Sunday, April 18, 2010

The skeletons from the Goldman cupboard

It was slightly long in coming, but had to happen. The Goldman Sachs enigma (the "perpetual money making machine") has finally been uncovered as the Securities and Exchanges Commission (SEC) in the US filed a civil law suit accusing it of defrauding its customers who had purchased risky mortgage related debt that were secretly devised to fail.

There were whispers all along that Goldman had been bundling and selling mortgages and other debts to unsuspecting investors while simultaneously betting against the same debts. Interestingly, despite the widespread knowledge of such practices, this is the first instance of action by the SEC against a Wall Street deal that helped investors capitalize on the falling sub-prime mortgage market.

The instrument in the SEC case, called Abacus 2007-AC1, was one of 25 deals that Goldman created so that it and select clients could bet against the housing market. The buyers of Abacus 2007-AC1 bonds - synthetic CDOs, created by packaging bundles of CDS (that insure against default of underlying mortgage bonds) - would keep receiving regular payments so long as the underlying securities stayed healthy, but would have to pay up the full insured amounts (or their full investments) if the securities failed.

In the instant case, Goldman created Abacus 2007-AC1 in February 2007, ostensibly through an independent deal manager ACA Management (who identified and packaged the mortgage bonds) for investors, but actually at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst. Though investors were told that ACA was selecting the bonds impartially, Goldman let the Paulson fund select mortgage bonds that they believed were most likely to lose value.

Unknown to both ACA and its investors (foreign banks, pension funds, insurance companies and other hedge funds), at the same time the Paulson fund and Goldman's proprietary trading desks were betting against the same bonds (so as to cause the bonds to default and the CDS's to kick in and make good the insurance contracts).

In fact, Goldman had let the Paulson fund pick and choose the underlying bonds, ones that it knew was likely to default. As the Abacus deals plunged in value, Goldman and certain hedge funds made money on their negative bets, while the Goldman clients who bought the $10.9 billion in investments lost billions of dollars.

Such deals were triple-wins for Goldman Sachs

1. It would buy the CDS's on sub-prime mortgage bonds at cheap prices (in view of their high risk) and then repackage them, get it rated AAA and sell it at better terms (lower premium payouts to holders of the CDS) to investors. Through this, they were able to arbitrage the market for such insturments.

2. Its proprietary trading desk would bet on these bonds defaulting (by either selecting those bonds that they know are most likely to default or by taking up short positions on them and driving down prices and forcing events like a ratings downgrade or margin calls) and keep making the premium payments to the investors in the CDOs. Once the underlying bonds finally defaulted, the CDO investors lost their all their investments which get paid out by way of insurance redemption. And Goldman and its select clients shared this.

3. Finally, Goldman made large money from fees for arranging all these deals - both with investors and the clients.

Steve Waldman has this superb summary of the scandal

"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... But the firm’s behavior was certainly unethical. If Goldman cannot acknowledge that, I can’t see how investors going forward could place any sort of trust in the firm. Whatever does or does not happen in Washington D.C., Goldman Sachs needs to reform or die."

Though Goldman has denied all these allegations and has vowed to vigorously defend itself, Wall Street hammered Goldman shares by more than 13%. This incident may have irreparably damaged Goldman's "reputation and its ability to keep its hands on so many sides of a trade — a practice that is immensely profitable for the firm". It could also trigger off a cascade of law suits against Goldman by its investors, especially the major banks like ABN and IKB, who lost their investments in these Abacus instruments. Interestingly, John Paulson or his fund are not part of the civil suit filed by SEC.

See also this Times debate and Joe Nocera on the scam. Paul Krugman points to George Akerlof and Paul Romer who had highlighted the possibility of financial institutions taking excessive risks at the expense of the society and tax payers if they sensed profit opportunities and if the incentives were also so aligned.

Though the case against Goldman appears very clear, it may be the loudest testament to the virtual paralysis of financial market regulation in the US that there exists the real danger that Goldman may escape relatively unscathed. As Yves Smith writes, "This case should be a slam-dunk, but years of deregulation have narrowed the ground for lawsuits." It is an indictment of the whole system that instead of expressing such doubts we should have been asking, as Prof William Black writes, "Why have there been no criminal charges?"

The one silver lining in the cloud is the fact that, as Mark Thoma writes, it provides a great opportunity to silence the conservatives and Republicans and push through the financial market regulatory reform proposals currently being debated in the US Congress. In fact, the supporters of reforms should ride the momentum generated by the populist backlash against Goldman and drive home strong regulatory reforms in the Bill. It is important that they act immediately in view of the limited public memory horizons.

Update 1 (20/4/2010)
Goldman's earnings rose 91 percent in the first quarter of 2010, to $3.46 billion or $5.59 a share, up from $1.81 billion or $3.39 a share in the same period last year. Revenues increased 36 percent to $12.78 billion, up from $9.42 billion in the quarter a year ago.

This Times article explains why the case against Goldman, while clear cut for the layman, may not be as easy to prove legally.

Update 2 (24/4/2010)
More evidence, from emails, that Goldman made massive money betting against mortgages is available here. See also this NYT story that examined emails traded by Goldman Sachs executives saying that they would make 'some serious money' betting against the housing markets. See also this from Goldman hearings.

Update 3 (4/5/2010)
James Kwak on synthetic CDOs like Abacus.

Update 4 (21/7/2010)
Goldman Sachs agrees to pay $550 million to settle federal claims that it misled investors in the Abacus subprime mortgage product as the housing market began to collapse.

Update 5 (23/6/2011)

Slate has an article that examines the claim that Goldman Sachs misled its clients by continuing to promote and sell them securities backed by sub-prime mortgages even as its trading desk was betting on the sub-prime mortgages going bad and declining. It writes,

"Starting in late 2006, Goldman Sachs made trades that would pay off if the housing market tanked. Was this a massive bet that the housing market was going to crash, as Goldman's critics maintain? Or was it merely a hedge, an attempt by the firm to reduce its risk, as Goldman claims?"

Goldman obviously claims the later.

Update 6 (15/3/2012)

Greg Smith's sensational resignation letter where he accuses Goldman of a culture which puts making money for the firm at the cost of client over anything else. He was Goldman Sachs executive director and head of the firm’s United States equity derivatives business in Europe, the Middle East and Africa.

1 comment:

Anonymous said...

Pretty Good Summary.