Goldman Gives Preferential Treatment to Junior CDO Holders Over Senior

Goldman is a law unto itself, with no respect for propriety or notions like “fair dealing” (which in many contexts supercede particular contractual provisions).

The latest incident of Goldman scumminess is in one of the opaque corners of the credit markets, namely, collateralized debt obligations. Goldman launched a major program of synthetic collateralized debt obligations from 2006 into 2007. The early deals served to lay off its subprime risk; its later deals were mainly to dump CMBS risk.

The latest Goldman predatory practice is using contractual details (the deal equivalent of “gotchas” in credit card agreements) to undermine the well understood premise underlying ALL structured credits, namely, that bottom tranches take losses first. With two Abacus deals (and since these are Goldman programs, one has to assume it very knowingly planted these trap doors), Goldman is favoring the junior investors over the seniors. From Bloomberg:

Goldman Sachs Group Inc. paid off at face value some junior-ranking slices of two collateralized debt obligations at the potential expense of more-senior classes that now are likely to default, according to Fitch Ratings.

Goldman Sachs, the most-profitable securities firm, applied its “sole discretion” to ignore standard payment priority and use cash in reserve accounts for the Abacus 2006-13 and Abacus 2006-17 CDOs to retire lower-ranked notes, Fitch said yesterday in separate statements.

The moves are unusual in that the most senior creditors are typically the first in line to get paid. Fitch analyst Karen Trebach said the use of reserve funds may help cause or add to losses for holders of the CDO’s remaining classes.

“We are not aware of the use of this feature in other transactions we rate,” Trebach said in a telephone interview.

Yves here. This is the cute part, Goldman is using the cash in the CDO to redeem junior tranches that are at least impaired, and probably toast:

Goldman Sachs bet against $1.4 billion in commercial-backed securities and other CDOs through default swaps that were inserted into the Abacus issues, and it then sold notes from the CDOs equal to part of that amount, Fitch said. The cash raised was put in an “eligible investment account.” As with similar “synthetic” deals, securities bought for that account could be used to repay the CDOs, make payouts on the underlying swaps or both partially.

Goldman Sachs also had the ability to use “principal proceeds from the eligible investment account” to redeem Abacus classes “without regard to sequential order,” which it chose to do to retire junior classes, Fitch said.

Motivations for such action could include ownership of the notes or separate bets against higher classes, according to Howard Hill, a former Babson Capital Management LLC portfolio manager who founded securitization-related departments at four of the primary dealers that trade with the Federal Reserve, among them Deutsche Bank AG and UBS AG.

“You just don’t know without seeing who owns all the positions related to the deal,” Hill, who now runs a blog from New Milford, Connecticut, said in a telephone interview.

The reserve account may also be depleted because, while a Goldman Sachs unit entered into an agreement to buy securities in it at par to enable payouts if needed, that’s not true in all situations, according to Fitch.

The “put option” can be voided if any of those securities default, which is now likely as 38 percent of Abacus 2006-17’s investments are rated CC, Fitch said. Investments, which had to be AAA rated, may have included notes such as mortgage securities or other CDOs, Trebach said.

The “probable” default of account investments may also trigger the unwinding of the Abacus CDOs, and the amount garnered in sales may not be enough to terminate the underlying default swaps as would also be required, Fitch said. About 98 percent of swaps held by Abacus 2006-17 are tied to bonds with “junk” ratings or near that level and under review, the firm said.

If Goldman Sachs hadn’t used some of the cash in the accounts to redeem notes, the senior securities would be “less exposed to losses,” Trebach said. If what’s left is insufficient, even the Abacus CDOs’ super-senior swap classes may be called upon to make up the difference, she said.

