naked capitalism

Goldman has just issued an eight page letter to shareholders, in which it tries to defend itself against its critics, particularly regarding its conduct vis-a-vis AIG, with how it got short the residential mortgage market, and its compensation.

To be more terse than usual: the AIG argument is generally plausible (and not inconsistent with what Tom Adams’ analysis has found), the other two are problematic. to put it politely.

Goldman has been charged with overly aggressive marks on its AIG related exposures, which have included allegations of nefarious intent. There have long been problems with this theory. The big one is that there was and still is a greaat deal of denial among banks as to how far mortgage-related paper needed to be marked down. Tom Adams looked at the marks that Goldman asked, based on news reports and other sources, and found their marks to be realistic. Moreover, the CDOs in question were not owned by Goldman (it has been clear for some time that at least some of the AIG-related CDOs were client position; the letter indicates they all were). That means that Goldman was a swap intermediary; it had sold CDS protection to clients, then turned around and laid that risk of on AIG.

There is one part of Goldman’s argument that is tripe, however:

Over the ensuing weeks and months, we continued to make collateral calls, which were based on market values, consistent with our agreements with AIG. While we collected collateral,
there still remained gaps between what we received and what we believed we were owed. These gaps were hedged in full by the purchase of CDS and other risk mitigants from third parties, such that we had no material residual risk if AIG defaulted on its obligations to us.

Yves here. Neil Barofsky of SIGTARP has dismissed this argument. If AIG had foundered, the CDS market would have suffered cascading counterparty failures. The idea that Goldman’s insurance of AIG risk was any good is an utter canard. The fact that they are still trying to sell that discredited line does call their candor on other issues into question.

On Goldman’s betting against its clients, the firm mentions only in passing that it used CDOs to lay off mortgage risk. The reason the use of a CDO is important is that, while the offering documents contemplated all sorts of outcomes, investors would assume that Goldman was acting as an intermediary and had devised its CDO merely to satisfy market demand and lay of mortgage pipeline exposure, acting as an intermediary. But in using a CDO to create a short positio, Goldman would have the incentive to dump the very worst dreck possible into the CDO. And had Goldman disclosed its role, investors would have looked at the deal much harder.

In addition, Goldman makes it sound as if it laid off its risks on professional counterparties:

The investors who transacted with Goldman Sachs in CDOs in 2007, as in prior years, were primarily large, global financial institutions, insurance companies and hedge funds (no pension funds invested in these products, with one exception: a corporate-related pension fund that had long been active in this area made a purchase of less than $5 million)

Yves here. This is wonderfully incomplete. Goldman started its synthetic CDO program in 2004, doing 25 deals in total. Who was on the other side of these trades prior to 2007? And who were these “global financial institutions”? Were they big Eurobanks, which could be correctly viewed as professional counterparties, or does that list include foreign financial chumps like the German bank IKB? Similarly, while insurance companies are nominally professional investors, monolines save ACA were not insuring purely synthetic deals (or do they simply mean the Abacus trades with AIG?). And even though the monolines blew themselves up on CDOs, it was not for want of technical knowledge of the product. By contrast, “insurers” covers a multitude of players, some of whom are not terribly savvy and would see themselves as clients rather than trading counterparties.

Goldman’s section defending its compensation is simply lame. It so clearly believes its pay is deserved that it doesn’t even try hard here. Consider:

…we announced that for 2009 the firm’s entire management committee would receive 100 percent of their discretionary compensation in the form of Shares at Risk which have a five-year period during which an enhanced recapture provision will permit the firm to recapture the shares in cases where an employee engaged in materially improper risk analysis or failed sufficiently to raise
concerns about risks.

Enhancing our recapture provision is intended to ensure that our employees are accountable for the future impact of their decisions, to reinforce the importance of risk controls to the firm and to make clear that our compensation practices do not reward taking excessive risk.

The enhanced recapture rights build off an existing clawback mechanism that goes well beyond employee acts of fraud or malfeasance and includes conduct that is detrimental to the firm, including conduct resulting in a material restatement of the financial statements or material financial harm to the firm or one of its business units.

Yves here. This sounds good, right? Read it again. It includes ONLY the management committee. The ranks of producers (de facto profit centers) goes far deeper into the firm than the management committee. This mechanism is far too shallow, in terms of the number of employees covered, to be effective (ahem, how rich are management committee members already before they reach that lofty level?)

And this:

In addition, our shareholders will have an advisory vote on the firm’s compensation principles and the compensation of its named executive officers at the firm’s Annual Meeting of Shareholders in May 2010.

Yves again. Many of Goldman’s large investors met with the firm in 2009 to object to the bonuses that the firm appeared ready to offer. Their pleas were rebuffed. And I would be curious to know how Goldman shares are held (as in how many are in mutual funds which routinely support management).

So Goldman is unrepentant, not that that is any surprise.

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