Goldman, Deutsche, and the Destructive Use of Synthetic CDOs Come Into Focus

Gretchen Morgenson and Louise Story have a good article up at the New York Times on synthetic CDOs (or more accurately, synthetic ABS CDOs, for “asset backed securities” CDOs). The press is finally starting to turn some lights onto one of the activities that played an important role in the crisis, but has not gotten the attention it deserved.

There has been a tendency to lionize subprime shorts, with no consideration to the destruction they left in their wake. While I am not opposed to stock shorting (all it takes is the uptick rule to prevent bear raids), shorting via CDS is quite another matter, particularly since, with CDS, the exposures are typically a multiple of the value of the cash bonds. Given the levered nature of a short via CDS, this creates a very big incentive for the CDS holders to see if they can take action to make events turn out their way.

Now that may seem like a peculiar characterization; how could people who shorted subprime have done damage? After all, the housing market is huge. But CDS made the exposures to subprime going bad much bigger than the size of the market, and the parties on the wrong side of the bet were often highly levered players like big capital markets firms (per the BIS, with only 3-4% equity on average) and insurers.

The part that has surprised me is that the John Paulson story, which Gregory Zuckermann attempted to tell glowingly in his book The Greatest Trade, is actually quite damning. Deutsche Bank and Goldman come off badly too. To make a much longer story short, credit default swaps on mortgages became possible starting in June 2005 when ISDA came up with a protocol. Zuckermann credits Greg Lippmann of Deutsche, a particularly aggressive derivatives salesman, as the moving force behind this effort:

Lippmann’s radical thought was, What if an investment could be created to mimic the existing mortgages? That way, new mortgages wouldn’t have to be created to satisfy hungry investors; rather, a “synthetic” mortgage could be sold to them.[emphasis in original]

In February, Lippmann called traders from Bear Stearns, Goldman Sachs, and a few other firms struggling with the same issues, inviting them, along with a battalion of lawyers, to a conference room at Deutsche. Sitting around a blond-wood conference table, they debated ideas into the night, while picking at take-out Chinese food. Their light-bulb idea: Create a standardized, easily traded CDS contract to insure mortgage-backed securities made up of subprime loans

Yves here. Zuckermann contends that Paulson went to Wall Street to create synthetic CDOs so Paulson could short subprime. Paulson was open about his intention: he wanted to create the deal (by funding the equity tranche, typically 4-5%) and go short the ENTIRE deal, that is, buy all the CDS used in the synthetic CDO (well probably not all; even subprime CDOs had to have a certain potion be less drecky stuff). This was an out and out plan to toast the party on the other side, particularly since the party funding the equity layer had (at a minimum) veto rights (which in this case could be used to exclude better quality exposures!).

Bear Stearns, ironically, thought the Paulson plan did not pass the smell test, but Deutsche and Goldman were eager. Paulson was responsible for creating $5 billion in synthetic CDOs, but in the end this was not his main mechanism for shorting the subprime.

To the New York Times article. It’s good yet odd. It does signal very clearly the destructive potential of synthetic CDOs. It presents Goldman’s synthetic CDO program as first a way to lay off its exposures, later a way to get short for fun and profit. It has a graphic that shows a sampling of deals. Reading between the lines, it looks as if the authors are on the Goldman-AIG trial, but going where the story and their sources take them, which was into the bigger question of the use of synthetics:

Pension funds and insurance companies lost billions of dollars on securities that they believed were solid investments, according to former Goldman employees with direct knowledge of the deals who asked not to be identified because they have confidentiality agreements with the firm.

Goldman was not the only firm that peddled these complex securities — known as synthetic collateralized debt obligations, or C.D.O.’s — and then made financial bets against them, called selling short in Wall Street parlance. Others that created similar securities and then bet they would fail, according to Wall Street traders, include Deutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc., an investment company whose parent firm was overseen by Lewis A. Sachs, who this year became a special counselor to Treasury Secretary Timothy F. Geithner….

But Goldman and other firms eventually used the C.D.O.’s to place unusually large negative bets that were not mainly for hedging purposes, and investors and industry experts say that put the firms at odds with their own clients’ interests.

The article also indicates that Goldman engaged in Paulson-like behavior, teeing up the deals (presumably providing the equity tranche) and took pretty much the entire short side (the reason we highlight this issue is we believe some firms were stealthier and teed up CDOs without buying all the CDS protection created by the deal):

Rather than persuading his customers to make negative bets on Abacus, Mr. Egol kept most of these wagers for his firm, said five former Goldman employees who spoke on the condition of anonymity. On occasion, he allowed some hedge funds to take some of the short trades.

