also will testify on Tuesday, responded to a report on the firm's trading activities, showing that – in one day - the firm netted over $50 million by taking short positions that increased in valued as the mortgage market cratered. Mr. Viniar wrote: “Tells you what might be happening to people who don't have the big short.” Levin said: “There it is, in their own words: Goldman Sachs taking ‘the big short’ against the mortgage market.”

In a third e-mail, Goldman employees discussed the ups and downs of securities that were underwritten and sold by Goldman and tied to mortgages issued by Washington Mutual Bank's subprime lender, Long Beach Mortgage Company. Reporting the “wipeout” of one Long Beach security and the “imminent” collapse of another as “bad news” that would cost the firm $2.5 million, a Goldman Sachs employee then reported the “good news” – that the failure would bring the firm $5 million from a bet it had placed against the very securities it had assembled and sold.

In a fourth e-mail, a Goldman Sachs manager reacted to news that the credit rating agencies had downgraded $32 billion in mortgage related securities – causing losses for many investors – by noting that Goldman had bet against them: “Sounds like we will make some serious money.” His colleague responded: “Yes we are well positioned.”

Go here for the actual emails: http://levin.senate.gov/newsroom/release.cfm?id=324169

The Catch-22 of Credit Rating Model Transparency

As reported in the New York Times...

One of the mysteries of the financial crisis is how mortgage investments that turned out to be so bad earned credit ratings that made them look so good.

One answer is that Wall Street was given access to the formulas behind those magic ratings — and hired away some of the very people who had devised them. In essence, banks started with the answers and worked backward, reverse-engineering top-flight ratings for investments that were, in some cases, riskier than ratings suggested, according to former agency employees...

The rating agencies made public computer models that were used to devise ratings to make the process less secretive. That way, banks and others issuing bonds — companies and states, for instance — wouldn’t be surprised by a weak rating that could make it harder to sell the bonds or that would require them to offer a higher interest rate.

But by routinely sharing their models, the agencies in effect gave bankers the tools to tinker with their complicated mortgage deals until the models produced the desired ratings.

“There’s a bit of a Catch-22 here, to be fair to the ratings agencies,” said Dan Rosen, a member of Fitch’s academic advisory board and the chief of R2 Financial Technologies in Toronto. “They have to explain how they do things, but that sometimes allowed people to game it.” ...David Weinfurter, a spokesman for Fitch, said via e-mail that rating agencies had once been criticized as opaque, and that Fitch responded by making its models public...

Read the rest of the article at www.nytimes.com/2010/04/24/business/24rating.html

Friday, April 23, 2010

Goldman’s biggest lie

Original posted on Reuters by Felix Salmon:

Alea has given us Abacus for Dummies: a very useful quick overview of the structure of the deal. And in doing so, he helps to reveal Goldman’s biggest lie.

Simplifying Alea even further, we have five steps here:

  1. The reference portfolio is put together.
  2. Goldman sells super-senior protection, Paulson buys it.
  3. IKB and ACA sell senior protection, Goldman buys it.
  4. Goldman takes the senior protection that it bought from IKB and ACA, and sells it on to Paulson.
  5. Goldman buys super-senior protection from ACA, through ABN Amro.

From Goldman’s point of view, steps 3 and 4 cancel each other out as a perfect hedge, and it can walk home happily with its fee income. And steps 2 and 5 should do the same thing, but they don’t: in step 2, Goldman sold super-senior protection on the top 50% of the deal, while in step 5 it bought super-senior protection only on the top 45% of the deal. So the hedge was imperfect, Goldman ended up long 5% of the deal, and, in the end, it lost lots of money.

But the fact is that there are two big-picture deals here, not one — and yet they’re very intimately connected.

In the first deal, the super-senior deal, Goldman acts as an intermediary, first selling protection to Paulson, and then buying it from ACA via ABN.

In the second deal, the actual Abacus deal, Goldman creates the Abacus vehicle, which issues securities to IKB and ACA, which are ultimately funded by Paulson taking the other side of the trade.

Now, let’s look at a page from the pitchbook:


The Super Senior tranche here is the one in the first deal; Class A is the notes which were sold to IKB; Classes B, C, and D were sold to ACA; and the First Loss equity tranche at the bottom is the bit of the deal which never existed since, as Alea says, “the deal doesn’t need an equity investor (and doesn’t have one)”. The fact of its nonexistence is conspicuous by its absence: “Not Offered” is by no means the same thing as “Does Not Exist”.

The fact is that the Abacus deal itself didn’t need a super senior investor, either, and didn’t have one. It just needed classes A through D, which were sold to ACA and IKB. The super-senior deal was entirely separate, and had nothing to do with Abacus, although it used the same portfolio of reference securities.

So the question arises: why on earth is the super senior tranche (and the equity tranche, for that matter) even listed in the pitchbook in the first place?

When Goldman refers to ACA as “the overwhelmingly largest investor in the transaction”, it’s clearly referring to the transaction as a whole, including the super-senior deal, rather than just the Abacus part of it. And what’s more, there’s something clean and elegant about the way in which the structure of the deal, as outlined in the pitchbook, goes smoothly all the way from First Loss all the way to 100%.

In theory, as far as I can tell, there’s no reason why the 45-50% tranche — the one that Goldman ended up holding onto and losing $90 million on — should ever have existed either: it, like the equity tranche, could simply never have been offered to anyone. Why didn’t Goldman just move the attachment point for the super senior tranche up from 45% to 50%, so as to match the hedge it bought from ACA via ABN?

After all, Paulson was not buying credit protection on the reference securities as a whole. But that’s how it looks, in the pitchbook. Here’s the pretty picture of the structure, in the same book:


If you’re ACA, looking at this structure, you know that as the deal is being put together, you’re negotiating to insure the Super Senior Amount which exists in this picture as a semi-fictional entity outside the structure and inside a grey dotted box. In other words, while you know it’s not a formal part of the Abacus structure, you also know that it exists.

And in this picture, the First Loss Amount has the same ontological status as the Super Senior Amount: it exists, but only outside the formal confines of the Abacus deal. Since ACA knew full well that the super-senior tranche existed — after all, it was negotiating to insure it — there’s no reason why it should have doubted that the equity tranche existed as well, just like it did in Magnetar trades with which it was familiar.

Here’s Goldman Sachs, in its letter to the SEC:

The fact that ACA may have perceived Paulson to be an equity investor is of no moment. As a threshold matter, the interests of an equity investor would not necessarily be aligned with those of ACA or other noteholders, and holders of equity may also hold other long or short positions that offset or exceed their equity exposure. Indeed, Laura Schwartz of ACA understood this from her work on a transaction that closed in December 2006 in which Magnetar, a hedge fund that bought equity and took short positions in mezzanine-level debt, participated. (See GS MBS-E-007992234 (“Magnetar-like equity investor”).)

This is, I think, inadvertently damning to Goldman’s case. It’s true that in the Magnetar deals the entity which was long the equity tranche was also short the debt. But at the same time, it’s also true that in the Magnetar deals there was no question that the equity tranche existed. So if ACA’s Schwartz was thinking in terms of the Magnetar deal which closed just before the Abacus deal started being negotiated, then it’s quite understandable that she believed in the existence of an equity tranche in this deal, too. And Goldman never did anything to disabuse her of that belief.

The clear message of the pitchbook is that this synthetic CDO was put together to mimic a cash CDO, which has to have all of its tranches spoken and accounted for. You can’t have a cash CDO without an equity tranche. Remember that if the only point of the Abacus deal was to create the Abacus securities, then there wouldn’t have been a super-senior tranche at all, and ACA would not have been the largest investor in the transaction.

Here, then, is arguably Goldman’s biggest lie of omission: it never told ACA that the equity tranche didn’t exist. If it was being a true and honest broker, it should have done. End of story.

How important is IKB’s sophistication?

Original posted on Reuters by Felix Salmon:

John Carney has a defense of Goldman Sachs up at the Daily Beast, based on the not-novel-at-all idea that the investors in the Abacus deal were sophisticated.

A document exclusively obtained by the Daily Beast demonstrates (view them here) that just a few months before it invested in the derivatives at the center of the SEC’s case, the German bank was touting its prowess as a sophisticated investor in those derivatives.

But no one is asserting that IKB, or any other party to this transaction, wasn’t sophisticated. The word never appears in the SEC’s complaint against Goldman, for instance, and I have yet to see a Goldman critic latch onto the idea that IKB was some kind of naive widow or orphan, who was bamboozled by all these CDOs and CDSs and whatnot.

On the other hand, Goldman itself loves hammering home the idea that the investors in the deal were sophisticated. Its first big public statement on the deal uses the word twice, its second uses the word three times, and its two letters to the SEC use the word no fewer than twenty-three times between them.

