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SEC Investigation of Goldman Trading Against Its Clients Widens

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The latest shoe to drop on the Goldman front is the report on Wednesday that the SEC was investigating yet another one of its synthetic CDOs, this one a $2 billion confection called Hudson. It isn’t clear whether the SEC will file charges, but this one has the potential to be particularly damaging in the court of public opinion, since this CDO was created solely as a proprietary trading position to help the firm get short subprime risk in late 2006, when the market was clearly on its last legs.

By way of background, the assets in a synthetic CDOs are credit default swaps. In the case of Hudson, they referenced $800 million of BBB subprime bonds, 2005 and 2006 vintage, and $1.2 billion of the ABX. The deal was a wipeout.

What makes Hudson different from the Abacus CDO that is the subject of an SEC lawsuit is that it was not even arguably intermediated between customers. Goldman was not only the initial short counterparty (as was indicated in the contract as standard verbiage), it was every and always intended to be the ultimate short counterparty. Why does this matter?

Synthetic CDOs were sold to investors as the economic equivalent of cash CDOs, ones whose assets were subprime bonds rather than credit default swaps. That was always more than a bit disingenuous. Cash CDOs had for some time been the way that underwriters would dispose of the pieces of subprime bonds they were unable to sell, namely the riskier tranches. Conceptually, it was like taking unwanted parts from (presumably) healthy pigs, grinding it up with a little bit of better meat plus some spices and turning it into sausage.

But the short players like Goldman set out to create sausage from pigs known to be sick because that would be more profitable for them, and this was a zero sum game: their profit came at the expense of their customers. Note that this is NOT inherent to investing, that the dealer’s gain is necessarily the customer’s loss. A dealer might exit a trade that he sees as unprofitable because he expect the price to fall in the next few days. The customer may have a completely different time horizon, and the success of his investment will not be affected much by what would be for him trading “noise” over the next few days.

Let’s put it more simply: how many of you would knowingly choose to be on the other side of a Goldman prop trade, particularly if you knew Goldman had designed the instrument to enable it to go short? Answer: probably zero.

There is an (in theory) less culpable scenario, but it does not get Goldman out of the SEC’s crosshairs. The initial motivation for its Abacus program (25 synthetic CDOs in total) was to lay off long CDS positions it took. Let us say a hedger like a bank wanted to reduce its subprime exposure. It could sell the loans or bonds, or simply hedge it by entering into a CDS with Goldman. From time to time, Goldman would flatten its position by bundling these exposures into a synthetic CDO. This was hardly unusual; a similar process was well established in the corporate CDS market.

So if that is the case (big if, one will have to look at Goldman’s intent, as revealed by internal messages, as to whether it was merely laying off exposures in a routine manner or cherry picking particularly drecky exposures to establish a profitable short), Goldman’s “we’re just acting as a market maker” argument is not a complete fabrication. But it still appears to have a legal problem. See this statement in its marketing documents (p. 346 of the Goldman documents released by the Senate):

Goldman Sachs has aligned incentives with the Hudson program by investing in a portion of equity and playing the ongoing role of Liquidation Agent.

Yves here. This is a flat out misrepresentation. The equity position is a Trojan horse for the much larger short position. The equity was at most 5% of an ABS CDO; the e-mails on preliminary deal structure show this one at 1% to 1.5%.; Goldman would be at least 98.5% net short this deal (if p. 401, which shows Goldman had a $8 million equity position, is correct, it was 99.6% short! And since per p. 402, it reported $17 million in P&L on the deal, so it took more out in fees than its equity stake. Nice work). It most certainly did NOT have incentives aligned with its investors

Goldman may argue that the disclaimer language in itty bitty print on the next page gets it off the hook, but I have my doubts that that will be viewed with much sympathy. There is a notion of good faith and fair dealing that underlies all contracts. It is such a bedrock concept that it is not clear that Goldman can try to disclaim its way out of it.

Goldman has more language that is misleading (p. 357):

Goldman Sachs’ objective is to develop a long term association with selected partners that can adapt to and take advantage of market opportunities

• The goal is to create attractive proprietary investments by leveraging expertise of both Goldman Sachs COO and Mortgage Desks while maintaining a consistent approach and creating a unified issuance program across multiple transactions

Yves here: Translation. We want to sell you more deals like this, so trust us, we won’t fleece you.