The piece also indicates that official investigations are honing in on the key question:

One focus of the inquiry is whether the firms creating the securities purposely helped to select especially risky mortgage-linked assets that would be most likely to crater, setting their clients up to lose billions of dollars if the housing market imploded.

Yves here. Um, exhibit one is the Zuckermann book…I cannot believe Paulson gave out so much ammo to critics, and that no one in the officialdom (yet) seems to have decided to make use of it.

The story also mentions how the dealers stacked the deck in their favor:

In early 2005, a group of prominent traders met at Deutsche Bank’s office in New York and drew up a new system, called Pay as You Go. This meant the insurance for those betting against mortgages would pay out more quickly. The traders then went to the International Swaps and Derivatives Association, the group that governs trading in derivatives like C.D.O.’s. The new system was presented as a fait accompli, and adopted.

Other changes also increased the likelihood that investors would suffer losses if the mortgage market tanked. Previously, investors took losses only in certain dire “credit events,” as when the mortgages associated with the C.D.O. defaulted or their issuers went bankrupt.

But the new rules meant that C.D.O. holders would have to make payments to short sellers under less onerous outcomes, or “triggers,” like a ratings downgrade on a bond. This meant that anyone who bet against a C.D.O. could collect on the bet more easily.

“In the early deals you see none of these triggers,” said one investor who asked for anonymity to preserve relationships. “These things were built in to provide the dealers with a big payoff when something bad happened.”

Yves here. The New York Times is running this as a front page story, but on one of the slowest business days of the year, which means it may have less impact than it should. Design or an accident of timing?


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  1. Michael M. Thomas

    I found the NYT account somewhat hard to follow. Two days ago, on HuffPo, Janet Tavakoli posted Goldman’s Abacus 2005-2. There’s nothing to indicate that what we’re looking at is a list of CDS bets on a series of CDOs, and not CDOs themselves. If this is so, then Goldman was buying (largely from AIG) protection on on a portfolio already consisting of protection, and how could they keep the bets internal to this Abacus fund for themselves if these were what investors were paying for? It needs to made clear that we are dealing with two sets of investors here. The investors who bought the original CDOs “proxied”in Abacus, who are at least one step back in the starvation chain, and the investors who counterpartied the CDS that make up Abacus itself.I think descriptions of Abacus-type transactions need to be very careful in the use of the word “short.”

    1. Yves Smith Post author

      As I am sure you know, the CDO is a separate legal entity, with its own liability and asset side of its balance sheet. Most people forget about the liability side when they think of them.

      AAA buyers (who were protection sellers) often hedged some or all of their risk with the monolines or ÅIG , usually for not the best reasons (reg or bonus gaming). Some monolines would not provide guarantees for pure synthetic CDOs, BTW.

      Anyone who bought an ABS CDO (they were heavily composed of subprime because they were “spready”) was betting subprime would be fine. So if it was synthetic, you were effectively a protection seller and stood to take a loss if the market cratered. The protection buyers were the shorts that made the synthetics possible. I agree you have a nomenclature issue if you are taking correlation trades (going long one tranche and constructing a short on another) but this is a pretty arcane area and most laypeople’s understanding will be pretty approximate.

      1. Michael M Thomas

        “So if it was synthetic, you were effectively a protection seller and stood to take a loss if the market cratered. The protection buyers were the shorts that made the synthetics possible.”
        This is what needs to be understood. Goldman was buying protection from the same investors to whom it was flogging these synthetic CDOs. This would add X basis points of notional pass-through yield from the “underlying” CDOs. Probably while expressing a grudging willingness to do so in the interest of facilitating its customers’ thirst for yield. And permitting GS to assert, when and if, that it was sharing the risk with its customers.
        This is a process that needs to be made comprehensible to an intelligent tenth-grader. It deserves more outrage than it can possibly generate if explications remain obtuse and confusing.

  2. Michael M Thomas

    Regarding your final comment, Yves, I think this is important to recognize. Mainstream media people – and their editors – will not give credit to, or work with, or supplement other journalists’ efforts. I learned this all too well in the 20 + years I wrote a weekly col for The New York Observer. Stories that should be simultaneously burning fiercely on the front page and lead-in screen of every bigtime medium will be limited to the originating outfit. Pitiful.

    1. Yves Smith Post author

      I recognize your name (I was flattered you were commenting) and remember your columns, which were particularly well written and pointed. If I recall correctly, you were a partner at Lehman in Bobby Lehman’s era, correct?

      Re the timing issue, I was trying to suggest something different. The WSJ last week had a rather odd story that looked like a Goldman has successfully spun the reporting, in which it discussed the size of Goldman’s exposures to AIG versus how little the firm supposedly made. The calculation of profit was obviously bogus.