Here, for example, is a chunk of the first letter:


The problem with all of this banging away about IKB’s sophistication is that it looks very much like protesting far too much. The SEC doesn’t need to show that IKB was unsophisticated, it just needs to show that Goldman didn’t make the disclosures required by the law.

Carney, a lawyer by training, tries to explain why he thinks this is such a big issue, but he’s far from convincing:

The sophistication of IKB will be an important issue in the Goldman case. In general, the securities laws of the United States assume that sophisticated investors can fend for themselves. That’s exactly why hedge funds—which only accept money from so-called “accredited investors”—are largely free from regulation. The focus of our securities laws is the protection of ordinary investors and market integrity.

I’m sure that a class on the history of US securities laws would be fascinated by their treatment “in general” of sophisticated investors, and by their overall focus in terms of investor protection. But the point at question here is whether Goldman failed to make necessary disclosures, simple as that. To be sure, the level of disclosure necessary changes according to the sophistication of the investor in question, and qualified institutional investors in the 144a market are much more sophisticated than ordinary individual investors. But the level of disclosure never goes away entirely, and in fact the statute in question is drawn very broadly:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

There’s nothing there about “any unsophisticated person”: if Goldman’s omission of Paulson’s role in its statements made what it was saying misleading, or if it was deceitful, then that’s it, case closed. IKB may or may not have been a sophisticated investor, but I don’t think that status matters nearly as much as Goldman and Carney think and/or hope that it does.

CDO Market – Rife With Collusion and Manipulation?

Original posted on Naked Capitalism by Tom Adams and Yves Smith:

Despite extensive credit crisis post mortems, many of the widely accepted explanations of what happened are at odds with facts on the ground. These superficial explanations are hard to dislodge because they tally with widely held beliefs about how the real estate and securitization market operate. The waters have been muddied even more by self-serving PR from various market participants.

The consensus reality of the credit crisis appears to be: it was the result of a complex combination of factors, no one can be blamed all that much (save maybe greedy borrowers and complicit rating agencies) and almost no one saw it coming.

We’ve argued that many of the arguments that support that view are myths. In particular, the more we have dug into the CDO market, the more we are convinced that it was central to the crisis. Furthermore, we believe that this market did not operate on an arm’s length basis, that many of the practices that were widespread in the industry amounted to collusion.

Collusion and resulting price distortions serve as the most likely explanations for behaviors that are consistently glossed over in the consensus accounts of the crisis. By early 2006, many mortgage market participants felt that the housing market was overheated and unsustainable. Many felt that mortgage rates should be higher, but despite interest rate tightening by the Fed, mortgage rates were not increasing. Even more distressing, credit spreads remained narrow despite widespread concerns that mortgage risk was increasing and deals were weakening.

Many economists and academics described this as a conundrum at the time and tried to come up with theories to explain it, none of which were terribly satisfying. None of them looked at a more likely culprit – the securitization market and, specifically, the CDO market.

CDOs distorted the mortgage market because they undermined the normal processes for pricing risky assets. For subprime debt, demand for the lower rated tranches had served to constrain market growth. If investors started to shun the BBB to AA rated tranches of subprime mortgage bonds, dealers were not willing to retain them, no new deals would be sold, and the market would need to find better quality mortgages or grind to a halt. But CDOs were the dumping ground for these tranches. A 1990s version of mortgage-related CDOs proved ultimately to be a Ponzi scheme (unsold risky CDO tranches were rolled into new CDOs), but even then, that CDO market imploded early enough that the damage was comparatively minor.

This time, the CDO market distortions were more significant and wide-ranging. In particular:

1. Demand for CDOs came not from long investors, who would be concerned about credit losses, but primarily from (a) short investors who wanted to bet aggressively against the housing market and needed a tool to allow them to do so without disclosing their real intentions (b) investment banks who created the CDOs so they could generate fees and bonuses by putting the CDO bonds in their trading portfolios (negative basis trades) and off balance sheet vehicles (SIVs) without regard to risk and (c) correlation traders who were indifferent to credit risk

2. The normal mechanisms for pricing risk were upended because of manipulation of the demand for mortgage and CDO bonds by a consortium of banks and CDO managers who masked the real appetite for the bonds and fabricated pricing for the bonds

3. By creating the illusion of demand for the mortgage and CDO bonds, the CDO managers and arranging banks operated under a well disguised conspiracy that allowed a massive housing bubble to be created which only exploded when the shorts became impatient for realizing their gains.

If traditional cash investors and insurers were avoiding the mortgage securities market, who was driving the yields and spreads lower? Many industry participants agreed that the “CDO bid” was distorting the market.

The mechanism was the CDO managers, who assembled the assets for cash or hybrid deals (ones like Magnetar’s that used a combination of mortgage bond tranches and credit default swaps). They were effectively extensions of investment banks, dependent on substantial credit lines from them. Perhaps more important, it appears that many of the larger CDO managers bought much, perhaps all, of the AA to BBB tranches of entire subprime mortgage bond issues to be placed into CDOs. Having a single affiliated party take down the riskiest layers of subprime deals means that normal arm’s length pricing was not operating, and the profit potential of CDO issuance, rather than investor demand, was driving the market.

Consider this series of interconnected transactions:

A “sponsor” indicates an interest in creating a CDO to an investment bank. In combination, the sponsor and the bank would select the CDO manager who would buy the mortgage bonds for the CDO at start up and oversee the portfolio after closing. The sponsor would typically provide the CDO manager with an investment objective and find a manager that could achieve these aims.

Since the CDO deals were typically over a billion dollars, the CDO manager didn’t usually have the capital to purchase the mortgage bonds. As a result, the investment bank for the deal would offer the manager a line of credit to use to purchase the bonds that the manager selected. When the CDO closed, the CDO would repay the line of credit.

The bank for the CDO would not offer the line of credit to a thinly capitalized CDO manager casually. They were sure to get an attractive rate of interest plus a security interest in the bonds being financed to protect them in case the CDO manager ran into trouble. In addition, the CDO manager would work hard to find investors in the CDO to pay of the loan from the investment bank.

Many CDO managers were repeat issuers and many had a fairly systematic approach to how they covered the market. For instance, in a particular period, a CDO manager might be responsible for a mezzanine deal and a high grade deal or two. This would mean that the CDO manager had multiple lines of credit active

This execution strategy meant that the CDO manager had significant capital at its disposal for the purpose of buying mortgage bonds. Normally, the process of bidding on newly issued mortgage bonds while trying to meet the eligibility criteria of the proposed CDO transaction can be timing consuming and arduous for the CDO manager. The clever ones with more influence and access to generously termed lines of credit, could use their capital to tremendous advantage. Rather than face the competition of multiple bidders on a particular bond of a new mortgage deal, the CDO manager, armed with multiple upcoming deals and lines of credit, could offer to buy the entire stack of subordinated bonds that the issuer was bringing to market: BB all the way up to AA. This would be very attractive to the issuer, since it made it easier to get his deal sold. It was attractive to the CDO manager, since they could slot the bonds into both their mezzanine deal and their high grade deal at the same time, saving them a considerable amount of work. In addition, it could be very attractive for the bank on the mortgage transaction, particularly if they were the same bank that was issuing the CDO. A bank that knew it would be able to sell its mortgage deal and supply bonds to its CDO deal at the same time would take comfort that it was not terribly exposed to market risk.

One additional feature that some CDO managers might employ is to have a line of credit established for an upcoming CDO squared. A CDO-squared is made up of other CDO bonds, rather than MBS bonds. Putting aside how ridiculous the concept sounds now, this type of deal served a tremendous importance at back in 2006 and 2007. Since the riskier tranches of a CDO were more expensive to the issuers and harder to place, a CDO manager who knew that he had a home for these slices of his upcoming mezzanine or high grade CDO could certainly sleep easier. If managed properly, a CDO manager working with a friendly bank could pre-place the all of the sub bonds for a number of mortgage deals into their mezzanine and high grade deals and also pre-place all of the sub bonds from their mezzanine and high grade deals into a CDO squared transaction.

This example illustrates that pricing was often not based on market demand. Is there any real price discovery if one buyer (the CDO manager) is snapping up all of the risky tranches from a mortgage deal, and the bank on the mortgage deal is the same bank on the CDOs where the bonds will end up? Similarly, if all the risky tranches of a CDO were all pre-placed into another CDO, did anyone even bid on them? And since all of these pieces fit so nicely together, wouldn’t getting competitive bids really have been rather inconvenient?

Consider the role that a company like TCW played in the market. TCW was the biggest CDO manager in the ABS CDO market. In 2006, TCW acted as manager on about $9.5 billion worth of CDOs over 7 transactions.

