McClatchy has a breathless piece up on CDOs and other “exotic” transactions that Goldman did in the Caymans (hat tip reader John D). The problem is that the author got his hands on some very solid information (prospectuses of 40 deals) but the story itself is a bit of muddle. While it has some helpful new details, it breaks less new ground than its hyperventilating tone would suggest.
Reading this piece is a “find the pony” exercise. Readers are encouraged to comment on, correct or suggest alternative interpretations, and amplify my efforts to parse this article.
The confused reporting starts at the very top. This is the first, then the third paragraphs:
When financial titan Goldman Sachs joined some of its Wall Street rivals in late 2005 in secretly packaging a new breed of offshore securities, it gave prospective investors little hint that many of the deals were so risky that they could end up losing hundreds of millions of dollars on them..
The documents include the offering circulars for 40 of Goldman’s estimated 148 deals in the Cayman Islands over a seven-year period, including a dozen of its more exotic transactions tied to mortgages and consumer loans that it marketed in 2006 and 2007, at the crest of the booming market for subprime mortgages to marginally qualified borrowers.
Yves here. OK, they don’t tell you what the deals are (as in what type), and the time frame is muffed. The piece starts out by talking about late 2005 onward, then a mere two paragraphs later, it talks about 2002 onward. This is significant because the ISDA protocol for credit default swaps on asset backed securities was not created until June 2005, so capital markets firms could not write credit default swaps on mortgage backed securities in any meaningful fashion. It thus appears it has a pretty heterogenous set of deals that all used CDS and were in the Caymans, and is trying to make generalizations across them. It’s pretty certain to be a mix of what most journalists and market participants call CLOs (collateralized loan obligations) which confusingly are considered to be a type of CDO but from a complexity standpoint are not remotely as hairy and opaque as ABS CDOs, which are resecuritizations (major constituent is tranches of asset backed securities, usually mortgage backed securities, while CLOs are made of whole loans).
We learn that at least some of the deals were synthetic, either wholly synthetic or to a large degree:
In some of these transactions, investors not only bought shaky securities backed by residential mortgages, but also took on the role of insurers by agreeing to pay Goldman and others massive sums if risky home loans nose-dived in value — as Goldman was effectively betting they would.
The “investor” in a synthetic deal is effectively a protection seller, acting in the role of guarantor. He receives income from credit default swap “premiums” and if the deal does badly, has to make good on the guarantee. And for CDS related to asset backed securities, many of the contracts required the “protection seller” or guarantor to pony up a payment merely in the event of a downgrade (while for CDS written on corporations, who are the “reference entities” used in hedging corporate bonds, the trigger is typically a default, bankruptcy filing, and sometimes a reorganization).
Yves here. Soon, we get to this confused paragraph:
Some of the investors, including foreign banks and even Wall Street giant Merrill Lynch, may have been comforted by the high grades Wall Street ratings agencies had assigned to many of the securities. However, some of the buyers apparently agreed to insure Goldman well after the performance of many offshore deals weakened significantly beginning in June 2006.
Yves here. UBS was an active buyer of CDO tranches from other banks for its own account, and people in the CDO business have told me that was atypical. Eurobanks that were NOT originators were often active buyers. I would enjoy some reader input here as to how often and why a capital markets firm would be an “investor” in a CDO of another firm. Perhaps this was pursuant to a correlation trade (it was popular for hedge funds and prop desks to trade “correlation risk” which often wound up looking like a simple spread trade, go long one tranche, say the BBB, and approximate a short of the next higher rated tranche). My impression is that this was not common, but “not common” in a market this big could still add up to a fair bit of activity.
This bit is simply frustrating:
Many of Goldman’s winning bets with other large U.S. banks raised the price tags of 2008’s government bailouts of Citigroup, Bank of America, Morgan Stanley and others by sums that no one has yet determined because the contracts are private, according to people familiar with some of the transactions.
However, one billion-dollar transaction that Goldman assembled in early 2006 is illustrative. It called for the firm to receive as much as $720 million from Merrill Lynch and other investors if defaults surged in a pool of dicey U.S. residential mortgages, according to documents in a court dispute among the parties.
Yves here. OK, they have access to the lawsuit…and this is the summary? No context as to what the deal was about? This is lame. Could this have been part of a correlation trade for Merrill? The story also implies Merrill was a significant participant, which may not be the case. I did a quick search and could not find any references save the McClatchy story. Any reader input would be of interest.
The author also gets very excited about the Caymans angle, when that was not a big deal. As Tom Adams, former head of structured finance at FGIC noted, “Offshore deals happened all of the time – its how certain private placements had to be done. The deal documents looked exactly the same as US deals and were drafted by the same lawyers.”