      The WSJ story might have led the NYT story to have been accelerated.

      1. Michael M Thomas

        I love your blog. Read it first thing every morning. I was at Lehman back when we used basis books that calculated yield to the third place right of the decimal point. I’ve always said that the curse of the computer has been that it makes possible the profitable trading of obscenely small fractions of money. Happy Christmas, Happy New Year!

        1. Yves Smith Post author

          Thanks so much for your kind words. I started out in investment banking at the very end of the “associate as scrivener” era, doing spreadsheets by hand on ledger paper to be typed by secretaries, but the flip side (as you would appreciate fully but few do now) that this labor-intensive process led to a much better grounding in the business. Having to look through financial statements (particularly footnotes) to extract key details really did mean you understood how both the reports and the companies themselves worked better than people who simply ran reports (already pre-formatted) from databases.

    2. Chervilant

      I have been watching with bated breath the brouhaha about mortgage-backed CDOs, wondering if (when?) the proverbial caca would hit the fan. Some of my old friends in the mortgage industry have asserted that subprimes are being rewritten on the QT, perhaps to avoid the hemorrhage of investors wiser to the deceitful ways of entities like AIG and Goldman? Wiser to the relative worthlessness of said CDOs? What say you?

  3. Ben

    Your post yesterday might have triggered the timing of this. I agree that it reads like a partial report on an investigation still in progress — maybe as the story has started to come out, the two reporters decided they didn’t want to be scooped on the part of it that they could already document.

  4. Eagle

    Sorry, missed the explanation of why anyone was forced to business with Goldman instead of just buying treasuries. If an institutional investor can credibly claim that they didn’t know higher yield meant higher risk, we have bigger problems.

    1. jdmckay

      If an institutional investor can credibly claim that they didn’t know higher yield meant higher risk,

      Overwhelming majority of them didn’t do due dilligence… period. I’ve talked to many, whole lot of ’em well before bottom fell out: they didn’t know even basics of “products” they were buying, only that Moody’s said it was AAA.

      we have bigger problems.


    2. Yves Smith Post author

      Have you never heard of performance pressures? Investor money migrates to funds that provide the best returns, no matter what the risk. And you forget that these manufactured AAA instruments were illiquid. They’d be remarked only on a downgrade or credit event (recall they were using credit models to price this rubbish, it never traded), so they would show LESS VOLATILITY than actively traded instruments. This would lead to artificially low Sharpe ratios (the pension fund consultants measure returns relative to risk, which is measured as price volatility, and the Sharpe ratio is the most commonly used metric).

      So it wasn’t just the ratings agencies that had bad scorecards. So did the fund consultant gatekeepers.

      And insurers and defined benefit fund pension funds are subject to similar competitive pressures. If you as the fund manager within one of these groups are doing less well than your peers, you will be pressured, perhaps fired. So your attitude, “Let them buy Treasuries” frankly is tantamount to “Let them eat cake” if you understand the bad incentives (particularly the overly short time horizons for measuring fund performance, which favors strategies that appear to deliver premium returns until they blow up) and metrics.

      Keynes’ observation, “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way with his fellows, so that no-one can really blame him,” is still operative.

      1. Francois T

        Last time I checked, a pension fund, by its very definition, should focus on this now quaint notion, known as the “long term”.

        That a manager at a pension fund, of all outfits, could be subjected to annual or quarterly pressures underlines everything that is wrong with the culture of our actual financial sector.

        But hey! That is what happens when you cluster so many of the “best and brightest” * in the same room; none of them dare ask basic questions, since it is beneath them to do so.

        *We briefly interrupt this writing for a huddle session with an air bag!

        1. charcad

          Last time I checked, a pension fund, by its very definition, should focus on this now quaint notion, known as the “long term”.

          Leo Kolivakis used to call for a return to those good old days, too. We have made part of this time trip. 30 yr long bond rates are below 5% again.

          Unfortunately virtually all pension funds (and insurance company portfolios designed to fund annuity contracts) are currently structured around much higher rates of return. 8% and even higher. I used to ask Leo how this gap could be consistently bridged? That is, other than maybe by the methods CALPERS, CALSTRS and others had already adopted years ago: speculating in small company growth stocks and even day trading commodity futures and options.

          This is the background when GS, Lehman and the rest came around with nominal mortgage paper stamped AAA by Fitch, S&P and Moody’s. Why would anyone at the funds even bother to read it with such pedigree papers? CALSTRS already had 14% of their portfolio committed to hedge funds and private equity. Another 50% was invested in “stocks” of companies of marvelously small sizes.