These transactions also depended on credit enhancement, typically from an AAA guarantor, and an industry participant says that while the monoline ACA (a preferred dumping ground, and the lone non AAA rated monoline by design, which was rewarded for its credulousness by getting downgraded in December 2007 to CCC), it is likely pretty much all the logical suspects provided guarantees to various transactions in this program, including AIG:

I doubt that Goldman faced ACA direct on the Abacus deals, and there were prob a bunch of them done with MBIA, Ambac, and AIG. There is still TONS of CMBS resecuritizations out there where the monoline was the bagholder on the super senior (e.g. the later Abacus deals).

Why is AIG as possible AAA guarantor of interest? Because if Goldman was left holding any of the AAA tranches (not impossible at all, it might not have placed all of the trade), it was already taken care of via AIG. It might have bought the junior tranches at distressed prices and decided to self-deal. Another possibility is that some of the junior tranche holders are preferred customers (a lot of hedge funds engaged in correlations trades using the lower-rated CDO tranches). A former monoline executive speculates:

….these “pure synthetic deals” were different from the get go: they were never intended to be real bond offerings and of they were shorting the collateral, they wouldn’t have cared about senior class interests.

Is this related to the double payment issue?

If goldman gold made whole for their AIG exxposure via the government, perhaps they could not (or felt it wrong?) to collect again on the same bonds do they paid cashflow to the junior bonds?

The reason I doubt the benign interpretation, that Goldman was avoiding double-dipping, was that the firm is so busy trying to burnish its image that it would have made a point of this issue. Unless, of course, it does not want to remind the serfs that Goldman’s widely touted subprime short came at the expense of the great unwashed public.

Update 11/14, 12:00 AM: This is from someone who saw the deal docs. His remarks suggest disclosure might have been inadequate:

I have read hundreds of securtization disclosure documents (and drafted quite a few) and dozens of cdo dox. I have never seen any sort of “sub bond cross over date” that would apply for a deal that was taking losses. This would be such an unusual feature it would need to be highlighted in red and underlined, if I am understanding the facts in this article.

I have seen structures that deliberately fast paid sub bonds via excess spread (ie not locked out from principal for the first 3 years). But this was permitted because it did not harm the senior notes – ie sub bond was replaced by overcollateralization via excess spread (it also lowered the coat of the liability structure… And allowed bbb holders to get out ahead of senior holders). And it was always clearly disclosed and well discussed and understood.

This is happened on a 3 year old, under performing deal, so excess spread is not likely available.

I can’t think of a situation where a manager would get this type of discretion – most deals are written to protect against this type of “discretion” because it creates uncertainty about what a bond is likely to get. Changes in priority or cashflow ia always set up as something that happens by operation of triggers or events clearly labeled in the dox.

Mbs historically permitted a limited amount of discretion to manage defaulted loans (modify, short sale, pursue deficiency) which had some opportunity for conflict between them and the bond holders. As a result, there would be many checks in the dox to limit conflicts, such as requiring that the servicer not be a holder of the senior bonds…

I can’t figure this issue out. I know the abacus deals (and deutsche’s Start deals) – i reviewed them briefly before turning them down (the sales men were relentless on these deals). I saw enough to know they were different from normal transactions. All of the normal rules were off on the sales process, structuring, review etc.

Despite that, in reviewing the offering term sheets, I didn’t see broad cash flow priority discretion left to the manager. I would have been very surprised if I had.

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27 comments

  1. Fu

    Ah, the Goldmen porcile hominids… the brazenish of their chicanery never ceases to amaze. Just when you thought they couldn’t top the last one, they come up with an even more amazing doozie!

  2. dun given

    AIG stopped writing protection on ABS CDOs after 2005. Doubt this is a way to rob the government. It is more likely that GS bought the juniors back at distressed levels and AGO/MBI is senior CP. these counteroparties still can pay. Double gold for sure! Complete conflict of interest regardless of who is involved!

    1. Yves Smith Post author

      Dun,

      I appreciate your general point, that there were a lot of ways to skin this cat, and Goldman is almost certain to be dealing the cards in its favor. ACA was the protection writer on at least some Abacus trades, so it really depends on who the guarantor was.

