Target Audience

I considered making some reference to Goldman’s woes when I sat down to post this, but I was amused by the description of the consumers of a web message board a friend had posted on.

He’s a portfolio manager who knows whereof he speaks, and he responded to a discussion on the SEC’s suit against Goldman.

“I just wrote this for a community site that caters to local shut-ins, malcontents, and the perpetually incensed.” (His message after the break….)

Here is a description of the Goldman Sachs (GS) trade in a nutshell:

First, in 2006 GS took a firmwide negative view of the housing market, that is, they began to take steps to dramatically reduce the firm’s exposure to it’s multi-billion inventory of mortgage backed securities (MBS) that it carried on it’s balance sheet.

As a major dealer in the market for MBS, GS profited both from the interest that this trading position earned for them (positive carry), and it enabled them to make active markets for investors that were interested in either buying or selling such securities. Dealers routinely offset market exposure through hedging, selling a similar security vs one held.

The problem at the time was that the MBS about which GS had the greatest concern were of the now well known Subprime variety. The bugaboo was that unlike traditional GNMA, FNMA, FHLMC securities which were highly liquid and easily sold or hedged, no natural hedge existed for the Subprime bonds; therefore, a hedging vehicle needed to be created.

The community of Wall Street Dealers came to an agreement on a type of synthetic structure that essentially mimiced the characteristics of the soon to be problematic Subprime bonds. This structure was called a Pay As You Go (PAUG) Credit Default Swap (CDS).

Now Wall Street firms, or anyone else that met market sophistication and financial criteria could, for the first time, express a negative view of the market relatively cheaply, and they did.. in size.

Lets remember that this was during a period where, although delinquencies were rising, the individual securities were still outwardly performing well.

Firms with a direct exposure to mortgage creation had reams of data that even the most scrupulous and sophisticated investor had no real access to, but could only devine from data provided from originators and the same Wall Street firms that were interested in getting these assets off the books, pronto. The data investors were getting was often misleading or incomplete, which in no small way contributed to their continued appetite to buy bonds.

These troublesome bonds were most efficiently packaged and sold to investors in the form of structured credit vehicles called Collateralized Debt Obligations (CDO’s). CDO’s incorporated these assets and carved them into smaller bonds (tranches) within the structure, that carried ratings from AAA to unrated Equity.

Traditional CDO’s were issued by a recognized money manager as a sponsoring entity. The CDO manager assembled the collateral, paid the issuing dealer significant fees for marketing, etc., and received a nominal running fee.

Now follow me through the looking glass. In late 2006 and 2007, the period associated with the notorious GS Abacus transaction at the heart of the fraud allegation, both the dealer community (GS, Deutsche Bank, Merill, UBS, Citi) and certain hedge funds began to enter into a nefarious symbiosis.

The fees which the dealers earned fro CDO issuance were typically ~$7mm per Bln bonds issued, and paid up front. By keeping the CDO machine going, they could accomplish several things. They could keep ringing the cash register while servicing their hedge fund clientele and simultaneously run down or offset their own exposures..sort of a “Perfect Storm” for investors.

The Abacus transaction at the heart of the GS fraud allegations is
illustrative of just how perverse the situation had gotten.

First of all, the fees were paid by John Paulson’s hedge fund which had assembled a portfolio of adversely selected collateral, nasty stuff. Second, in a gesture to attract a key buyer of the senior assets, GS named ACA Capital, a collateral manager and bond insurer) as the deal manager. By accepting this role, and related management fees, and putting their imprimatur on the Paulson portfolio, albeit with some minor changes, they gave some outward comfort to the investor community. ACA claims, somewhat belatedly, that they believed that Paulson would be the equity sponsor, or at least have some alignment with the transaction.

When it came time to launch Abacus, presto, Paulson wasn’t a buyer. He was short all of the bonds and squarely at odds with both ACA and the deal’s investors. Now, at this point things really start to smell fishy.

Apparently, according to the offering documents, no equity was ever contemplated to be one can logically assume that it was retained by GS (CDO equity was marketed to yield ~20%). When the deal tanked this is where they may potentially claim to have lost their money, but they aren’t talking about how much they made from their offsetting trades. If Paulson made 1bln, GS made 1Bln PLUS the 20% return on the equity during their holding period. Remember, they got the equity at a zero cost basis, that means for free.

At this point, one can argue why didn’t ACA pull out of the transaction once they learned the deal had no traditional sponsor, since they are now playing the role of an aggrieved party? How can GS claim nothing occurred when they allowed a short investor to sponsor a multibillion $ transaction? I can’t overemphasize how far from the accepted norm this is.

It stinks. A lot of people got screwed.

—— End of Forwarded Message


4 Responses to Target Audience

  1. Eric iousa says:

    Do you think GS reaction, by denieing they did anything wrong will come back to bite them. There are multiple of examples, such as GE CEO saying all is well and then yanking there divvie several days later. This is obvious security fraud if they are lying to there holders after the accusation, a fraud of in itself. It maybe that GS is the poster child of this era, take down GS and appease the public that the blood sucking squid has been killed.

  2. W.Kinsolving says:

    Howard, I hope it’s okay that I put this on VF. The Pubes on that board are wailing that the SEC case is all Obama getting his reform passed. This nails it.


  3. W.Kinsolving says:

    Interesting: a couple of replies from VF:

    <<My understanding is this was not a traditional CDO, but a synthetic CDO. Which means someone was on the short side and they were paying the interest that would have been paid if it was a traditional CDO. — HiStream [ ] [ all comments » ]
    — reply », private reply »

    And as a result of what HiStream said, there was no equity piece to be held, not just held but missing from the for sale list in the prospectus. As to ACA, Paulson and Pellegrini still insisting they made suggestions only to the port, and less than half were accepted by ACA. As to the port itself, a very representative looking collection of lenders and servicers, from Wells to Ameriquest. Wells was either the originator or servicer on 29% of the reference portfolio(tracking index). — captainlate [ ] [ all comments » ]
    — reply », private reply »

    • hhill51 says:

      Of course there was equity. Where else would the excess cash go from buying BBB bonds and issuing AAA bonds? Read about the Magnetar trade. They drove the deals by offering to buy the equity. And those were synthetic. I saw Liesman on TV push this same patently false idea. It was missing from the prospectus because Paulson paid for it (in his structuring fee of $15 million), and no doubt Goldman retained it, or planned to sell it later.

      As to Ameriquest, their production was chock full of loans that Wells wouldn’t touch. A number of large investors felt that way and avoided them completely, even with their double-digit market share. The only shelf that was worse was Goldman’s alt-A shelf GSAMP, where they had the cojones to close deals with loans that were already 60 days’ delinquent.

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