Note that Goldman explicitly says it is NOT laying off its own exposures, and by implication based on the body language thus far, it is pickin’ good stuff for this deal (p. 358):

• Goldman Sachs’ portfolio selection process:

• Assets sourced from the Street. Hudson Mezzanine Funding is not a Balance Sheet COO
• Goldman Sachs COO desk pre-screens and evaluates assets for portfolio suitability
• Goldman Sachs COO desk reviews individual assets in conjunction with respective mortgage trading
desks (Subprime , Midprime, Prime, etc.) and makes decision to add or decline
• All CDS use rating agency approved confirms (pay as you go)

It appears this deal was not an easy sale (p. 803, from an October 2006 e-mail by Michael Resnick):

do we have anything talking about how great the BBB sector of RMBS is at this point in time … a common response I am hearing on both Hudson’ HGSl 1s a concern about the housing market and BBB in particular!

We need to arm sales with a bit more – do we have anything?

Now Goldman defenders may argue that the investment bank is being unfairly singled out. However, that is hard to take seriously. There were very few banks in the business of synthetic CDO programs for their own account : Goldman, who is being investigated, Morgan Stanley, ditto, and Deutsche Bank….not. One industry source has also told us that Citigroup did deals along similar lines, but we have not gotten independent confirmation (update: aha, some new G2 in a very good article at the Financial Times tonight).

Some cynics may contend that the failure to go after Deutsche Bank is due to the fact that the head of SEC enforcement, Robert Khuzami, not only comes from Deutsche, but was involved in its CDO business. But the reality is more complicated. Getting someone like Khuzami, who is also a former prosecutor, was a coup for the SEC. He would clearly have to recuse himself from any cases involving his former employer. Insiders can correct me if I am wrong, but not only does the SEC not appear to have anyone who could step into Khuzami’s shoes (in terms of having both the product knowledge and the litigation experience), but it would be difficult to hire someone with a similar profile. Thus the fallback may be to perfect the litigation strategy on Goldman and Morgan so it then can then be deployed against Deutsche and not require someone as high powered to lead the effort.

Just because the wheels of justice seem to be grinding a bit slowly does not mean that in the end, they will not grind exceedingly fine.

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13 comments

  1. Siggy

    What is/are COO?

    Is there any reference to the notional pool that was used in Hudson?

    This inquiry in conjunction with Timberwolf and Abacus is a very serious confluence of liabilities.

    I would not be surprised if there is a major breakup of Goldman.

    Had to go the web site to get to this, have I been unsubscribed?

    1. psychohistorian

      “Just because the wheels of justice seem to be grinding a bit slowly does not mean that in the end, they will not grind exceedingly fine.”

      I guess there are some of us that believe that the wheels of justice have fallen off the bus. Extend and pretend are not just being used as strategies in the financial area as they are exceedingly effective in escaping justice as well.

      1. Doug Terpstra

        Excellent quote; do you know the source? How I wish it were true; it seems like a lot of collateral grinding going on.

        1. Doug Terpstra

          OOPS!(red face) None other than Yves Smith is the source of that brilliant quote! I hadn’t read the post before scanning comments. Do you have divine insight, Yves, or is it wishful thinking?

  2. NS

    “Just because the wheels of justice seem to be grinding a bit slowly does not mean that in the end, they will not grind exceedingly fine.”

    I’ll respectfully disagree. Its become exceedingly clear that over 3 years into this mess with evidence including and beyond Goldman’s activities…nothing has been or will be done. The high triple-digit Trillion dollar derivatives market is hands off. I think its all just Kabuki to look like something is being done to keep us out of the streets.

    JPM bribed local officials, participated in anti-trust activities, structured bond deals which are proven toxic. The politicians and deal makers involved in that ONE deal of Birmingham AL are in Jail, yet JPM is untouchable. Why, because they and other brokerages repeated this and similar deals nation wide. DOJ and state AGs where are you? We know, its rhetorical.

    We’re still paying AIG execs millions annually (so we won’t lose them) as taxpayers are the majority shareholders.

    But the answer to balance the budget is to cut back reimbursement rates on Medicaid for sick kids and the same on Medicare for sick and old people. They are the problem according to the ‘sophisticated’ wonks. So they should suffer first and most with no recourse ability.

    The GAO reported that 2/3s of large businesses/corporations have shelters in the Bahamas specifically to shunt profits to avoid taxation. The large banks have many multiples there and elsewhere but the FBI/IRS are working with few resources to go after the hundreds of billions annually lost revenues there. An individual can easily setup an account there, no questions, no authorities…its EASY, I looked. UBS and our good pal Uncle Phil made tax evasion for the most wealthy a fine art and technologically easy golf course pass time with their unique mobile devices to move funds without detection. Oh yeah, justice will prevail alright.

    I think the message and trend is clear. I guess I’m one of Uncle Phil’s whiners as being an honest schmuck today requires bending over permanently.

    What will the honest schmucks get? Not even utilitarian banking, safe harbor for our paltry little pennies saved.

    rant off/

    apologies.