      I’ve had people on CDO desks tell me otherwise re AIG, they were writing CDS on some of the Abacus deals which were ABS CDOs, albeit CMBS, not RMBS. The source of the “AIG quit writing CDS on subprime in 2005” is something of an urban legend via Joe Cassano, who lied to investors on conference calls (meaning there is a clear record of his dishonesty) more than once. AIG was guaranteeing vintage 2006 RMBS via 2005 deals that were largely cash on the asset side (it took time to assemble assets) and as any mortgages left the CDOs in older deals, the CDO manager would substitute with current vintage, so AIG was most assuredly insuring 2006 and 2007 vinatage RMBS too.

      And we have identified at least two Merrill CDOs and six Goldman (including two Abacus) trades guaranteed by AIG that most assuredly were ABS CDOs and post 2005 using Intex, which is an industry standard tool for structured products. It allow you to drill into the collateral. Four were substantially subprime, two high grade Alt-As, the other two CMBS.

  3. mechanic

    What you are saying is that there are no “free markets”. Obviously fraudulent, worthless swill is being sold to the public through a cartel of unscrupulus agents, with tacit approval and support by a corrupt government.

    All under the cloak of secrecy to prevent a stampede out of the “market” which would cause the collapse of the cartel.

    Sweet.

  4. craazyman

    And Don John entered into his house, which they called a john, and sat upon his pile, which reacheth up as unto a heaven, and called his disciples and said unto them.

    “When ye go to the market place let not your communications be Yeah and Nay, as the hypocrites do, for truly they will have no reward for their labors.

    But when ye pray, and prepareth ye to greet thy neighbor, entereth into thy closet so that no man seeth, and let thy words be as snakes in the grass, who slink and slither and coil, yeah around themselves as it were, into a knot.

    Nor forgive ye men their trespasses against thee, for there be no profit in mercy nor doth pity increaseth thy stature. And deception be not an abomination, nor doth tickery reduceth thy pile, and even as ye confound thy neighbor and be as a briar unto him, ye shall find favor in the lord of hosts and ye shall prosper.”

    And the disciples did as they were instructed and their words were as snares and as the tounges of serpents, and their words numbered even as the stars in the heavens, and they bound the multitude into a great vexation, for the multitude was rendered as a man whose pile bloweth away like a house of sand, yeah unto the ends of the earth, as in a storm.

    The Gospel According to Mammon, VI, ix – xii

  5. Francois T

    Yves,

    About this clause: “Goldman Sachs also had the ability to use “principal proceeds from the eligible investment account” to redeem Abacus classes “without regard to sequential order,”

    The way I read it, this clause say “You’re a senior tranche holder…but we, Goldman Sachs, reserve the right to say otherwise.”?

    I have no pretension to any expertise in structured finance, but which senior or super-senior tranches holder would agree to buy any CDO with such a clause?

    1. Jim in MN

      Have you looked into any of you or your loved ones’ pension, insurance, or church savings funds lately? I’d give it about 1 in 3 that a fund manager piled toxic waste into it.

      Wachovia subs who ‘no longer exist’ (nor does Wachovia) piled lots and lots of garbage into at least one major denomination’s primary investment vehicle–I have done the research personally.

      You can probably find it on your street.

      1. Gary Kopff

        Jim,

        I read your Nov 13 post to the story about GS preferential treatment to junior CDO holders. I am very interested in your observation about Wachovia:

        Wachovia subs who ‘no longer exist’ (nor does Wachovia) piled lots and lots of garbage into at least one major denomination’s primary investment vehicle–I have done the research personally.” Would you contact me off-linme at (202) 363-0073 OR GARY.KOPFF@AYA.YALE.EDU

    2. Peripheral Visionary

      Jim beat me to it. The most likely purchasers of this toxic waste would be pension plans, trusts, or endowments. And of those, pension plans are potentially government-guaranteed, so this may be yet another instance of shifting losses onto the taxpaying public. The only mercy in all of this is that these instruments are not bank-eligible holdings.