  5. rcyran

    Reminds me of M. Lewis’ excellent article:

    Not only did he not mind that Eisman took a dim view of his C.D.O.’s; he saw it as a basis for friendship. “Then he said something that blew my mind,” Eisman tells me. “He says, ‘I love guys like you who short my market. Without you, I don’t have anything to buy.'”
    That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage.”

    PS- I want to know what happened to Byron as well – my favorite reporter ever, and he seems to have disappeared off the face of the earth.

    1. Martin

      Thank you for posting this link…I’ve been looking for this article off and on for a couple months but couldn’t remember enough details to find it. I read it when it first came out but I now know much more about that subject and wanted to revisit. Hat tip to you and Merry Christmas

  6. Wreckless Eric

    From the POV of an interested ( if not particularly knowledgable ) outsider, this looks like parts of the financial system spontaneously developed into something like a Financial AIDS Virus & began to merrily devour their own host.

    Now the system is infected through & through, and the taxpayer is (for some reason I never did get) obliged to pour billions into the disease wracked financial complex , in the process ( ‘well yes it’s just an unfortunate side effect’ ) fattening up the parasites ever more.

    Unfortunately it seems the financial ‘body’ has now been transmogrified into an organism which is run for the benefit of the parasites who prey on it, said parasites having apparently succeeded in taking over the remaining brains of the organism by means of a neat process called ‘lobbying’.

    Meanwhile we are exhorted to genuflect to this arrangement on the grounds that it represents ‘the free markets in operation’& therefore must be – by definition – beyond reproach.

    Is it much comfort to someone dying of some appalling viral infection to tell them by way of consolation that it’s just the way it has to be because ‘it’s the free play of biological forces’ ?

  7. Independent Accountant

    Here I go again. Where was PriceWaterhouseCoopers (PWC) when all this was going on? Where should it have been? If PWC didn’t understand the economics of these transactions, it should have resigned the Goldman account. Well PCAOB, where are you?

  8. Michael M. Thomas

    It seems obscene to deal with questions like this on Christmas Eve. Tune into 105.9 in NYC for the incredibly moving festival of nine carols live from King’s College, Cambridge.

  9. Robespierre

    Wasn’t the selling of a defective product by the cigarette companies the basis to the states’ lawsuits against them? Isn’t this also applicable against GS et all? I’m assuming that many of the pension funds that lost money belong to the states. Can this be done?

  10. Siggy

    A very long time ago I worked as a phone clerk on the floor of the CBOT. That was an open outcry, ticker tape and tote board market. Sell orders were written on red slips, buys on blue. Phone clerks were taught to fold them over to hide the color. When delivering the order slips, always walk, never run. Since then, the world has turned over several times and the markets are now dominated by electronic trading. Electronic front running is common and the scalping that it engenders is flat out theft. So long as regulators abrogate their responsibilities, you will have more of the same. It may be that we have reached a point of conduct where cheating is considered normal and acceptable.

    Creating synthetic trading instruments is going to be proven to be a great scam. Going short those very same synthetic instruments by way of CDS comes very close to being a felony. Most assuredly it can be tortous.

    The NYT article is enlightening and clearly only part of a larger story. There are hearings scheduled and they should be closely followed. What should be watched is how the major players spin their admissions and denials. This will be theater of dissembly in the extreme.

    What continually appears in the media is the concept that the instruments that are being traded are complex and hard to understand. That is a lie. A nine year old can apprehend the nature of a single contract. What is moderately complex is the coupling of concurrent and sequential trades that in their aggregate have a common purpose; to take a profit from the Market, not over time but immediately.

    Your blogs to this issue have been excellent and much of commentary has been informative. Keep up the very good work; and, do take some time to savor the holidays.

    Merry Christmas Yves.

  11. wally

    “One focus of the inquiry is whether the firms creating the securities purposely helped to select especially risky mortgage-linked assets that would be most likely to crater, setting their clients up to lose billions of dollars if the housing market imploded.”

    What the investigators are going after here is far, far beyond betting against your own clients or even selling securities you know to be defective. This accusation is: they deliberately made a defective product with the express intent of harming clients, then bet that it would.

  12. Michael M. Thomas

    Can’t resist posting this and then will shut up:

    I was looking up something in Chernow’s big book on Morgan and found on pp.354-55 this great exchange in the summer of 1932 (before the election) between Leffingwell of Morgan and FDR: “…You and I know,” (wrote Leffingwell,) “that we cannot cure the present deflation and depression by punishing the villains, real or imaginary, of the first post war decade, and that when it comes down to the day of reckoning nobody gets very far with all this prohibition and regulation stuff.” To which FDR replied: “I wish we could get from the bankers themselves an admission that in the 1927 to 1929 period there were grave abuses and that the bankers themselves now support wholeheartedly methods to prevent recurrence thereof. Can’t bankers see their own advantage in such a course?” And then Leffingwell again: “The bankers were not in fact responsible for 1927-29 and the politicians were. Why then should the bankers make a false confession?”