Picture 2

The deals have an interesting pattern – alternating between high grade ($5.5 billion) and mezzanine ($3.4 billion) and across four banks, Goldman, Merrill, Wachovia and Morgan Stanley. The high grade deals included not just A and AA MBS bonds but also similarly rated bonds from other CDOs, including potential the mezzanine and high grade deals managed by TCW during this period.

During this same time 2006, those four bankers owned or acquired subprime lenders who typically securitized most of their originated loans. By rotating among the lenders owned by these banks, TCW could achieve decent diversity in their CDOs without ever having to pursue other lenders for their bonds. While they certainly mixed the bonds of other lenders into the mix to achieve better diversity scores from Moody’s (and lower rating agency cost of issuance, TCW may have offered to take all, or nearly all, of the mortgage bonds issued by the acquired lenders of Merrill Lynch, Wachovia, Morgan Stanley and Citigroup when they brought a subprime or Alt A mortgage deal or perhaps even the occasional deals where the banks had offered the bonds of third party mortgage lenders. If so, it’s likely the offer was received well.

Consider the systemic impact. Lower costs on for the CDO translated into lower, more aggressive bids for the mortgage bonds, which translated into lower mortgage rates – all of which were potentially being set between just 4 or 5 traders

But the risky tranches represented only a relatively small portion of the mortgage or CDO transactions. What happened to the biggest portion of the transactions – the senior (AAA) bonds? The bond insurers insured a decent amount of the market in 2006 (about a third), but even the many of the insured bonds needed a buyer and the uninsured senior bonds still needed a home. As we learned last week when Citigroup testified at the FCIC, Citigroup were big buyers of their own CDOs. Just like with the mezzanine and high mortgage deal, it was probably much more convenient for bank who was selling the senior CDO bonds, to convince management to acquire the bonds themselves rather than try to sell them in a messy, time consuming bid process. Similarly, Yves discussed in ECONNED that Eurobanks frequently retained AAA tranches because Basel II rules gave them considerable latitude in how much (as in how little) capital to charge against them.

As a result, from the top of the structure – the senior bonds of a high grade or mezzanine CDO, all the way down through the mortgage bonds and into the price of the mortgage loans – third party assessments of the risk and rewards of the loan appear to have been limited to non-existent.

The result was that riskier and riskier loans were being originated at effectively lower costs for issuers with little outside feedback. In one big happy family among the mortgage issuers, CDO managers and CDO investors, there would have been little motivation to worry about increasing risk or wider spreads. They were all keen to keep the great fee machine rolling.

Finally, if you throw the shorts into the equation, you complete the picture. Hedge funds who wanted to short subprime were pushing for more and more CDS on MBS, which led to the creation of more CDOs, which in turn, bought more cash and synthetic MBS bonds, helping to keep spreads low. The tight spreads on the mortgage deals created a great buying opportunity for the shorts, who were getting to bid on what we now know were extremely risky loans at bargain basement prices. Once the risks in the mortgage loans began to emerge, spreads on the bonds finally started to widen, sometime in mid 2007. By then it was too late – the deals were already created. Since the bonds had never really been distributed very widely and sat with highly leveraged firms that could not take much in the way of losses, the result was systemic risk and financial crisis.

Abacus for Dummies

Original posted on Alea:

First, a reference portfolio is constructed

Second, Paulson buys protection on the 45%/100% tranche (super senior) from Goldman Sachs, this is a bilateral trade with nothing to do with the Abacus SPV other than using the same reference portfolio.
This leaves Goldman Sachs short protection on the 45%/100% tranche.

Third, Goldman Sachs sells notes to IKB ($192 milion) and ACA ($42 million) => this leaves Goldman Sachs long protection (via purchase from the Abacus SPV) on the notes notional and short protection on the 45%/100% tranche.
Notes sold are well below what was expected in the “flipbook”.

Fourth, post-deal closing Goldman Sachs sells its long protection on the notes (acquired from the Abacus SPV) to Paulson => this puts back Goldman Sachs as short protection on the 45%/100% tranche

Fifth, more than a month after the deal closing, Goldman Sachs buys protection from ACA (through ABN/AMRO) on the 50%/100% tranche, this a bilateral trade with nothing to do with the Abacus SPV other than using the same reference portfolio => this leaves Goldman Sachs short protection on the 45%/50% tranche (5% of total notional).
The ACA deal (50% to 100% = 50%) is for $909 million notional, which implies a total notional of $1.8 billion for the deal, also below the level announced in the “flipbook”.

The deal goes sour and Goldman Sachs exposure is wiped out => $1.8 billion * 0.05 = $90 million

This a synthetic CDO referencing a static portfolio and protection was bought/sold NOT on the entire portfolio notional but only on the super senior tranche and the notes sold to qualified investors.

It is completely irrelevant whether Paulson was or wasn’t an equity investor as the deal doesn’t need an equity investor (and doesn’t have one).

Seize the yachts! The best financial reform? Let the bankers fail

Original posted in the Washington Post by James Grant:

The trouble with Wall Street isn't that too many bankers get rich in the booms. The trouble, rather, is that too few get poor -- really, suitably poor -- in the busts. To the titans of finance go the upside. To we, the people, nowadays, goes the downside. How much better it would be if the bankers took the losses just as they do the profits.

Happily, there's a ready-made and time-tested solution. Let the senior financiers keep their salaries and bonuses, and let them do with their banks what they will. If, however, their bank fails, let the bankers themselves fail. Let the value of their houses, cars, yachts, paintings, etc. be assigned to the firm's creditors.

Of course, there are only so many mansions, Bugattis and Matisses to go around. And many, many such treasures would be needed to make the taxpayers whole for the serial failures of 2007-09. Then again, under my proposed reform not more than a few high-end sheriff's auctions would probably ever take place. The plausible threat of personal bankruptcy would suffice to focus the minds of American financiers on safety and soundness as they have not been focused for years.

"The fear of God," replied George Gilbert Williams, president of the Chemical Bank of New York around the turn of the 20th century, when asked the secret of his success. "Old Bullion," they called Chemical for its ability to pay out gold to its depositors even at the height of a financial panic. Safety was Chemical's stock in trade. Nowadays, safety is nobody's franchise except Washington's. Gradually and by degree, starting in the 1930s -- and then, in a great rush, in 2008 -- the government has nationalized it.

No surprise, then, the perversity of Wall Street's incentives. For rolling the dice, the payoff is potentially immense. For failure, the personal cost -- while regrettable -- is manageable. Senior executives at Lehman Brothers, Citi, AIG and Merrill Lynch, among other stricken institutions, did indeed lose their savings. What they did not necessarily lose is the rest of their net worth. In Brazil -- which learned a thing or two about frenzied finance during its many bouts with hyperinflation -- bank directors, senior bank officers and controlling bank stockholders know that they are personally responsible for the solvency of the institution with which they are associated. Let it fail, and their net worths are frozen for the duration of often-lengthy court proceedings. If worse comes to worse, the responsible and accountable parties can lose their all.

The substitution of collective responsibility for individual responsibility is the fatal story line of modern American finance. Bank shareholders used to bear the cost of failure, even as they enjoyed the fruits of success. If the bank in which shareholders invested went broke, a court-appointed receiver dunned them for money with which to compensate the depositors, among other creditors. This system was in place for 75 years, until the Federal Deposit Insurance Corp. pushed it aside in the early 1930s. One can imagine just how welcome was a receiver's demand for a check from a shareholder who by then ardently wished that he or she had never heard of the bank in which it was his or her misfortune to invest.

Nevertheless, conclude a pair of academics who gave the "double liability system" serious study (Jonathan R. Macey, now of Yale Law School and its School of Management, and Geoffrey P. Miller, now of the New York University School of Law), the system worked reasonably well. "The sums recovered from shareholders under the double-liability system," they wrote in a 1992 Wake Forest Law Review essay, "significantly benefited depositors and other bank creditors, and undoubtedly did much to enhance public confidence in the banking system despite the fact that almost all bank deposits were uninsured."

Like one of those notorious exploding collateralized debt obligations, the American financial system is built as if to break down. The combination of socialized risk and privatized profit all but guarantees it. And when the inevitable happens? Congress and the regulators dream up yet more ways to try to outsmart the people who have made it their business in life not to be outsmarted. And so it is again in today's debate over financial reform. From the administration and from both sides of the congressional aisle come proposals to micromanage the business of lending, borrowing and market-making: new accounting rules (foolproof this time, they say), higher capital standards, more onerous taxes. If piling on new federal rules was the answer, we'd long ago have been in the promised land.

Until 1999, Goldman Sachs was a partnership, with the general partners bearing general and unlimited liability for the firm's debts. Today, Goldman -- like the vast majority of American financial institutions -- is a corporation. Its stockholders are liable only for what they invested, no more. And while there are plenty of sleepless nights, the constructive fear of financial oblivion is, for the senior executives, an all-too-distant nightmare.