      1. Anonymous Jones

        “…shifting losses onto the taxpaying public” is, I guess, a fine way to say it if you want to take a passive viewpoint of the matter. An active viewpoint would probably use the words “outright looting of the community for personal gain.”

  6. Siggy

    I’m not a fan of GS. Yet, this discussion points to a very important consideration, just what does the indenture provide?

    As to why anyone would buy into subordinantion at the seller’s option is a puzzlement. The most probable explantion is that the buyer did not read the indenture and/or the projected holding period was deemed to be sufficiently short so as to make the consideration moot.

    For the senior tranche holders who were cut out the question is what does the indenture call for?

    Lets assume that what GS did was a contractualy available option. Lets suppose that you bot this trash from GS, upon this occurance would you again trade with GS?

    The foregoing leads to the probability that the holders of the redeemed tranches were highly valued customers.

  7. jake chase

    Well, I suppose this is a good example of the CDS market shifting risk from those hoping to avoid it to those unable to spot it. Now I understand why Barney Frank insists on exempting OTC derivatives as a legitimate way to disburse risk. Good old Barney. Thank goodness he is keeping our money safe!

  8. craazyman

    I probably enjoy more than most folks lampooning the psychopathic dragon known as Mammon and it’s manifestation in the Manichean order of phenomenization, but hey, what happened to “Caveat Emptor”. At some point Darwin has to take over and clean some clocks, just to preserve the DNA. Maybe Goldman really is doing the lord’s work. :)

  9. Eagle

    So even institutional investors can no longer be held accountable for what they sign? Why bother having contracts at all, let’s just play it by ear and make sure no one loses too much or gains too much on any deal.

  10. Yearning to Learn

    help a plebe understand why people bother trading or investing with these firms anymore?

    One would think that Goldman et al are killing the Golden Goose… but evidently “investors” are that stupid that they come back again and again.

    there must be some serious cognitive dissonance… but I’m not sure who has it… me or these “investors”

  11. psychohistorian

    I keep wanting to know when the criminal proceedings are going to begin?

    In lieu of those proceedings, when are the lynchings going to start?

    If none of the above then bend over because GS is driving.

  12. PQuincy

    Pacta servanda sunt, they all say. Contracts are sacred, and no one should be blamed for enforcing a contract’s terms.

    But contracts can be flawed in ways that justify overturning them, and they can be structurally corrupt in ways that call for strict regulation to ensure transparency and lack of collusive misconduct.

    First, and importantly, there are substantively unconscionable contracts. The old ‘company stores’ operated strictly on private contracts, and were thus formally ‘legal’ and theoretically enforceable. Yet the contracts they employed were prima facie unconscionable, in that they involved two parties already in a relationship of power and dependence, and imposed terms on the weaker party that ensured de facto indentured servitude. The fact that the contracts were formally proper is thus not determinative. (Note that this is not the same as prima facie non-binding contracts, such as the classic contract to sell oneself, or someone else, into slavery, which cannot be binding under any circumstances). Unconscionable contracts can be formally correct, but should still not be enforceable.

    A second possibility, one employed systematically by corporations in this our age of ‘deregulation’ is informationally overwhelming contracts. When the contractual terms run to hundreds of pages of detailed legalese, in which all kinds of mischief can be subtly hidden, parties without the resources to decipher the mass of information can be fatally disadvantaged — particularly, as was evidently routinely the case during the bubble years, when the snake-oil/bond salesmen made the actual contract difficult or impossible to access until the last minute. I have read about this happening in Germany for various lease-option and asset transfer contracts. The documents ran to hundreds or thousands of pages, involved large amounts of money, and were not available to the (usually non-specialist) town officials until the day of contract completion. One can, of course, argue that officials should have refused to sign until they had time to review, or send to competent experts to review, but various forms of pressure made such as step less likely. I don’t know whether there’s yet any legal doctrine to describe this kind of abuse of contract, but the substance of the abuse is pretty obvious.