The article goes through some background, including how much Goldman originated in RMBS and related instruments ($40 billion in 2006 and 2007). This is where the piece goes a bit off the rails:
In 2006 and 2007, as the housing market peaked, Goldman underwrote $51 billion of deals in what mushroomed into an under-the-radar, $500 billion offshore frenzy, according to data from the financial services firm Dealogic. At least 31 Goldman deals in that period involved mortgages and other consumer loans and are still sheltered by the Caymans’ opaque regulatory apparatus.
Yves here. That number is most assuredly NOT all RMBS CDOs. In fact, have looked at a couple of the Abacus deals, one has some RMBS, but also included other exposures. There are industry databases that do show collateral compostion; Dealogic is not one of them. Back to the article:
Goldman’s wagers against mortgage securities similar to those it was selling to its clients are now the subject of an inquiry by the Securities and Exchange Commission, according to two people familiar with the matter who declined to be identified because of its sensitivity.
Yves again. We have another sloppy bit here:
Goldman’s subprime dealings burned taxpayers a second way…three foreign banks — France’s Calyon and Societe Generale and the Bank of Montreal — bought protection against securities they purchased in Goldman’s Caymans deals, using AIG as a backstop.
Those banks got a total of $22.6 billion from AIG (Societe Generale $16.9 billion, Calyon $4.3 billion and Bank of Montreal $1.4 billion), though not all of the money was related to investments in deals underwritten by Goldman.
Yves here. Look, I am as fond of taking on Goldman (or any securities firm engaging in bad behavior) but this is simply irresponsible. Three foreign banks that hedged some Goldman deals with AIG got bailouts. Got that part. The article then cites the GROSS AMOUNT of the rescue, and cutely throws in “though not all the money” was related to the Goldman deals.
The author evidently has NO IDEA how big these exposures are, and they could have been comparatively small ($50 million? $100 million?) But putting big number of the total exposure first creates the impression that the amount related to Goldman was large (Google “anchoring”), particularly since the disclaimer is so half-hearted. “Not all” implies “most” when it appears the author has no idea of the actual numbers.
Now having said that, there are still some useful bits.
ACA was deeply involved, and I don’t recall seeing numbers this large before:
The insurance unit of ACA Capital Holdings Inc. wrote $65 billion in swaps coverage, mostly on the Caymans deals called collateralized debt obligations, or CDOs, before it folded and turned nearly all its assets over to the banks that had thought ACA would backstop them.
And this section was also worthwhile:
_ Goldman’s Caymans deals were riddled with potential conflicts of interest, which Goldman disclosed deep in prospectuses that typically ran 200 pages or more. Goldman created the companies that oversaw the deals, selected many of the securities to be peddled, including mortgages it had securitized, and in several instances placed huge bets against similar loans.
_ Despite Goldman’s assertion that its top executives didn’t decide to exit the risky mortgage securities market until December 2006, the documents indicate that Goldman secretly bet on a sharp housing downturn much earlier than that.
_ Goldman pegged at least 11 of its Caymans deals in 2006 and 2007 on swaps tied in some cases to the performance of a bundle of securities that it neither owned nor sold, but used as markers to coax investors into covering its bets on a housing downturn.
There is a particularly interesting contention:
The Wall Street figure who insisted upon anonymity said that despite all the hoopla, there were few private investors in CDOs, and that banks have suffered most of the losses, one reason “why you haven’t seen a lot of complaining.”
Yves here. Again, it is hard to know for sure who the investors are, since only the packager/underwriter knows for sure. But based on reports from some who were active in that business, plus various press reports, this statement is narrowly true, but a lot of these banks were second and third tier European institutions. Remember “banks” covers a multitude of sins. And reader Crocodile Chuck, via e-mail, reminds us that CDOs were sold to Australian town councils and fire brigades:
The councils here are under continual barrage of ‘cost shifting’ from the state and fed govt’s. On top of this, liability cover for parks, public places is increasing. The population is aging, and consumes more services (many delivered locally). Everyone has to do more with less.
Of course the ‘officers’ for investment went for yield-AS LONG AS IT
WAS ‘AAA’. A lot of these ppl haven’t been to university.
Yves here. Having said that, the councils would not be targets for a pure synthetic deal, but for a cash or hybrid (one with bonds and CDS both as the assets). But the McClatchy piece makes clear that some of the deals were hybrids.
