On Goldman’s (and Now Morgan Stanley’s) Deceptive Synthetic CDO Practices (aka Screwing Their Customers)

Goldman is trying to diffuse the increasingly harsh light being turned on its dubious practices in the collateralized debt obligation market, with the wattage turned up considerably last week by a story in the New York Times that described how a synthetic CDO program called Abacus was the means by which Goldman famously went “net short” subprime. We’ve mentioned Abacus repeatedly because AIG wrote guarantees on at least some of the Abacus trades.

One of the things that has been frustrating in watching this debate is the peculiar propensity of quite a few observers to defend Goldman and its brethren, and to argue, effectively, caveat emptor. Contrary to the fantasies of libertarians, that is not in fact how markets, particularly securities markets, operate. In virtually every market in the world, when someone represents his wares as being sound and safe and they turn out to be “bad” and dangerous, the seller is considered to have some responsibility for the damage. Remember those Pintos that turned into fireballs when rear-ended? The pets that died from pet food laced with melamine from China? No one suggested that the buyers of those products were at fault.

I’m deliberately using extreme examples, but as we proceed, you will see they are not unreasonable. Those products did not fail by design (well, the faults of the Pinto were known and left uncorrected). By contrast, Goldman wanted its Abacus trades to fail. That was the most profitable course of action for them (note the Times clearly states that that was the role of the Abacus trades and Goldman has not disputed that claim). They were net short, this was no mere hedge of a long position but a trading bet. And those CDOs did turn out to be big turkeys.

If you sell a stock when have inside, non public information that the company was in serious trouble without disclosing this information – you are likely to be held accountable. If you sell a manufactured product and it causes harm, you might be held liable regardless of whether you knew it was faulty (strict liability). In fact, if sellers were not held responsible for product quality to some degree, commerce would become impractical. In a pure “buyer beware”, dog-eat-dog world, every transaction would require extensive and prohibitively costly due diligence.

Now let us turn to the CDO market (and by “CDO” we mean “ABS CDO” or “asset backed security CDO; there are other types), where buyers (contrary to uninformed views otherwise) DID routinely perform extensive due diligence, and nevertheless, lemming-like, went to slaughter. It wasn’t just the investors or the now-derided guarantors; many banks wound up with lots of CDOs on their balance sheets (for not very good reasons, but that is beyond the scope of this post).

But then we have the famed short sellers who used synthetic CDOs as their means for getting short. With a synthetic CDO, no one puts up cash. It is a little corporate entity. The asset side is various credit default swaps, in this case, “referencing” mainly subprime bonds, the BBB tranches. So the cash flow comes from the premium payments on these CDS. The liability side is tranched, so you have an equity tranche, BBB, A, AA, and a junior AAA layers, then say two more AAA layers and the infamous super senior tranche (there could be more tranches than this, but you get the general idea). But the investors do not make cash payments; they are effectively protection sellers, or insurers. But it is important to note that is not how the deals were hawked; they were presented as a convenient, faster-to-launch alternative to the old-fashioned cash CDO. (This may seem like a distinction without a difference, but as you will see soon, it matters).

Now let us turn to Goldman. The New York Times last week published a story that discussed how a Goldman synthetic CDO program (series of deals) called Abacus. Goldman was not merely the structurer of these deals; unbeknownst to its investors, it was usually the ONLY protection buyer in these deals; it occasionally let some favored hedge funds participate in a minor way on the short side. In other words, the sole purpose of these deals was for Goldman to put on a short position.

Goldman issued a disingenuous defense on its website. It isn’t long, but let’s look at the key sections:

Synthetic CDOs were an established product for corporate credit risk as early as 2002. With the introduction of credit default swaps referencing mortgage products in 2004-2005, it is not surprising that market participants would consider synthetic CDOs in the context of mortgages. Although precise tallies of synthetic CDO issuance are not readily available, many observers would agree the market size was in the hundreds of billions of dollars.

Many of the synthetic CDOs arranged were the result of demand from investing clients seeking long exposure.

Synthetic CDOs were popular with many investors prior to the financial crisis because they gave investors the ability to work with banks to design tailored securities which met their particular criteria, whether it be ratings, leverage or other aspects of the transaction.

Yves here. This is all background, but notice that “synthetic CDO” includes synthetic collateralized loan obligations. In fact, if you had said “synthetic CDO” prior to the recent focus on synthetic ABS CDOs, most Wall Street types would have assumed you meant synthetic CLOs. It was a longer established, bigger, and less complex product. CLOs are tranched products made from leveraged corporate loans.

As an aside, this bit is simply precious: “… it is not surprising that market participants would consider synthetic CDOs in the context of mortgages.” Ahem. Goldman pushed the ISDA protocol that made synthetic CDOs possible, and along with Deutsche, launched the first deals. And who were these “market participants” who were so keen to get synthetic CDOs done? Not the long investors, but none other than John Paulson, the famed subprime short. To pretend that the growth of subprime ABS CDOs was driven by the long side is a misrepresentation. It was the shorts that pushed the development of this product.