The job before Congress is to bring the fear of God back to Wall Street. Not to stifle enterprise but quite the opposite: to restore real capitalism. By all means, let the bankers savor the sweets of their success. But let them, and their stockholders, pay dearly for their failures. Fair's fair.

Thursday, April 22, 2010

Goldman's Dirty Customers

Original posted on The Daily Beast by John Carney:

While Goldman and hedge-fund king John Paulson garner all the scrutiny, John Carney reveals how the shadiest player in the saga might be the alleged victim.

In Michael Lewis’ bestseller The Big Short, when Greg Lippman, one of the top traders dealing with the kind of derivatives that helped implode the world’s economy, was asked who was selling insurance on all the lousy subprime loans, he answered concisely: Dusseldorf. “Stupid Germans,” Lippman purportedly told wary hedge-fund investors, despite the fact that he worked at a Deutsche Bank. “They take the ratings agencies seriously. They believe in the rules.”

But the Germans selling the credit default swaps to Goldman Sachs—the very swaps at the heart of the SEC’s case against Goldman Sachs—weren’t stupid. In fact, they were wily and wealthy financial players. Nor did they necessarily play by the rules: Their dealings with Goldman seemed designed to evade regulatory and auditor supervision—something the SEC conveniently shoved down the memory hole in order to paint the Germans as just another victim of Goldman fraud.

In short order, Rhineland became one of the biggest buyers of the complex investment products puked out by the likes of Lippman at Deutsche Bank, JP Morgan Chase—and Goldman.

Rather than suckers, a thorough study of the case indicates that Dusseldorf-based IKB Deutsche Industriebank—which seems to eerily resemble the “stupid Germans” Lippman was referring to when seeking buyers for his eventually toxic collateralized debt obligations—was playing the same game that Goldman was.

In a nutshell, the SEC is alleging that hedge-fund titan John Paulson approached Goldman with a list of mortgage-backed securities he wanted to bet against and, since it's generally not possible to bet directly against a mortgage-backed security, Goldman agreed to provide credit protection, before pawning off the mirror image of Paulson’s basket, named Abacus, to unsuspecting customers, while pocketing a profit on both sides of the transaction.

Enter Dusseldorf’s IKB. Beginning in 2001, CEO Stefan Ortseifen pursued a strategy to turn his modest operation that specialized in lending to small and midsize companies into an aggressive global player dealing in risky assets while, as detailed by financial reporter Nick Dunbar, getting around the prying eyes of his largest shareholder, a conservative, government-owned development bank. Specifically, he set up off-balance-sheet, offshore company called Rhineland Funding, The Wall Street Journal reported, that would buy risky securities, while escaping direct regulatory or auditor scrutiny. Since IKB controlled Rhineland, which was listed on the Irish stock exchange, and lent it money, it could siphon profits out via hefty management fees. Meanwhile, IKB remained at arm’s length, reducing its exposure by pawning off a portion of its dicey Rhineland loans to others.

It was a piece of regulatory arbitrage: In essence, IKB was investing in complex mortgage bonds without having to set aside regulatory capital or report the increase in risky assets to its regulators or auditors.

In short order, Rhineland became one of the biggest buyers of the complex investment products puked out by the likes of Lippman at Deutsche Bank, JP Morgan Chase—and Goldman. One banker told Euroweek that IKB—through Rhineland and similar tactics—had become one of the five or six largest investors in Europe. Thus, Goldman found them a willing buyer for the junk piled into Abacus.

The crucial question in the SEC’s case against Goldman is whether Rhineland should have been told that Paulson was ultimately the short-seller in this deal or that he had played an important role in selecting the securities that went into Abacus. While it’s not clear that in 2007 anyone would have been worried about a little-known hedge fund being short a deal if they weren’t already worried about Goldman being short, Rhineland certainly should have asked how the portfolio was constructed.

So why didn’t Rhineland—or the managers who controlled it from Dusseldorf—make these inquiries? Most likely, because IKB was playing the game even more aggressively.

Because Rhineland was an off-balance-sheet entity, IKB’s exposure to Rhineland was limited by the size of its guarantees and credit lines. If a particular transaction lost money, the conduit, Rhineland, was on the hook, but the bank, IKB, was not. If Rhineland made money, on the other hand, the bank took a big share of the gains. In short, the profits were the bank’s and the losses were someone else’s problem. Financial engineering at its best—and worst.

Simultaneous with the Abacus deal, IKB executives were busy with another piece of financial chicanery, insulating their bank from losses at Rhineland courtesy of a French bank, Calyon, which agreed that, if requested, it would pay $2.5 billion for assets held by Rhineland. In exchange, the value of those assets would be guaranteed by IKB and a bond insurer named FGIC. The deal was known as Havenrock II.

But Abacus and similar deals were already sucking money out of Rhineland, according to a person familiar with the matter. The ratings agencies were threatening to downgrade a host of subprime bonds, scaring off other lenders. Deutsche Bank, which had bought a piece of the liquidity facility IKB provided Rhineland, alerted German authorities, according to Dunbar.

A closing dinner for Havenrock II was held in Dusseldorf in July 2007, according to Bloomberg News. Just three days later, IKB announced that it was failing and had to be rescued by the German government. Calyon was out $2.5 billion. IKB paid $625 million to Calyon. But FGIC refused to pay the remaining $1.875 billion. Calyon sued FGIC, FGIC sued IKB. FGIC wound up paying Calyon just $200 million in a settlement, according to reports.

When Calyon asked IKB to pay for the shortfall, IKB said that Calyon “failed to conduct any, or any adequate, appraisal of the risks,” according to a report from Bloomberg. Calyon wasn’t cheated or duped, IKB said. Rather, the bank entered into the agreement to “fulfill its ambitions to develop and diversify significantly its activities in securitization and structured credit,” IKB said in court filings quoted by Bloomberg.

In other words, IKB’s defense against Calyon anticipated in an eerily precise way Goldman’s defense: Everyone involved were big boys who knew—or should have known—what they were getting into.

IKB has taken a deserved pounding in Germany. Four members of the board of managing directors were forced to step down. The CFO was ousted, along with Ortseifen, who was charged with stock-market manipulation and embezzlement. (The charges were later dropped when investigators concluded they couldn’t establish an intent to harm the bank.) The assets—and losses—from Rhineland were brought onto IKB’s balance sheet.

The SEC omitted these facts from its complaint. It’s hard to make a case, after all, when the victim acts even more capriciously that than alleged wrongdoer.

Are Interest Rate Derivatives a Ticking Time Bomb?

Original posted on Washington's Blog:

Derivatives are the world's largest market, dwarfing the size of the bond market and world's real economy.

The derivatives market is currently at around $600 trillion or so (in nominal value).

In contrast, the size of the worldwide bond market (total debt outstanding) as of 2009 was an estimated $82.2 trillion.

And the CIA Fact Book puts the world economy at $58.07 trillion in 2009 (at official exchange rates).

Interest rate derivatives, in turn, are by far the most popular type of derivative.

As Wikipedia notes:

The interest rate derivatives market is the largest derivatives market in the world. The Bank for International Settlements estimates that the notional amount outstanding in June 2009 were US$437 trillion for OTC interest rate contracts, and US$342 trillion for OTC interest rate swaps. According to the International Swaps and Derivatives Association, 80% of the world's top 500 companies as of April 2003 used interest rate derivatives to control their cashflows.
So interest rate derivatives are the world's largest market.

The largest interest rate derivatives sellers include Barclays, Deutsche Bank, Goldman and JP Morgan. While the CDS market is dominated by American banks, the interest rate derivatives market is more international.

In comparison to the almost $500 trillion in interest rate derivatives, BIS estimates that there were "only" $36 trillion in credit default swaps as of June 2009. Credit default swaps were largely responsible for bringing down Bear Stearns, AIG (and see this), WaMu and other mammoth corporations.

Where's the Danger?

In 2003, John Hussman wrote:
What is not so obvious is the extent to which the U.S. economy and financial markets are betting on the continuation of unusually low short-term interest rates and a steep yield curve. This doesn't necessarily resolve into immediate risks, but it could profoundly affect the path that the economy and financial markets take during the next few years, by making the unwinding of debt much more abrupt.

In response to very low short-term interest rates, many U.S. corporations have swapped their long-term (fixed interest rate) debt into short-term (floating interest rate) debt, to the extent that an increase in short-term rates could substantially raise default risks. Similarly, a growing proportion of homeowners have refinanced their mortgages into adjustable rate structures that are also sensitive to higher short-term yields. Finally, profitability in the banking system is unusually dependent on a steep yield curve, with a widening net interest margin (the difference between long-term rates banks charge borrowers and the lower short-term rates they pay depositors) ...