    1. Robespierre

      That is like saying the the perpetrator of a homicide is not responsible because the authorities where neither looking or cared. Of course, society at large would think non sense. Just because our government officials are either negligent or corrupted that does not dismiss the crimes committed by these people.

      1. Michael M. Thomas

        Posted simply because I would have thought that greatest of all experts on the 1929 Crash and Depression, Mr Benjamin Bernanke, might have been familiar with it.

        1. Robespierre

          I meant to imply that what Leffingwell said was non sense. Sorry if I came across as implying something else.

  13. Hugh

    I note the word “fraud” has not been used by anyone. This is theft by deception. The question is why investigators have gotten court orders to seize and examine evidence from participants like GS, MS, and Deutsche Bank. It would seem a logical step, even if it did scare the hell out of them and the markets. Now if I were of a conspiratorial turn of mind, I might even think that this is precisely the reason that such searches are not being executed, another wrinkle of the TBTF theme: too big too investigate.

    I agree with lambert strether too. It is by design and it echoes the Risen/Lichtblau affair. You have to keep in mind that this is not a breaking story, like of a plane crash, but one where Keller had considerable latitude in its placement. I would find it completely unsurprising if the reporters used the fear of being scooped to convince him to run it, but it is just so very, very Keller to run it, as you say, on one of the slowest news days of the year.

  14. Mannwich

    Don’t worry, Yves. The article will still make the rounds. It’s number one on the Times’ “most emailed list”. I just did my part as well.

  15. sechel

    One piece I don’t recall you discussing was their ownership of Litton, which gave them early intelligence into the declining real estate market.

  16. jake chase

    Synthetic CDOs on subprime existed because somebody chasing yield wanted to buy them. Anybody could manufacture and sell them, since you didn’t even need any mortgages to start with. Maybe you should start by asking why we have financial regulation at all if we allow this?

    By the way, we continue to allow it. What is the outstanding volume of synthetic CDOs on Turkey, Greece, Spain, etc.? What was the volume of synthetic CDOs on GM and what was their role in pushing GM into bankruptcy?

    1. Chervilant

      Oh, puh-leeeeeeeze!

      There’s enough ‘blame and shame’ to go around, isn’t there?

      Are not ALL of us complicit in this massive Ponzi scheme we call capitalism? Are not ALL of us trained to avidly and HAPPILY participate in this increasingly toxic economic behavior?

      I think our energy would be better placed finding a way to behave economically that benefits the MOST at the expense of a FEW, rather than a FEW at the expense of the MOST. However, when I make suggestions of this nature, I am most often tarred a “Marxist commie socialist pinko fascist” (add any other pejorative currently promulgated by the M$M). People are going to resist to the death giving up their filthy lucre…

  17. craazyman

    Q: What do Goldman lawyers call the fine print disclaimers in deal contracts that buyers never read and probably wouldn’t understand anyway?

    A: The “Santa” Clause

    boowah aha ha ahahahahah!

    I think I’ll leave my white sheet, rope and torch at home and not join this lynch mob — as much as I revile “Contemporary Finance” and Goldmint Stinks.

    Seems to me that the big pension funds and other “sophisticated investors” wanted all the BBQ they could eat when the pig was roasting on the fire. And if they could get in on a sweet little synthetic CDO that put a fat yield in their pocket for no money down while they helped put folks in nice big houses, well then, supersize it! And put some sauce on it, chef!

    And can anyone explain these things? I haven’t heard a good explanation yet. Ms. Morgenson’s is terrible. And Ms. Tavikoli’s too. If I were conspiracy minded I’d say they were in on the fraud, and are trying to give folks such big headaches with these contorted, word-fogged blurry explanations that even the original perpetrators wouldn’t understand what they did. Where are the editors? Why does this stuff read like it’s Chinese street signs? You could make a flow chart out of these explanations and it would be 15 arrows pointing in 5 dimensions at once. Worse than a bad fishing knot, really.

    Make it simple. It really is.

    So now the tide’s out, and all the “sophisticated investors” are revealed to be the naked morons that they were. Well, at the time they were swimming, who really knew when the bubble would pop. In theory, it could have gone on and made money for these people. As Keynes himself said “Markets can remain irrational longer than you or I can remain solvent.”