    1. charles

      Knowing the German banks’exposure to the South of Europe
      sovereign bonds, this could be some sort of hedge

  3. Doug Terpstra

    Yves, would that you were head of the SEC (Treasury and Fed). I don’t have the smarts or a Financialese-to-English dictionary for some of this trading stuff, but the case against Goldman as you’ve distilled it looks inevitably damning—convincing to me were I a juror. As much as they hurt, I do appreciate the revelations.

    Is fraud still a crime, or has our captured legislature sanatized it with definitions so dense, proofs so anal, and penalties so trivial that it might as well be common practice? It seems so common already.

    It’s not a sarcastice or facetious question. Just one very current example: the legislature capped BP’s economic damages at $75 million, saying in effect, the most you’ll pay for any disaster you cause is 30-hours of you revenue, (no prison time for negligence or reckless endangerment) period—30-hours revenue for the greatest preventable manmade environmental disaster in the history of the world! That is deeply-flawed on its face, a crime by the legislature, in my book, and repeated in every lobbyist-written bill after bill after bill in Congress. It’s horrible. This doesn’t look like America anymore.

  4. bena gyerek

    i read through a lot of the subpoenaed emails from goldman. things that interested me:
    – when they first identified that the market was heading for meltdown in dec 06, their head of mortgages, dan sparks, referred in pretty much his first email on the subject to “structured exits” as a way of offloading their subprime exposure.
    – contrary to popular opinion, goldman as a whole did not put on a massive net short prop position (though they did get reasonably short the market). what they did do was put in place very rapidly a big synthetic short on their trading desk in order to hedge their natural long business exposure (i.e. warehoused assets for cdo business, etc). a large part of that synthetic short seems to have involved selling synthetic bbb cdo tranches.
    – the bank was not very active in the subprime rmbs market (but relatively more active in subprime cdos). it also claimed to apply very high standards, particularly with regards originator selection. my take on this is they got involved in the underlying market enough to see how toxic it was, and to identify the most abusive originators, whom they rightly avoided for reputational reasons. i also infer that this market insight was what led them to stay relatively light in the business in the first place and to see the bubble bursting earlier than others.
    – if i am feeling really disingenuous, i may also infer that they would have known exactly which originators’ rmbs to stuff in their synthetic cdos when they put their short in place. however i have no data for this. certainly if i were investigating goldman i would look at a list of the originators that goldman blacklisted for their rmbs business, and see how many showed up in their prop short synthetic cdo trades.
    – their initial hedging strategy included “jump risk protection” – basically buying protection on way otm senior tranches of iboxx. this implies they were positioning for a really rapid market collapse. however, it seems the market actually sold off more slowly than they expected, and over smaller movements they were still long delta, and bled p&l. so in 2q07 the management actually decided to unwind this correlation position, prematurely as it turned out.
    – goldman’s trading desk made an absolute killing in 3q07. but it seems that this was not because of their synthetic short, which had largely been unwound by then (in line with the largely complete shutdown of their subprime cdo business).
    – instead it looks like they made their money from “buy and flip” trades. goldman bought downgraded cdo tranches in distressed sales from real money clients. it then flipped these at a multi-point markup to hedgies, selling them a piece of what remained of their synthetic index hedge at the same time (so they offloaded the basis risk as well, killing two birds with one stone). from emails, this was senior management’s strategy from the beginning – i.e. get flat the market so they were best positioned to exploit distressed sales when the market went into total meltdown.

  5. Sam

    Very basic question here: Can someone explain what the “equity” was in these products. Yves variously refers to it as 5% or .6%… Is this merely straight RMBS CDOs vs. the CDS’s that make up the rest of the the Synthetic CDO?

  6. Doc Holiday

    Thank God Goldman is driving the Brownian Exposure Train, versus having retarded blind monkey’s driving…

    See: Option Implied Volatility 177
    regime and a high-correlation/high volatility regime. When this regime switching model is fitted to international equity indices it predicts exceedence correlation functions similar to those found in the Longin-Solnick
    empirical analysis.
    Das and Uppal (2004) provide a different explanation for the empirical
    evidence: they argue that international equity market index prices can be
    modelled as following time-invariant continuous-time Brownian motions
    mixed with co-ordinated Poisson jumps, which give rise to simultaneous
    negative return shocks to all the index prices.

    Note that, like the Ang-Bekeart regime-switching model, this model explains the observed high exceedence correlations for large-magnitude negative values of the exceedence parameter a. In a related approach using a discrete-time setting, Lo (1999) suggests a phase-locking model, in which correlations between assets switch from moderate values to very high values when the market enters a crisis period. Amen…..

    From the Bible of MonkeyMen With Large Breasts: http://economics.nuim.ie/staff/connor/documents/cgk_january_version_final_version.pdf

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