I wish organizations like McClatchy would put stuff like the deal documents it has on line once an article like this has been out for two weeks. They are unlikely to refer to them again, and if so, only in a cursory way. Fresh sets of eyes could get a great deal more out of them.
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Yves,
Bloomberg often leaves the reporter’s e-mail under the story. I would venture to guess if you really want to know and are willing to make some long-distance phone calls or inquiries to McClatchy, you can get those documents you refer to at the end of your post. Most journalists are pretty giving that way, especially if they gave up the trail of scent themselves.
Good idea….I will try that in a week or so….
Yves,
I doubt if this has any of the answers or gaps in information you’re looking for, but it has a lot of things that would be interesting to the average taxpayer of this country. They might be curious to see Goldman’s effective tax rate after they feed the money through their tax evading rackets in the Cayman Islands etc. The link is to an article by freelance writer Anthony M Freed.
http://open.salon.com/blog/anthony_m_freed/2008/12/18/goldman_sachs_evades_taxes_takes_tarp_funds
It seems they got the offering memoranda, which didn’t really add anything to the story. But they had to write a piece noting they had gotten them, so they just reiterated what they had written before. Oh, and they threw in “Cayman Islands” in every other sentence to make it seem extra-super-scary.
(re: Caymans: feeding the deals through the Cayman Islands doesn’t change the treatment of the funds for US taxpayers. It’s done for the benefit of US exempt organizations and foreign taxpayers that aren’t subject to US tax)
“I would enjoy some reader input here as to how often and why a capital markets firm would be an “investor” in a CDO of another firm.”
First impression, but given the level of activity, isn’t it natural for two sided trading books to develop? Correlation trading or spread trading or whatever you’d like to call it. Like a CDO “hedge fund”. Of course, the “hedge” is only directional at best, and very iffy at that, but what else is new? Given the nature of the outright risk, I’d be surprised if it wasn’t common as a trading book operation. But I don’t have first hand knowledge.
P.S.
e.g. if Goldman is net short the CDO market, it makes sense to me that they have limits on the size of their overall net short exposure. If they’re selling CDO’s like mad and running up against those limits, they want some way of adding gross long positions quickly, at least directionally.
The purpose of such limits presumably would be to limit the amount of “premium” expense (or whatever the right terminology is) they’re paying out net on their short position.
Again, no first hand knowledge here.
First impression, but given the level of activity, isn’t it natural for two sided trading books to develop?
I would expect this, particularly since the players concerned do it routinely for all their other activities. I would also anticipate a reasonably active OTC secondary market to appear so market participants could adjust their net positions.
Nice parsing of a very poorly written article. What is so very unfortunate is that the article effectively evades some very crucial points about fair dealing and potential fraud. The article is also very telling in regard to the financial competence of the writer and the editorial staff. Clearly a third rate job about a very important economic event. It also reads like a piece that was rushed to press.
just because it’s old news doesn’t mean that it isn’t something we shouldn’t a) be upset about and/or b) declare we need to change.
obscenely wealthy people getting wealthier due to government support through your and my tax dollars is something to be upset about, at minimum, especially when the middle and lower classes are getting a much smaller piece of the economic pie, day by day and year by year. The corporations are eating us alive out here.
You seem to be “splitting hairs” of the article and ignoring the essential truth of it and again, the obscenity of these people’s and corporation’s actions, for their own gross benefit, to the huge detriment of us, out here, individually and of the country, as a larger group.
Mo Rage
The blog
The post may be a little nit picky, but that just highlights how ridiculously complex all this–and that just makes me think that it’s complex *in order* to obfuscate and confuse and put things over on people.
The last point in the post, then, is the relevant point–that Goldman et al sell this stuff to people that they *know* don’t understand it *and* betting against them.
How this is a legitimate business arrangement is the real question, irregardless of how lost in the details experts and lawyers (maybe) can get.
What interests me, and my memory is fuzzy, but I remember that there was something about the USAPATRIOT Act (and its revisions to the criminal laws on money laundering) that got filtered through bank regulations and the “foridden counterparties” list. I seem to remember that there were going to be additional hoops to jump through if one wanted to deal with any entities in the Caymans, Bermuda, a few of the other “usual suspects.”
I could be entirely mis-remembering — it’s been a long time. But there could be some very interesting waivers that Goldman got for these ventures if I’m remembering correctly.
Running investment funds through the Caymans is par for the course. Nothing unusual at all, and McClatchy’s fetishization of it doesn’t cover them in glory.
Tell me someting new, like why you think Investor confidence fell 124% in one day for Japan,12/31/09 or why gold all of sudden is up 2% after a record sell off.