According Bank for International Settlements, the U.S. interest rate swap market [has] nearly doubled in size in the past two years. The reason this figure is so enormous is that there are usually several links in the chain from borrower to investor. A risky borrower may enter a swap with bank A, which then takes an offsetting swap position with bank B (earning a bit of the credit spread as its compensation), and so on, with a cheerful money market investor at the end of the chain holding a safe, government backed security, oblivious to the chain of counterparty risk in between.

Aside from the risk that any particular link in this chain might be weak (know thy counterparty), the U.S. financial system has gone one step further. In order to hedge against the risk of defaults, banks frequently lay credit risk off by entering “credit default swaps” with other banks or insurance companies. These swaps essentially act as insurance policies for credit risk.


In short, the U.S. financial system is in a delicate balance. On the issuer side, a great many borrowers have linked their debt obligations to short-term interest rates. This is tolerated by the financial system because the debt has been swapped out through financial intermediaries, so investors get to hold relatively safe instruments like bank deposits and Fannie Mae securities. This mountain of debt in the U.S. financial system - tied to short-term interest rates - is ultimately and perhaps somewhat inadvertently backed by the U.S. government.

On the investor side, Asian governments intent on holding their currencies down relative to the U.S. dollar have purchased a great deal of U.S. government and agency debt – effectively “buying dollars.” ... A reduction of demand for U.S. short-term debt, either by foreign governments (particularly in the event that Asian governments decide to revalue their currencies) or by U.S. investors, could have very undesirable consequences.

All of which is why the U.S. is now extremely dependent on short-term interest rates remaining low indefinitely.

In March 2009, Martin Weiss wrote:

Until the third quarter of last year, the banks’ losses in derivatives were almost entirely confined to credit default swaps — bets on failing companies and sinking investments.

But credit default swaps are actually a much smaller sector, representing only 7.8 percent of the total derivatives market.


Thus, considering their far larger volume, any threat to interest rate derivatives could be far more serious than anything we’ve seen so far.

And Monday, Jerome Corsi argued that cities, states and universities might be wiped out by changes in interest rates:

As interest rates begin to rise worldwide, losses in derivatives may end up bankrupting a wide range of institutions, including municipalities, state governments, major insurance companies

, top investment houses, commercial banks and universities.

Defaults now beginning to occur in a number of European cities prefigure what may end up being the largest financial bubble ever to burst – a bubble that today amounts to more than $600 trillion.


A popular form of derivative contracts was developed to permit one money manager to "swap" a stream of variable interest payments with another money manager for a stream of fixed interest payments.

The idea was to use derivative bets on interest rates to "hedge" or balance off the risks taken on interest-rate investments owned in the underlying portfolio.

If an institutional investment manager held $100 million in fixed-rate bonds, for example, to hedge the risk, should interest rates rise or fall in a manner different than projections, a purchase of a $100 million variable interest rate derivative could be constructed to cover the risk.

Whichever way interest rates went, one side to the swap might win and the other might lose.

The money manager losing the bet could expect to get paid on the derivative to compensate for some or all of the losses.

In the strong stock and mortgage markets experienced beginning in the historically low 1-percent interest rate environments of 2003 through 2004, the number of hedge funds soared, just as the volume of derivative contracts soared from a mere $300 trillion in 2005 to the more than $600 trillion today.

Unsophisticated Entities Getting Taken by Interest Rate Derivatives Salesmen

In 2008, Bloomberg pointed out that the SEC was investigating shady interest rate derivatives sales by JP Morgan and Morgan Stanley to school districts.

In 2009, New York Times writer Floyd Norris noted:

On the front page of The Times today, Don van Natta Jr. has a good article about the woes of little towns and counties in Tennessee that bought interest-rate derivatives sold by Morgan Keegan, an investment bank based in Memphis.

It turns out that these municipalities did not understand the risks they were taking. The derivatives have now blown up, and the officials are blaming the bank.

Matt Taibbi also recently noted that JP Morgan used interest rate swaps to decimate a small Alabama town:

The initial estimate for this project was $250 million. They ended up spending about $3 billion on this. And they ended up owing about $5 billion in the end, after you look at all the refinancing and the interest rate swaps and everything.
As the Bloomberg, Times and Taibbi stories hint, many unsophisticated schools, cities, states and universities were played by the big interest rate derivatives sellers, just as many people were played by the CDS sellers. So the fallout will likely be substantial.

But Aren't Interest Rate Derivatives Straightforward and Useful?

You might assume that interest rate derivatives appear to have a much more straightforward, legitimate business purpose than credit default swaps.

Yes, maybe. But the people thought the credit default swap salespeople and their bosses didn't really didn't understand them.

And as George Soros pointed out in 1994, the excessive use of dynamic hedging can and often does backfire:

I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend toward equilibrium and, on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do they can be very disruptive, exactly because they affect the fundamentals of the economy…

The trouble with derivative instruments is that those who issue them usually protect themselves against losses by engaging in so-called delta, or dynamic, hedging. Dynamic hedging means, in effect, that if the market moves against the issuer, the issuer is forced to move in the same direction as the market, and thereby amplify the initial price disturbance. As long as price changes are continuous, no great harm is done, except perhaps to create higher volatility, which in turn increases the demand for derivatives instruments. But if there is an overwhelming amount of dynamic hedging done in the same direction, price movements may become discontinuous. This raises the specter of financial dislocation. Those who need to engage in dynamic hedging, but cannot execute their orders, may suffer catastrophic losses.

This is what happened in the stock market crash of 1987. The main culprit was the excessive use of portfolio insurance. Portfolio insurance was nothing but a method of dynamic hedging. The authorities have since introduced regulations, so-called 'circuit breakers', which render portfolio insurance impractical, but other instruments which rely on dynamic hedging have mushroomed. They play a much bigger role in the interest rate market than in the stock market, and it is the role in the interest rate market which has been most turbulent in recent weeks.

Dynamic hedging has the effect of transferring risk from customers to the market makers and when market makers all want to delta hedge in the same direction at the same time, there are no takers on the other side and the market breaks down.

The explosive growth in derivative instruments holds other dangers. There are so many of them, and some of them are so esoteric, that the risks involved may not be properly understood even by the most sophisticated of investors. Some of these instruments appear to be specifically designed to enable institutional investors to take gambles which they would otherwise not be permitted to take ....

Doug Noland wrote an intriguing article in 2001 - based on the research of Bruce Jacobs (doctorate in finance from Wharton, co-founder of Jacobs and Levy Equity Management) on portfolio insurance - arguing that interest rate derivatives were widely being used without understanding the risks they create for the system (warning: this is long ... go get some caffeine, sugar, nicotine or exercise, and then come back and keep reading):

I would like to suggest moving Bruce Jacobs' excellent book, Capital Ideas and Market Realities to the top of reading lists. From the forward by Nobel Laureate Harry M. Markowitz: "Many observers, including Dr., Jacobs and me, believe that the severity of the 1987 crash was due, in large part, to the use before and during the crash of an option replication strategy known as 'portfolio insurance.' In this book, Dr. Jacobs describes the procedures and rationale of portfolio insurance, its effect on the market, and whether it would have been desirable for the investor even if it had worked. He also discusses 'sons of portfolio insurance," and procedures with similar objectives and possibly similar effects on markets, in existence today."

From Dr. Jacobs' introduction: "This book ... examines how some investment strategies, especially those based on theories that ignore the human element, can self-destruct, taking markets down with them. Ironically, the greatest danger has often come from strategies that purport to reduce the risk of investing.


"In 1987, as in 1998, strategies supported by the best that finance theory had to offer were overwhelmed by the oldest of human instincts - survival. In 1929, in 1987, and in 1998, strategies that required mechanistic, forced selling of securities, regardless of market conditions, added to market turmoil and helped to turn market downturns into crashes. Ironically, in 1987 and 1998, those strategies had held out the promise of reducing the risk of investing. Instead, they ended up increasing risk for all investors."


I would like to explore the concepts behind the current dangerous fad of derivatives as a mechanism to insure against rising interest rates, as well as the momentous ramifications to both financial market and economic stability from these instruments that rely on dynamic hedging strategies. From Jacobs: "Option replication requires trend-following behavior - selling as the market falls and buying as it rises. Thus, when substantial numbers of investors are replicating options, their trading alone can exaggerate market trends. Furthermore, the trading activity of option replicators can have insidious effects on other investors."

Dr. Jacobs adeptly makes the important point that the availability of portfolio insurance during the mid-1980s played a significant role in fostering speculation that led to the stock market bubble and the crash that followed in October 1987. "Rather than retrenching and reducing their stock allocations, these investors had retained or even increased their equity exposures, placing even more upward pressure on stock prices. And, of course, as equity prices rose more, 'insured' portfolios bought more stock, causing prices to rise even higher…Ironically, the dynamic trading required by option replication had created the very conditions portfolio insurance had been designed to protect against - volatility and instability in underlying equity markets.And, tragically, portfolio insurance failed under these conditions (because…it was not true insurance). The volatility created by the strategy's dynamic hedging spelled its end."


