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 issued..so 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