It’s a Multiple Choice Question
On 12/31/09, Why did investor confidence fall 124% in Japanor and why did gold rally 2% after a record sell off?
A. because the derivitive market for interest rate swaps froze up six months ago…
B. because the CDS market is now 80% frozen as 12/31/09
C. Goldman Sachs is in the process of recalling all of loans to Japan triggering derivitive payouts…
D. ALL OF THE ABOVE
Why did banks buy for their own account? Either 1) negative basis trades or 2) intrenal incentives led the desks to retain tranches as they were not being transfer priced correctly.
As to UBS purchasing, let’s remember that they were tryingt to set up Dillon Read as an internal hedge fund at the time.
Who was the marginal buyer of the super-senior trancheds? Irish SIVs owned by German Landesbanks who were monitizing the expiring state guarantees.
One question you ask is about UBS. Why did they buy senior CDO tranches for their own account? I think the answer is that they had so much depositor money they had to do something with it.
The whole focus of UBS back then was to built the global deposit base. They bought Paine Webber to achieve that and they also went over the top in the high net worth deposit business. (that led to the crisis with DOJ)
So they had trillions of very low cost money available to them. They did not have sufficient loan demand to use this much money. So they bought assets. They bought good stuff. The bought the best rated stuff. And they got absolutely killed in the process.
Good plan gone bad.
Bruce, you are one of the true gems of the Econ/finance blogging world. I mean that sincerely. We need more rapidity of posts from your site. When I visit your site I always learn something.
Bruce,
Actually, there were specific bad incentive and metrics that were more operative at UBS than elsewhere, although pretty widespread in the industry. Hate to be mysterious, but more on that later….
Yves there,
Charcad here. It seems to me it would be most useful to take a couple of these CDO deals and do full body dissesctions from head to toe. Whichever ones for which fully leaked or FOIA disclosed documentation and informed eyewitness commentary can be developed.
There are some points that are still hazy to me. And others I simply am not persuaded of yet. Particularly about whether or not a secondary market was promised to the institutional buyers, and perhaps was functioning behind heavy curtains. Offshore?
1. http://www.usvigers.com/ This is the Virgin Islands gov’t employees pension fund that is now suing Morgan over CDOs (the Business Week article cited previously. And link now dead fyi.) The food chain was more complex than Morgan ==> US VIGERS. I’ll guarantee that neither the VIGERS board or any of its local employees spontaneously called Morgan and asked for CDOs while hunting high yield investment grade debt. Someone the VIGERS people trusted brought these deals to them and represented them as investment grade debt paper. Who were these factotums? And who did they owe a fiduciary duty to? (Obviously I suspect VIGERS’ IAs here).
And I’ll wager that at some point in the sales process the phrase “just like bonds” or “just like senior debt” was commonly used to explain CDOs to non-illumined folk.
2. The trustees of the Ten Humping Buffalo, Montana Employees’ Retirement Fund and the rest of the local government investors have nominal “professional” IAs standing between them and the New Orleans riverboat boys at G/S, Morgan et al. It’s reasonable to conclude none of the Sacred 300 who really understood CDOs were in this class of advisors.
Still, most (if not all) of these nominal pros had to believe there was going to be a viable secondary market for this stuff. A very large group of the beneficial buyers cannot legally own junk paper if it was originally bought as investment grade debt. i.e. somewhere between AAA and BBB- they have to sell it. Consequently they do not get knowingly buy into illiquid paper as investment grade.
The issue here is what G/S, Morgan and others claimed would happen later. I can say that if they had clearly stated up front that this stuff would always be illiquid then the institutional market would have been a tiny fraction of what it ultimately developed into.
When pension funds want to fill the riskier parts of their portfolios with illiquid paper they call Simon’s and get an equity partnership or thiry in shopping malls. Or they get shares in a Venture Capital fund. Stuff like that.
Here is what is in a typical synthetic CDO prospectus regarding liquidity:
“Limited Liquidity. There is currently no market for the Offered Securities. Although the Initial Purchaser or the Placement Agent may from time to time make a market in any Class of Notes or the Preference Shares, neither the Initial Purchaser nor the Placement Agent is under any obligation to do so. In the event that the Initial Purchaser or the Placement Agent commences any market making, the Initial
Purchaser or the Placement Agent, as the case may be, may discontinue the same at any time. There can be no assurance that a secondary market for any of the Offered Securities will develop, or if a secondary market does develop, that it will provide the holders of such Offered Securities with liquidity of investment or that it will continue for the life of the Offered Securities. In addition, the Offered Securities are subject to certain transfer restrictions and can only be transferred to certain transferees as described
under “Transfer Restrictions.” Consequently, an investor in the Offered Securities must be prepared to hold its Offered Securities for an indefinite period of time or until the Stated Maturity of the Notes (or in the case of the Preference Shares, liquidation of the Issuer).”