"In the months following the (1987) crash, a number of investigative reports examined the trading data for the crash period. The Securities and Exchange Commission and the Brady Commission (the Presidential Task Force), for two, found that the evidence implicated portfolio insurance as a prime culprit." ...

Dr. Jacobs' wonderful effort explains ... the potential dangers of a complex financial theory taken up with little appreciation of its suitability for real-world conditions and applied mechanistically with little regard for its potential effects. It is a story about how a relatively small group of operators, in today's complicated and interconnected marketplaces, can wreak havoc out of all proportion to their numbers…it is a story of unintended consequences. For synthetic portfolio insurance, although born from the tenets of market efficiency, affected markets in very inefficient, destabilizing ways. And option replication, although envisioned as a means for investors to transfer and thereby reduce unwanted risk, came to be a source of risk for all market participants."

Unfortunately, this language seems at least as applicable to today's interest rate derivative market as it was for equity portfolio insurance. It is certainly our view that the contemporary U.S. and global financial system characterized by unfettered money, credit and speculative excess creates unprecedented risk for all market participants, as well as citizens both at home and abroad. Not only have flawed theories prevailed and past crises been readily ignored, derivatives (interest rate in particular) have come to play a much greater role throughout the U.S. and global financial system. The proliferation of derivative trading is a key element fostering credit excess and a critical aspect of the monetary processes that fuel recurring boom and bust dynamics, as well as the general instability wrought by enormous financial sector leveraging and sophisticated speculative strategies. This certainly makes the proliferation of interest rate derivatives significantly more dangerous than stock market derivatives. Under these circumstances, it does seem rather curious that more don't seriously question the soundness of this unrelenting derivative expansion. Unfortunately, ignoring the dysfunctional nature of the current system does not assist in its rectification - anything but. Indeed, it is my view that these previous market dislocations will prove but harbingers of a potentially much more problematic crisis that is quietly fermenting in the U.S. (global) credit system.


Clearly, the gigantic interest rate derivative market should be recognized as a very unusual beast. Instead of providing true interest rate hedging protection, this is clearly the financial sector having created a sophisticated mechanism that, despite its appearance, is limited to little more than "self insurance" - "The Son of Portfolio Insurance." I have written repeatedly that markets cannot hedge themselves, and that derivative "insurance" is different in several critical respects from traditional insurance. From Dr. Jacobs: "Synthetic portfolio insurance differs from traditional insurance where numerous insured parties each pay an explicit, predetermined premium to an insurance company, which accepts the independent risks of such unforeseeable events as theft or fire. The traditional insurer pools the risks of many participants and is obligated, and in general able, to draw on these premiums and accumulated reserves, as necessary, to reimburse losses. Synthetic portfolio insurance also differs critically from real options, where the option seller, for a premium, takes on the risk of market moves." Such exposure to unrelated events is far different from exposure to a market dislocation. Quoting leading proponents of portfolio insurance from 1985, "it doesn't matter that formal insurance policies are not available. The mathematics of finance provide the answer…The bottom line is that financial catastrophes can be avoided at a relatively insignificant cost."

Amazingly, such thinking persists to this day. The above language, of course, is all too similar to the flawed analysis/erroneous propaganda that is the foundation for the proliferation of hedging strategies and the explosion of derivative positions. Dynamic hedging makes two quite bold assumptions that become even more audacious as derivative positions balloon: continuous markets and liquidity. As writers of technology puts ...experienced, individual stocks often gap down significantly on earnings or other disappointing news, not affording the opportunity to short the underlying stock at levels necessary to successfully hedge exposure. And when the entire technology sector was in freefall, market illiquidity made it impossible for players to dynamically hedge the enormous amount of technology derivatives (put options) that had been written over the boom (especially during the final stage of gross speculation). The buying power necessary to absorb the massive shorting necessary for derivative players to offload exposure (through shorting stocks or futures) was nowhere to be found - so much for assumptions.

Granted, derivatives can be a very effective mechanism for individual participants to shift risk to others, but a proliferation of these strategies significantly influences their effectiveness and general impact. The availability of inexpensive "insurance" heightens the appetite for risk and exacerbates the boom. This characteristic has significant ramifications for both the financial system and real economy. It also creates completely unrealistic expectations for the amount of market risk that can be absorbed/shifted come the inevitable market downturn. Many adopt strategies to purchase insurance at the first signs of market stress. Once again, the market cannot hedge itself, and the tendency is for derivative markets operating in a speculative environment to transfer risk specifically to financial players with little capacity to provide protection in the event of severe financial market crisis.


There is another key factor that greatly accentuates today's risk of a serous market dislocation, that was actually noted by the BIS: "Net repayments of US government debt have affected the liquidity of the US government bond market and the effectiveness of traditional hedging vehicles, such as cash market securities or government bond futures, encouraging market participants to switch to more effective hedging instruments, such as interest rate swaps."

This is actually a very interesting statement from the BIS. First, it is an acknowledgement that "liquidity" and the "effectiveness of traditional hedging vehicles" have been impaired, concurrently with the exponential growth of outstanding derivative positions. This is not a healthy divergence. We have posited that the explosion in private sector debt, having been the leading factor fueling U.S. government surpluses, has produced The Great Distortion. As such, the viability of hedging strategies such as those that entailed massive Treasury securities sales in 1994 is today suspect. There are fewer Treasuries and a much less liquid Treasury market, in the face of unimaginable increases in risky private-sector securities and hedging vehicles. And while this momentous development has not yet created significant market disruption, the true test will come in an environment of generally increasing interest rates. Rising market rates will dictate hedging-related securities sales, and will test the liquidity assumptions that lie at the heart of derivative strategies. It is certainly my view that models that rely on historical relationships between public and private debt are increasingly inappropriate in today's bubble environment, as are the associated assumptions of marketplace liquidity. Importantly, dynamically shorting securities in the liquid Treasuries market is no longer a viable method for the financial sector to hedge the enormous interest rate risk that they have created. The "answer" to this dilemma, apparently, has been an explosion of "more effective hedging instruments, such as interest rate swaps (from the BIS)." We very much question the use of the adjective "effective." ...

All the same, the interest rate swaps market remains Wall Street's favorite "Son of Portfolio Insurance." A similar pre-'87 Crash perception of a "free lunch" conveniently opens the door to playing aggressively in a speculative market. But an interest rate swap is only a contact to exchange a stream of cash flows, generally with one party agreeing to pay a fixed rate and the other party a floating rate (settling the difference with periodic cash payments). With characteristics of writing an option, the risk of loss is open ended for those taking the floating side of the swap trade. There's no magic here, with one party a loser in this contract in the event of a significant jump in market rates. In such an event, this "loser" will certainly plan to dynamically hedge escalating exposure. If you are on the "winning" side, you had better accept the fact that the greater your "win," the higher the probability of a counterparty default. Somewhere along the line, these hedging strategies must be capable of generating the necessary cash flow to pay on derivative "insurance" in the event of higher interest rates. Obviously, the highly leveraged and exposed financial institutions that comprise the swaps market have little capacity to provide true insurance. In a rising rate environment, these players will have enough problems of their own making as they are forced to deal with their own bloated balance sheets, mark-to-market losses [what a quaint notion], and other interest rate mismatches, let alone enormous off-balance sheet exposure. As I have written previously, purchasing large amounts of protection against sharply higher interest rates from the U.S. financial sector makes about as much sense as the failed strategy of contracting with Russian banks for protection against a collapse in the ruble. Sure, one can play this game, but we are all left to hope that the circumstances never develop where there is a need to collect on these policies.

At some point, higher interest rates will force the financial sector to short securities to dynamically hedge the massive interest rate exposure that has been created. What securities will be sold and from where will buyers be found with the necessary $100s ($ trillion plus?) of billions of liquidity? Will agency securities be aggressively shorted? What are the ramifications of such a development to a market that is almost certainly highly leveraged with enormous speculative trading? I can assure you that these are questions that the derivative players would rather not contemplate, let alone discuss. ...

The problem is that the strong perception that has developed that holds that the Fed will ensure that interest rates and liquidity conditions remain market friendly is actually the key assumption fostering the explosion in interest rate derivatives and reckless risk-taking. It should be clear that the assumptions of liquidity make no sense whatsoever without the unspoken assurances from the Federal Reserve. The resulting proliferation of derivatives, then, has played a momentous role in the intermediation process whereby endless risky loans are transformed into "safe" securities and "money." The credit system's newfound and virtually unlimited capability of fabricating "safe" securities and instruments is the mechanism providing unbounded availability of credit - the hallmark of "New Age Finance." It is the unbounded availability of credit that, at this very late stage of the cycle, that creates extreme risk of dangerous financial and economic distortions, including the distinct possibility of heightened inflationary pressures. Ironically, the proliferation of interest rate derivatives has created the very conditions that they had been designed to protect against - volatility and instability in the underlying credit market, as well as acute vulnerability to the real economy.