    A third possibility is collusively corrupt contracts. One can’t argue that the financial advisors to church pension funds or public pension funds were, prima facie, so dependent on Goldman that the contract is unconscionable because of it; nor, theoretically, were they incompetent to review the documents critically in the sense of #2 above. Nevertheless, such advisors may have been in a structural position that made their advice, and thus the subsequent conflict, corrupt and invalid. Many such advisors regularly did large amounts of lucrative business involving Goldman Sachs or the other vampire squids, which brought in hefty fees and benefits. An advisor who insisted on close review and scrupulous advice to his clients might well have been cut out of such deals, not only with the one client involved, but with many. Without any need for actual bribery, such a situation creates a structural collusive incentive to overlook disfavorable contractual elements. Here, traditional contract law might allow the client to have recourse against the advisor — but of course, the advisor is a small fish without the means to make the pension fund good for Goldman’s abusive contract terms.

    Beyond that, more outright corruption no doubt took place as well, with direct kickbacks and bribes to relevant agents involved in signing such disadvantageous contracts. Here, traditional law might require proof that Goldman itself had participated in such corruption to recover from Goldman; otherwise, again, the ‘liable’ agent would not have the resources to cover the damages.

    In short, contract absolutism, like other legal absolutisms, should be eschewed: contracts are social facts in a social context. “Pacta servanda sunt” is a good starting point for analysis, and an acceptable default, but further review can indeed find legitimate reasons to find contractual abuse, and thus the possibility of denying the enforceability of contracts, in any particular case.

    By the way, IANAL, not to mention an not an economist, so this discussion should be taken philosophically…we’re all philosophers, after all!

  13. Skippy

    Why does the mental picture pop up in my head of a GS investment vehicle driving down the road placarded as general load, when in fact its hazardous/explosive!

    Skippy…Seems the only laws we have left that are enforced are just to put people into prison or on the doorstep there of.

  14. craazyman

    All right, look, I was the guy who sold those idiots the tranches. OK. I admit it. All right. So I thought they could read. Is that so bad? Can we move on already? I’ve got a meeting I have to go to.

    -Jolly B. Trader, Executive Senior Vice President Managing Director Proprietary Dark Pool Trading, PhD, LLC, LLD, MBA, CFA, ICBM, AM, FM, PM, GMT, BYOB, IOU (just kidding)

  15. Left Coast Tom

    Someone bought a tranched “investment” from Goldman wherein Goldman reserved to itself the right to ignore tranche order, and they’re surprised at the result? Maybe they should attempt to void the contract on the grounds that they weren’t really adults and, therefore, were unable to legally bind themselves to such contracts.

    To me the outrage is that public money was funneled through AIG to bail out a group of reprobates that includes Goldman. But limiting this to Goldman, _per_se_, and considering we’re discussing “investment” “opportunities” only open to “sophisticated investors”, I don’t really see the problem. But I do understand the point in highlighting the issue.

    1. Yves Smith Post author

      LC Tom,

      A reader who saw these deals (and BTW is an attorney by training), suggests that if the Bloomberg depiction is accurate, then the disclosure was insufficient:

      I have read hundreds of securtization disclosure documents (and drafted quite a few) and dozens of cdo dox. I have never seen any sort of “sub bond cross over date” that would apply for a deal that was taking losses. This would be such an unusual feature it would need to be highlighted in red and underlined, if I am understanding the facts in this article.

      I have seen structures that deliberately fast paid sub bonds via excess spread (ie not locked out from principal for the first 3 years). But this was permitted because it did not harm the senior notes – ie sub bond was replaced by overcollateralization via excess spread (it also lowered the coat of the liability structure… And allowed bbb holders to get out ahead of senior holders). And it was always clearly disclosed and well discussed and understood.