    Goldman may be clever like a soul-less fox, but I can’t credit them with the ability to see the future.

    I have a very hard time feeling pity for the immediate losers on these trades. The rest of us are covering their losses, while they still take big salaries as pension fund managers and directors. Let me get my hankee out and cry. Can you play a violin for me, a nice sad song???

    And if there is any lesson here, it should be that Ben Bernanke and other “regulators” and the politicians that enabled this have no business being retained in their current roles. They were asleep at the wheel — or totally complicit — when this style of finance was spreading like the swine flu. They screwed up big time and should own up to it.

    And perhaps the brain trust at Goldman should voluntarily resign and dedicate their lives to public service. That might be an appropriate response. But an unlikely one. ha hah. I’m not sure I’d want these snakes anywhere near public service anyway. Maybe just go home and bother the public no more. And don’t run for governor anywhere, please, OK?

    Can’t wait for the 2010 elections. Should be interesting. Meanwhile, all these investigations will likely do is make more lawyers rich.

    Q: Why was Goldman Sachs overjoyed to see tons of coal in its Christmas stocking?

    A: Because it was getting killed by a huge short position!


    1. Hugh

      I have no sympathy for pension fund managers, but do for their pensioners. But it is important to realize that with most funds underfunded in relation to their promised payouts managers, in addition to stupidity and greed were pushed into making riskier bets to make up the inherent shortfalls in their funding. They could hardly have been riper for the picking by predators like Goldman if they had been wearing t-shirts with “Desperate Sucker” written on them. So they got set up and taken down by Goldman and friends. What is really unconscionable is that in the current climate of reflating bubbles in stocks and commodities, the pension managers are committing the same mistakes they did during the housing bubble, and the result will be the same: they will get burned when things go south and lose billions.

      “Goldman may be clever like a soul-less fox, but I can’t credit them with the ability to see the future.”

      They don’t have to, or at least not very much. It didn’t take a genius to see that there were problems with the housing bubble in 2006 and that by 2007 it wasn’t a question of if but when the bubble would burst. I wasn’t even following economic issues that closely at the time and even I knew this. But back to Goldman, they don’t need to be especially smart or prescient, no one really does, if you know your bets are going to be covered by the Treasury, which at the time just happened to be run by your former Chairman and CEO.

      1. marc fleury

        This cuts both ways. The way I see it, if GS is “so smart” they will have a hard time regaining the confidence of investors. As an investor, I would be vvvvvery wary of having GS on the other side of a trade.

  18. Michaelc

    We’re losing sight of the forest a bit here, though the trees are fascinating and should be clearly described.
    The forest bit is that the synthetic CDOs were simply additional monolines. The sponsors of the vehicles (the banks) clearly understood that AIG and the existing monolines put an upper limit on their trading activities. They needed more insurers to keep the game going and diversify their exposure.

    So they came up with a structure where non regulated investors act as monoline insurers. They structured it such that the long term bondholders bear risk only in the event of a catastrophic market collapse. Fund short term with CP, whose investors will only be concerned with yield and rating. Float it with minimal capital. Equity and cp holders will take the hit for noncatastrophic losses. Chances are they (CP buyers) won’t realize the extent of their risk until too late. Result. Exactly as planned. Canadian CP goes off the rails when the underlying CDOs tank and CP investers get a rude shock. ABCP markets freeze, Montreal Accord is negotiated and most of the world today is still in the dark about what actually happened.
    Long term bondholders realize they are equity holders in a catastrophic insurance pool and weep.

    To describe the generic synthetic CDO transaction to a tenth grader I think I’d put it this way.
    GS and others (lots of others) sponsored insurance companies that weren’t called insurance companies.
    The insurance companies wrote policies that protected houses (ABSCDO)against fire (default)
    Investors bought bonds and equity to get the company up and running.

    If no houses burned (defaults) the investors get to keep all the premiums. If some houses burn(default) the insurance co pays out and at the end you take a hit for those losses. Simple insurance, just substitute CDS for houses and understand the CDS is on CDOs . Got it?

    Then if you’re a clever sponsor, set up an insurance company that insures some of the houses (crap CDOS you wrote) that you control.
    Sell the company to the investors.

    Go short. Buy some CDS protection on the new company.
    Set fire (mark down the CDO you wrote)
    Collect insurance.

    Merry Christmas

    1. fresno dan

      Michael C: Thanks for the explanation and analogy. I am afraid that try as I may, I am still too obtuse to understand this stuff and far below the intelligence of a 10th grader (I need to find a site that can explain this to a 5th grader – any suggestions would be appreciated), though I am straining so hard I feel as if my brains will pop out my ears.