The bad news is that there sure is a lot riding on what appears to be one massive and increasingly vulnerable speculation and derivative bubble that fuel the perpetuation of the historic U.S. Credit Bubble. I have said before that I see the current bets placed in the U.S. interest rate market as probably "history's most crowded trade."


Most economists and financial institutions assume that interest rate derivatives help to stabilize the economy.

But cumulatively, they can actually increase risky behavior, just as portfolio insurance previously did. As Nassim Taleb has shown, behavior which appears to decrease risk can actually mask long-term risks and lead to huge blow ups.

Moreover, there is a real danger of too many people using the same strategy at once. As economist Blake LeBaron discovered last year, when everyone is on the same side of a trade, it will likely lead to a crash:

During the run-up to a crash, population diversity falls. Agents begin using very similar trading strategies as their common good performance is reinforced. This makes the population very brittle...

Given that the market for interest rate derivatives is orders of magnitude larger than credit default swap market - let alone portfolio insurance - the risks of a "black swan" event based on interest rate derivatives should be taken seriously.

Anything that is orders of magnitude larger than the global economy could be risky - one unforeseen event and things could destabilize very quickly. Too much of anything can be dangerous. Water is essential for life ... but too much and you drown.

But I am confident that no one - even the people that design, sell or write about the various interest rate derivatives - really know how much of a danger they do or don't pose to the overall economy. In addition to all of the other complexities of the instruments, the very size of the market is unprecedented. Independent risk analysts would do a great service if they quantified and modeled the risk.

Finally, even if the widespread use of interest rate derivatives does not harm the economy as a whole, it will certainly harm the cities, states and other governmental and quasi-governmental entities which are on the wrong side of the trade. My hunch is that - just as the fraud in the CDO and CDS markets was exposed when the "water level" of the economy fell, exposing the rocks underneath - rising interest rates will reveal massive fraud in the interest rate derivative market.

Monday, April 19, 2010

Goldman Sachs: Too Big To Obey The Law (TBTOTL)?

Original posted on the Baseline Scenario by Simon Johnson:

On a short-term tactical basis, Goldman Sachs clearly has little to fear. It has relatively deep pockets and will fight the securities “Fab” allegations tooth and nail; resolving that case, through all the appeals stages, will take many years. Friday’s announcement had a significant negative impact on the market perception of Goldman’s franchise value – partly because what they are accused of doing to unsuspecting customers is so disgusting. But, as a Bank of America analyst (Guy Mozkowski) points out this morning, the dollar amount of this specific allegation is small relative to Goldman’s overall business and – frankly – Goldman’s market position is so strong that most customers feel a lack of plausible alternatives.

The main action, obviously, is in the potential widening of the investigation (good articles in the WSJ today, but behind their paywall). This is likely to include more Goldman deals as well as other major banks, most of which are generally presumed to have engaged in at least roughly parallel activities – although the precise degree of nondisclosure for adverse material information presumably varied. Two congressmen have reasonably already drawn the link to the AIG bailout (how much of that was made necessary by fundamentally fraudulent transactions?), Gordon Brown is piling on (a regulatory sheep trying to squeeze into wolf’s clothing for election day on May 6), and the German government would dearly love to blame the governance problems in its own banks (e.g., IKB) on someone else.

But as the White House surveys the battlefield this morning and considers how best to press home the advantage, one major fact dominates. Any pursuit of Goldman and others through our legal system increases uncertainty and could even cause a political run on the bank – through politicians and class action lawsuits piling on.

And, as no doubt Jamie Dimon (the articulate and very well connected head of JP Morgan Chase) already told Treasury Secretary Tim Geithner over the weekend, if we “demonize” our big banks in this fashion, it will undermine our economic recovery and could weaken financial stability around the world.

Dimon’s points are valid, given our financial structure – this is exactly what makes him so very dangerous. Our biggest banks, in effect, have become too big to be held accountable before the law.

On a more positive note, the administration continues to wake from its deep slumber on banking matters, at least at some level. As Michael Barr said recently to the New York Times,

“The intensity, ferocity and the ugliness of the lobbying in the financial sector — it’s gotten worse. It’s more intense.”

This is exactly in line with what we say in 13 Bankers – just take a look at the introduction (free), and you’ll see why our concerns about “The Wall Street Takeover and the Next Financial Meltdown” have grabbed attention in Mr. Barr’s part of official Washington.

But at the very top of the White House there is still a remaining illusion – or there was in the middle of last week – that big banks are not overly powerful politically. “Savvy businessmen” is President Obama’s most unfortunate recent phrase – he was talking about Dimon and Lloyd Blankfein (head of Goldman). After all, some reason, auto dealers are at least as powerful as auto makers – so if we break up our largest banks, the resulting financial lobby could be even stronger.

But this misses the key point, which Senator Kaufman will no doubt be hammering home this week: There is fraud at the heart of Wall Street.

And we can only hold firms accountable, in both political and legal terms, if they are not too big.

It is much harder to sue a big bank and win; ask your favorite lawyer about this. Big banks can more easily hold onto their customers despite so obviously treating them as cannon fodder (take this up with the people who manage your retirement funds). Big banks spend crazy amounts on political lobbying – even right after being saved by the government (chapter and verse on this in 13 Bankers.)

When you really do want to take on megabanks through the courts – and have found the right legal theory and compelling lines of enquiry – they will threaten to collapse or just contract credit.

No auto dealer has this power. No Savings and Loan could ultimately stand against the force of law – roughly 2,000 S&Ls went out of business and around 1,000 people ended up in jail after the rampant financial fraud of the 1980s.

We should not exaggerate the extent to which we really have equality before the law in the United States. Still, the behavior and de facto immunity of the biggest banks is out of control.

These huge banks will behave better only when and if their executives face credible criminal penalties. This simply cannot happen while these banks are anywhere near their current size.

Fortunately there is precisely zero evidence that we need banks anywhere near their current size – we document this at length in 13 Bankers (in fact, this was a major motivation for writing the book).

Break up the big banks before they do even more damage.

A Goldman blogger round-up

Original posted on FT Alphaville by Joseph Cotterill:

The weekend produced a veritable Eyjafjallaj√∂kull ash cloud of blogging and bloviating on the SEC’s filing on Friday against Goldman Sachs and its structured products trader Fabrice Tourre. Here’s the best we’ve read.

Getting shorty in CDOs

First — the key SEC charge is that Tourre allowed John Paulson to pre-select bonds in a proposed CDO and then to short them, without informing its other investors, ACA Capital included.

In a stand-out post, Steve Waldman questions the role of shorting in CDOs overall, arguing that CDOs are more akin to securities than derivatives, in terms of disclosure:

Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO. They no more thought they were trading “against” short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio. Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors. That’s inexcusable. Was it illegal? I don’t know, and I don’t care.

In a separate post, Steve mulls a more abstract view of whether Goldman did indeed act as a ’secret agent’ for one client to the disadvantage of another.

And was that pragmatic, let alone legal?After reading the filing, Bond Girl is cutting:

Seriously, why the hell would anyone want to be a client of Goldman Sachs after reading this?

Why would you work with a firm where employees mock the transactions they are arranging for you to purchase in emails?

Why would you work with a firm that would let someone that it knows is going to have a short position in the investment – because it helped them attain it – help structure that investment for you?

Why would you work with a firm that sees your multi-million-dollar business relationship as nothing more than collateral damage in its ultimate pursuit of fees?

This is not what investment bankers do. This is what backstabbing sociopaths do.


ACA and due diligence

Meanwhile, Henry Blodget and Felix Salmon squared off over whether Paulson’s prior involvement did indeed materially affect ACA’s position — or whether a ’sophisticated investor’ should have known better. Quite the ding-dong, this.

Blodget argues that there is a difference between control and influence:

Paulson did NOT have control over which securities were selected for the CDO.

This is critical. It’s also a fact that is clearly visible in the evidence the SEC provided.

The firm that DID have control over which securities were selected, ACA, was a highly sophisticated firm that analyzed securities like this for a living. It had FULL CONTROL over which securities were included in the CDO. We know this because, of the 123 bonds that Paulson proposed for the CDO, ACA only included 55 of them. In other words, ACA dinged more than half of the bonds Paulson wanted in the CDO, presumably because they did not meet ACA’s quality hurdle.