      This is happened on a 3 year old, under performing deal, so excess spread is not likely available.

      I can’t think of a situation where a manager would get this type of discretion – most deals are written to protect against this type of “discretion” because it creates uncertainty about what a bond is likely to get. Changes in priority or cashflow ia always set up as something that happens by operation of triggers or events clearly labeled in the dox.

      Mbs historically permitted a limited amount of discretion to manage defaulted loans (modify, short sale, pursue deficiency) which had some opportunity for conflict between them and the bond holders. As a result, there would be many checks in the dox to limit conflicts, such as requiring that the servicer not be a holder of the senior bonds…

      I can’t figure this issue out. I know the abacus deals (and deutsche’s Start deals) – i reviewed them briefly before turning them down (the sales men were relentless on these deals). I saw enough to know they were different from normal transactions. All of the normal rules were off on the sales process, structuring, review etc.

      Despite that, in reviewing the offering term sheets, I didn’t see broad cash flow priority discretion left to the manager. I would have been very surprised if I had.

      1. Left Coast Tom

        If the conditions were other than what was described then it’d make sense to me to describe Goldman (in this context) as a law unto itself. The idea of ignoring tranche order really does go against the entire point of a tranched investment.

        As a larger point though…if every “investment” has unique features to the extent that an attorney is required to look over every deal, then these have to be completely illiquid – what’s the value of such a thing? Which is the opposite of what the GSEs tried to do in standardizing everything in order to make MBS tradeable.

        And the buyers had to be aware of this – these weren’t sold to average people on the street, they were sold to people who employ lawyers to look over everything.

        I’ve felt ever since the ’98 LTCM collapse that leaving “sophisticated investors” to their own was dangerous to the overall economy. I had hoped to see greater regulation at that point. Instead, Clinton and the GOP Congress gave us Gramm-Bliley, and I don’t recall institutional investors lining up to oppose that bill. So now, I just have a hard time mustering any sympathy, particularly when I suspect that they’re not really looking for a systemic solution, but rather a particular solution to their own problem.

        1. Yves Smith Post author

          LC,

          Having worked on underwritings, and later on looking at deals (albeit simpler ones) I would hazard to say is would NOT be typical for an investor to have an attorney read every deal, this would vastly increase the costs (for stuff like investing in a hedge fund or PE fund, probably, but not regular investments, even complex ones).

          The “nonstandardness” of CDOs lay in their asset and liability structures. You’d need to look at how the waterfalls worked (presumably interest and principal payments would be separate, how fees for the manager were taken out, what reserves for the equity tranche) but I would assume this would be in one section of the deal docs. And this is a business judgment matter, not a legal matter to assess that. That is where most investors would see the risk of the deal lying.

          If the guy who saw the deal is correct, and a very non-standard feature was not flagged, as he believes it should have been, this does indeed stink.

  16. nowhereman

    I must admit I am extremely niaive when it comes to CDO’s, CDS’s. RMBS’s and CMBS’s and their internal workings. But I can’t sit by and let the caveat emptor crowd get away with saying that the buyers of this crap should have known better. Many if not most of the institutional investors that were sold these “bill of goods” were limited to investing in AAA rated investments. Municipalities, school boards, pension funds and the like trusted the rating agencies assurance that these vehicles where safe and secure. After all this was their perported “expertise”. I know, you should still read the contract you are signing, but this was the system, and people trusted the system, and the system has let them down miserably, yet no-one in the “system” is held accountable and the you should have known better crowd ignores the fact that great fraud was perpetrated and continues to go unpunished. Yes indeed, I cannot understand why anyone in their right mind would continue to deal with any of these corrupt entities. And yet they do, and blame the victims. I guess that’s Capitalism. And if it is the “God Bless America”.

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