      “So they came up with a structure where non regulated investors act as monoline insurers. They structured it such that the long term bondholders bear risk only in the event of a catastrophic market collapse”

      I thought there was a catastrophic market collapse??? So, is what is happening that the “insurance” didn’t cover the specific catastrophe (you had fire insurance but got hit by a hurricane?)or the “insurance company” had insufficient funds to cover the catastrophe (i.e., the Mortgage backed securities defaulting)? I mean, if you have insurance, and your house burns down, you may be sad, but your monetary loss is made good. If all these subprime mortgages were all backed by these (CDO’s CDS, etc) than why was there a financial meltdown??? When you say “long term bondholders” are you referring to the bond holders of the subprime loans, or that the owners of the synthetic CDO’s are long term bondholders?

      Sorry for the uninformed questions, but a lot of these financial products strike me as “uneconomic” – that is, you can buy a warranty on a toaster, but is it really worth it? And pay 20$ for the warranty, for a toaster that costs 20$, and that pays only 10$ should the toaster fail.
      If your paying insurance on a bond defaulting, won’t that cut your yield – and don’t you just reach a point where it makes more economic sense to just buy treasuries – if your so concerned with safety?

      And in the final analysis, these products don’t seem to have protected anyone who bought them.

      1. Michaelc

        First, I should have said the sponsors created a non-regulated insurance co, not unregulated investors..
        Regarding the catastophic bit, the sponsors/LT bondholders didn’t anticipated a complete meltdown (at least the bodholders didn’t, the sponsors, who knows), so the capital structure division between LTD/STD/equity was calibrated to reflect likely losses. Equity takes first loss, ST takes next, LT takes last loss, and Super senior (an entirely new class, better than AAA (ha) takes no loss absent Armageddon. Guess who kept the Super Senior pieces. A goodly chunk was funded by unsuspecting CP investors. If the meltdown went according to plan, the only losers would be the equity and CP investors. Oops. Things got really ugly when the Super senior pieces got downgraded.

        Another twist that makes the ‘oversimplification’ of insurance company is that unlike an insurance company that needs to maintain a certain level of reserves to meet claims, these ‘insurance’ companies are fully funded at inception. In other words if the entity writes 1b in CDS it raises 1b in cash and keeps it on reserve.
        If LTD investors borrowed their share, collateralized by their claims to the ‘insurance’ co, they’re in a bind with their lenders.
        The CDS buyers (the insured), on the other get paid. Which leads us to the question of who was buying the insurance? The buyers were those who needed protection on the value of the underlying CDOs and those that speculated the market was going to go down (the housing market shorts)

    2. marc fleury

      1- Yes, Synthetic CDO’s are pools of “naked CDS” and this was a way to market naked CDS as AAA rated bonds to investors. The mechanism is clear.

      2- The presentation above puts the emphasis on “moral hazard” but I honestly believe that further investigation into synthetic CDO’s will expose them as the long-term liquidity drains they were and should be squarely blamed for the initial liquidity drain that Aug 2007 sparked and as a transmission mechanism of the subprime virus to other markets. For all the noise on this blog, treating liquidity symptons, even in the face of an underlying bankrupt system, was the right thing to do and Bernanke didn’t fall for that one. Give credit where credit is due.


      2/ However, the classic line of defense will be that this was mis-priced due to the gaussian distribution of risk assumed in the models. No one will claim they have done anything illegal, it was a just a gigantic mis-pricing. In other words, the instrument itself will not be deemed “illegal”. Just dangerous and fraught with risk.

      3/ Establishing that GS purposefully designed harmful products by packaging CDS on names it knew were in debt trouble is probably the more promising line of attack. This private use of assymetric information would be very damaging to GS’s image and would crush its image with many investors “they are so smart, you should NEVER be on the other side of a trade”.

      4/ I would be interesting to know in more detail whether GS was actually short the subprime market, by packaging its own CDS bets directly or was just acting as a “middle-man” in the deals with the J Paulson of the world. Just acting as a middleman is not directly reprehensible, taking short bets while selling the security was a clear conflict of interest. It would point to a new Glass Steagal to deal with this.

      1. Yves Smith Post author


        The Abacus deals (and Deutsche’s Start program) have been within the CDO community recognized as deals where Goldman was acting on its own behalf, not for customers, laying off its mortgage risk of various types (RMBS and CMBS). The New York Times piece is more specific, and says the firm also used Abacus trades to go net short.

        So no, these were NOT customer trades.