Now, did Paulson influence which securities ACA selected? Yes, he probably did. But any time someone says or does anything with respect to a security, there are lots of things that influence decisions.

Salmon calls this argument ‘pathetically unconvincing’:

Let’s remember here that in the end there were 90 securities in the CDO. Of those 90, it seems that 55 were chosen by Paulson. In other words, more than 60% of the securities in the CDO were picked, essentially, out of a stacked deck. It didn’t matter which securities ACA chose; Paulson had come up with his longlist of 123 securities precisely because all of them were particularly toxic. That’s a material fact which, if ACA had known it, would surely have sufficed to get them to exit the deal entirely.

Paul Kedrosky has the original flipbook for the ill-starred CDO, for reference.

Pivoting from that flipbook, Erik Gerding of The Conglomerate zeroes in on the SEC’s case over disclosure:

My guess is that a reasonable investor would indeed want to know that Paulson was involved in selecting the deck. What’s the support for this beyond the SEC’s Complaint? Look at the “flipbook” for the transaction provided to investors by Goldman…

It goes on at length of why ACA is a good collateral manager for the CDO. On p. 27, it includes a bullet point “Alignment of Economic Interest.” The SEC complaint zooms in on this little nugget (see Complaint Para. 38). (Note to law students: bullet points in “powerpoint” style are not only bad devices to communicate ideas, they have some itty bitty securities law problems when used to market securities. If you can’t formulate something in a complete sentence, try again.) Nowhere does the flipbook mention that the Paulson hedge fund was involved in selecting the collateral for the CDO.

But it’s far from a slam dunk, he notes. Still, Salmon has raised a wider set of questions about the Abacus deal — so this aspect will no doubt run and run as a point of bloggy contention.


Financial reform, post-Goldman

Barry Ritholtz has some questions too — more geared to the fallout on the current debate on US financial reform, however, as the Dodd bill lands on the Senate floor:

2. How endemic is this practice on the Street? Did other big derivative underwriters — Merrill, Morgan, Lehman, Deutsche, etc. — engage in similar (alleged) fraudulent practices when they were constructing and marketing these derivatives?

4. What does this say about the White House and Wall Street? Are the gloves off? Has the public outcry now reached the point where we might see vigorous prosecution of Wall Street wrongdoing?

7. How does this impact the Financial Reform legislation snaking its way through Congress? Will this add momentum to the call for stronger regulation of the Street? Of Hedge Funds?

8. Will this finally move derivative reform — exchange traded, full transparency/open interest, counter party disclosure, reserve requirements, perhaps even overturning CFMA — forward?

We might well ask — given some nifty Democratic capitalisation on the case already.

Channelling the ghost of the Depression-era prosecutor Ferdinand Pecora, Simon Johnson of The Baseline Scenario turns the charges into a rousing case for reform:

When you deliberately withhold adverse material information from customers, that is fraud. When you do this on a grand scale, the full weight of the law will come down on you and the people who supposedly supervised you. And if the weight of that law is no longer sufficient to deal with – and to prevent going forward – the latest forms of very old and reprehensible crimes, then it is again time to change the law.

Johnson also lays out the argument for pursuing Goldman executives higher up than ‘fabulous Fab’ Fabrice Tourre — plus John Paulson himself.

Hmm. That would really put the cat among the Senate pigeons.

Article Series - Abacus

  1. SEC charges Goldman Sachs with subprime fraud
  2. The case involving ABACUS 2007-AC1
  3. Markets Live transcript - Goldman/SEC special - 16 Apr 2010
  4. Formerly The Greatest Trade Ever
  5. Paulson: 'It's our money now'
  6. SEC/Goldman linkfest
  7. Introducing Fabrice "fabulous Fab" Tourre
  8. 'Goldman Sachs is disappointed...'
  9. This CDO is a Democrat
  10. ACA's rather disastrous CDO forays
  11. The analysts react
  12. A Goldman blogger round-up
And Naked Capitalism asks "Who is Next in the SEC’s Crosshairs? Some Possible (and Heretofore Overlooked) Suspects"

Both the traditional media and the blogosphere have taken an almost obsessive interest in the suit the SEC filed against Goldman last week with regard to one of its synthetic real estate related CDOs, Abacus 2007 AC1. Goldman’s shares and the stock market in general traded down, presumably seeing this suit as a turn in the tide, an end of the US government’s supine stance on questionable practices in the financial service sector.

Although the Wall Street Journal is reporting that the SEC is widening its investigation, so far it appears to be going only after very low hanging fruit. While the Journal notes that the SEC is looking into specific CDOs issued by Merrill, UBS, and Deutsche Bank, in all the examples mentioned, there is an existing private lawsuit against the investment bank. As we discuss in detail below, we think this initial salvo falls well short of the universe of possible miscreants.

So the big question remains: how aggressively will the SEC pursue these cases? As John Bougearel noted in an earlier post, it is too early to tell whether this suit is indeed the beginning of a concerted initiative (with the initial litigation allowing the SEC to perfect its legal arguments and uncover more information through the discovery process) or simply an effort to address (as in appease) to a public mad as hell about no-questions-asked bank bailouts and continuing subsidies to the financial services industry.

And while many commentators have focused on the quality of the SEC’’s apparent case, the truth is it is far too early to tell. The claims do look strong enough to survive summary judgment, which means the SEC will be able to seek more information from Goldman, Paulson, former ACA staffers, and various counterparties. It can add claims if it wants to as the case progresses.

And as other have noted, the odds are high that even if Goldman wins (or more likely, settles), it comes out the loser. When Procter & Gamble and other large companies sued Bankers Trust over losses they sustained on derivatives trades gone bad, many observers argued they didn’t have much of a case. Procter in particular had a sophisticated treasury operation; how could experienced market players claim they had been duped? The litigation appeared to be an effort to stem losses on bad bets.

But when P&G obtained access to taped conversations of BT staff discussing their and others’ trades, public opinion shifted dramatically. The bank’s posture was openly predatory (the most infamous quote was “Funny business, you know? Lure people into that calm and then just totally fuck ‘em.”). BT never recovered from the scandal, but it took a second run-in with the authorities (failing to turn abandoned client assets over to the state) that led to the bank’s sale to Deutsche Bank.

Assuming that the Goldman suit is the first step in a bigger initiative, where might the SEC and private claimants go next? There would seem to be at least three obvious channels: other John Paulson-related CDOs; non-Paulson Goldman Abacus trades; synthetic CDO programs like Abacus, apparently for the banks’ own accounts (the most notable example being Deutsche Bank’s Start program) and the Magnetar CDOs, which were structurally different than the Paulson program but appear to have been designed with the same intent, namely using a CDO to gain access to credit default swaps on particularly drecky subprime debt at cheap price (since the use of a CDO lured some counterparties into accepting AAA prices for at best BBB risk).

Greg Zuckerman’s book The Greatest Trade Ever discusses the origin of the synthetic CDO, and depicts Paulson as the moving force behind them, attributing $5 billion of CDOs to him. According to Zuckerman, Paulson approached Goldman, Deutshce Bank, and Bear Stearns in 2006 about launching synthetic CDOs that he would sponsor in return for taking down the ENTIRE short side (as in all of the CDS used to provide the cash flow for the CDO). Bear Stearns found the idea to be unethical (!) while Goldman and Deutsche went ahead.

Various commentors, including this blog (and later in an extensively researched New York Times story) have observed that Goldman’s Abacus program (25 deals, totaling over $10 billion) appeared to be designed to serve Goldman’s desire to put on a short position, yet presented to customers as no different than other CDOs. Deutsche Bank’s less widely discussed Start program appears to be along the same lines.

Although one of Magnetar’s deals is also on the list of cases the SEC is probing, this CDO (Norma) has been in the press since 2007, when it was the focus of one of the very first stories on dodgy CDOs, this one published by the Wall Street Journal. Magnetar’s program was far and away the largest of all the subprime short strategies that used synthetic or heavily synthetic CDOs as a major component. Our tally of the trades (more complete than ProPublica’s) puts the total at 29 transactions with a total par value of over $37 billion.

We’ve sorted the deals by banker, since the winks and nods that might have occurred between the dealer and the hedgie sponsoring the deal could have operated across multiple transactions. The list shows that some major CDO players have not yet received much critical scrutiny for their role in working with CDO sponsors who appear likely to have designed the deals to fail, namely Calyon, Mizuho, Citigroup, Lehman, and Wachovia. We’ve also put Calyon and Mizhuo together on our spreadsheet, since the team at Calyon decamped to Mizhuo (while any legal action would presumably target the bank-issuer, plaintiffs might want to examine the conduct of the professionals at both firms).

In other words, there is a lot of dirt if the SEC chooses to dig. And it is far too early to tell whether they have the Administration support and the bloodymindedness to do so.