I cannot imagine purchasing such a thing with my own money – so it happens when people are playing with other people’s money?
JCK,
Thanks. Can you say whose “typical synthetic CDO prospectus” this came from?
This language merely safe-sides Goldman, Morgan et al(as “Initial Purchaser/Placement Agent”) from an obligation to make a market.
The same CDO language also plainly anticipates they will make markets, and either that a secondary market already existed or will come into existence. Where was this “market” functioning? Obviously it was OTC. Offshore perhaps?
Prospectuses for Exchange Traded Funds have similar disclaimer language warning that markets for the securities may not develop. See page 10 of this Blackrock Prospectus
http://us.ishares.com/content/stream.jsp?url=/content/repository/material/prospectus/nasdaq.pdf&mimeType=application/pdf
Maybe Bruce Krasting can help here. I cannot conceive that UBS, or any bank, would buy this stuff believing they would hold until maturity no matter what else happened. 40 year mortgages were starting to be packaged into CDOs.
It will still be useful to do a full autopsy on a particular deal. With public employee pension funds there’s one or more layers of “independent consultants” between the fund trustees & fund officers and investment bank underwriters.
The prospectus clearly states, that there is no market in the securities…etc…etc…and “Consequently, an investor in the Offered Securities must be prepared to hold its Offered Securities for an indefinite period of time or until the Stated Maturity of the Notes…”
If you want to read it differently, that’s your problem, you have no case to claim that you didn’t know.
These terms are *totally brilliant* jck. Is there any way you could put the whole lot up somewhere, or do they sprawl on for pages and pages?
Risk factors run about 60 pages and prospectus 350 pages, so hard to put in the comment section…
The accusation against Goldman (et al) seems to be that they were creating and selling synthetic CDOs that they knew to be garbage and then betting against them. That’s not quite true. (It’s far more sinister.) Here’s how the deal actually worked.
Goldman would create and sell a regular CDO out of loans/bonds/mortgages it believed to be garbage. They would then create credit default swaps (CDSs) against the individual issues they had created that CDO from. THIS IS CRITICAL. They would not bet against the CDO they had just created and sold; only against the pieces they had created that product from. But this was just the FIRST step they were taking trying to hide (from their customers) exactly what they were doing and how shitty it was.
Next, they would keep both (!!!) the long side and the short side of these CDSs until they had enough long sides to create a synthetic CDO from, and then they would sell THAT to a different customer highlighting that it was a bond-equivalent as opposed to a collection of bets, and CERTAINLY hiding that those bets were against some other prodct Goldman had just sold.
It was THESE TWO STEPS TOGETHER that Goldman was using to totally obsure from their customers that they were betting against the very products they were creating. First, there was no reason for the buyers of the original CDOs to even suspect that these synthetic CDOs were about to be created, and second, it would have been nearly impossible for the purchaser of the synthetic CDO to have traced things back and determine exactly what it was Goldman was hiding in the deal.
So to summarize what exactly all these articles are getting wrong on this story, Goldman was NOT betting against the synthetic CDOs they were selling; these synthetic CDOs WERE THE BET ITSELF. And technically, Goldman was even betting against the original CDOs either.
And all of this was deliberately constructed in this fashion to completely hide from its counterparties (and perhaps even the law) exactly what Goldman was doing.
[NOTE: It also puts the lie to Goldman’s claim that these were merely standard hedges. Goldman sold the original CDOs, and so had no exposure left the hedge.]
P.S. The ONLY reason Goldman could possibly have had for constructing this in this fashion was to HIDE material information from their customers. There were FAR easier ways to get the EXACT SAME RESULT financially without all of this garbage.
Very interesting analysis on how GS might be making bets and hiding it using a layer of complexity. Would be interesting to see the details of such related deals to expose the fraud. Unfortunately it won’t be found until GS fails one of these days, which won’t happen as long as the Fed exists.
I remember hearing that UBS went absolutely bonkers over negative basis trades…
Re: I wish organizations like McClatchy would put stuff like the deal documents it has on line once an article like this has been out for two weeks. They are unlikely to refer to them again, and if so, only in a cursory way. Fresh sets of eyes could get a great deal more out of them.
I believe The Real News http://www.therealnews.com has an agreement to share content with McClatchy. If you like, I can put you in touch with someone who might be in a position to request the documents.