        1. marc fleury

          Yes the article is quite clear. It seems GS was speculating quite heavily (6x its CDO exposure?) all along and it was AIG afterall and uncle sam that ended up paying for the whole mess. Moral hazard was strong, conflicts of interest everywhere. But the fact that they used privileged information to screw their customers (including the US govt via AIG) is troubling.

  19. Dean Stockman

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  20. Michaelc

    Yves, will you expand on this critical point? or correct my interpretation. Your readers are saavier than I am, but “long protection equals short the market” is tough to keep straight as we meander through the CDO, then the synthetic and back again to the underlyings, and then on to motive.

    ” The article also indicates that Goldman engaged in Paulson-like behavior, teeing up the deals (presumably providing the equity tranche) and took pretty much the entire short side (BY BUYING UP ALL THE CDS SOLD BY THE SYNTHETIC)(the reason we highlight this issue is we believe some firms were stealthier and teed up CDOs without buying all the CDS protection created by the deal):

    Rather than persuading his customers to make negative bets on Abacus,( OR TIPPING THEM OFF TO WHAT HE WAS UP TO MORE LIKELY- SHAME ON GM FOR MAKING THIS POINT SO ABSTRUSELY) Mr. Egol kept most of these wagers for his firm, said five former Goldman employees who spoke on the condition of anonymity. On occasion, he allowed some hedge funds to take some of the short trades

    In other words, GS/Paulson etc originally bought all the protection in the Synthetic deal. (Synthetic writes protection, GS/Paulson buys the protection with the result that GS/P etc is short the market (market tanks,protection pays Goldman et al)) Correct?

    I’ve had some experience looking at these deals and appreciate they are meant to be opaque. But they can be made comprehesible to mere mortals. You write as an insider ( and very well, thank you) to a knowledgeable audience. NYT writes for an educated audience. The NYT article is preening essay meant to impress rather than enlighten their readers, to delight the blogosphe and reaffirm the myth that this is all to complicated for non professionals. What a travesty. Her piece deserves to be published on a slow news day.

    Hopefully a more widely targeted and informative followup page one article will be written under Taibbi or M Lewis’s byline. Then maybe it will get the attention it deserves.

    You can help by clarifying the long/short analysis into language a less experienced reader can clearly understand.

  21. ex VRWC

    Why don’t articles like this mention the other half of the story – that when they madethese bets they made to short yours and my mortgage and won, that the money to pay on their bets came from you and I and our children in the form of the bailout of the likes of AIG? I read the article and didn’t see AIG mentioned at all? Am I just missing something?

    It would seem to me that connecting the dots between these speculators and their short bets, the crisis, and the government basically making good their bets to keep them afloat is a picture that could resonate right down to ‘Joe Six Pack’.

  22. Mary Bourdon

    For several years now, I have been cynical about Goldman Sachs. It started in late 2007 (I believe) when Abbey Cohen stated on CNBC that “we” ‘see the market going to 16,000(plus or minus)’. But what really drove me over the edge was Goldman’s ‘Oil to 200.00 a barrel’ declaration in mid 2008. The “we” at Goldman supported their investor advisory on oil(their opinion was blabbed about on every major news station) with the declaration that the demand for oil would not slow down, that it would just keep growing (Goldman’s participation in the market manipulation of oil prices helped to speed up the financial crash).

    If Goldman was betting that they would make lots of money on mortage defaults, then how does an investor advisory ‘oil will not go down’ square with betting against housing (China’s too big to fail theory?). The ‘oil at 200’ media blast (they had to have known that they would get a free ride on their declaration) took place only a few months before September 08 market panic.

    Goldman didn’t sincerely believe that demand for oil would keep growing, because they knew that some sort of economic decline was coming. No matter what price American’s ought to pay for gas at the pump, the price shock of 08 was too fast and too much for Americans to deal with.

    Goldman is cunning for the short term, stupid in the long term. As a business, they don’t add much value to the U.S.

    They need to become a smaller bank with not much power to effect the whole economy. Goldman’s real smarts (lack of) can be seen on their previoius quarter balance sheet–which amounts to a modest income from fees charged to clients.

    Goldman isn’t smart or talented in the true sense of these words, just connected to people in high places.

    1. charcad

      If Goldman was betting that they would make lots of money on mortage defaults, then how does an investor advisory ‘oil will not go down’ square with betting against housing (China’s too big to fail theory?)…No matter what price American’s ought to pay for gas at the pump, the price shock of 08 was too fast and too much for Americans to deal with.

      And which group did $4/gal gasoline and $5/gal milk hit proportionally the hardest? Can you say ssss…subprime?
      You have to get to work to get paid at all, kids have to eat, utilities have to be paid…. So which bill in the pile would you choose to leave unpaid, maybe just a bit at first?

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