As we stressed in a recent post, the bulk of the value of a deal was in the AAA tranches, which for ABS CDOs represented 70% to 90% of the total value. They did not drive the structure of the deal; it was well cooked by then and they had influence over certain parameters. As someone who did package CDOs told us:

They [the AAA investors] usually couldn’t see the big picture (e.g. they were getting long massive amounts of risk), yet they were keen to nitpick over documentation. On managed transactions they usually didn’t have the right to DK individual collateral items, but they could (and often did) negotiate deal parameters (e.g. max AA CDO bucket, max synthetic bucket, reporting, controlling class provisions, etc.) I would say that they were brought into the deal around mid-way, once the manager and majority of the equity was locked down. The banker/structurer had to be the arbitrator between equity, monoline, the rating agencies, and their own P&L from the structuring fee & warehouse carry.

In other words, the AAA investors were not equal parties in negotiating, despite their economic weight; many parameters were largely set before they were brought in. The main drivers in the structuring were the equity investors, the monoline, the rating agencies, and the bank’s own economics.

Goldman, of course, protests that everyone is a grown-up, and perfectly capable of taking care of themselves:

The buyers of synthetic mortgage CDOs were large, sophisticated investors. These investors had significant in-house research staff to analyze portfolios and structures and to suggest modifications. They did not rely upon the issuing banks in making their investment decisions.

Yves here. I find this “sophisticated investor” bit very amusing. Just because an investor might be “sophisticated” by securities law standards does not mean he is highly skilled as far as ABS CDOs are concerned.

People who were in that business have consistently said that very few people are competent in the product. One estimated 1000, another even fewer. This is in the world, mind you. No matter how you cut and slice it, this is far fewer than were dealing in the product. This is no surprise to me; I did work in the early days of OTC derivatives, and it was widely known then that the number of people who understood the products was a small fraction of the population selling and buying them. So we’ve had nearly 20 years of it being completely acceptable, even normal, for “sophisticated” investors to dabble in instruments that they were at least a bit, maybe a lot, beyond their ken.

As an aside, that was not for dint of trying to become more knowledgeable. In CDO-land, one of the dirty tricks the dealers played was model arbitrage. The customers were given models for assessing the deals that were less sophisticated than the ones used by the packagers/underwriters.

So let’s go to the next bit of Goldman self-defense:

For static synthetic CDOs, reference portfolios were fully disclosed. Therefore, potential buyers could simply decide not to participate if they did not like some or all the securities referenced in a particular portfolio.

Yves here. Hard to know for certain, but my impression is this is largely irrelevant. Many, if not most, deals were managed, meaning they were effectively blind pools. In those cases, the parameters would be specified, and the equity investor would have a veto on particular assets. And the AAA investors could nix certain categories (say no option ARMs or CMBS) but not particular bonds.

And even if the portfolios were specified, how realistic was it to assume they could be evaluated? The CDOs were composed mainly of trances of subprime RMBS, the BBB tranche in “mezz” CDOs. A typical subprime bond issue contained 5000 mortgages. I honestly do not know how many bonds would be in a CDO, but it was obviously more than 100. 100 RMBS tranches means 500,000 mortgages.

In the early days of the crisis, bottom fishers tried looking at CDOs and for the most part gave up on systematic evaluation. It would take too long and cost too much money to assess the value due to the complexity. Those factors were no less operative when the CDO was being launched. In other words, one could argue that the long investors, particularly the AAA investors, who were earning not-sexy spreads, would find it uneconomic to do old-fashioned, granular credit analysis. That isn’t to say they didn’t stress test them; in fact the monolines modeled them assuming six to eight grade downgrades, which was considered catastrophic for AAA paper. It never occurred to anyone that AAA paper could go to CCC. Why? That had simply NEVER happened before, in the absence of massive fraud…..until it happened on a very large scale, with CDOs.

But what were the economics to the shorts? Aha, if you are buying at 140 basis points, and you in the end close out your position at 10,000 (which happened in some cases) you have vastly more upside than the long side. That means you can afford to do much more due diligence, or if you are Goldman or someone packaging a synthetic CDO to suit your needs, you can afford to do the work to devise something that suits you well but will not be obviously toxic to those on the other side of the trade.

This is the part the defenders of Goldman, Deutsche, and others are missing. Heretofore, the packagers had been…packagers. They had product in their warehouses from mortgage originators that they were putting into deals. Just as in traditional underwritings, they were assumed to be balancing the needs of the issuer against those of the buyer. It is more than a bit disingenous for Goldman to protest the everyone knew it could be on the other side of the trade:

It is fully disclosed and well known to investors that banks that arranged synthetic CDOs took the initial short position and that these positions could either have been applied as hedges against other risk positions or covered via trades with other investors.

Yves here. Please. If these deals were regulated by the SEC, Goldman’s role in the deal would have had to be disclosed and it would have made a CONSIDERABLE difference in the pricing. To pretend otherwise is an insult to a reader’s intelligence.

And a lawsuit filed against Morgan Stanley suggests that synthetic CDO buyers, when an investment bank was using the deal for its own purposes, are advancing credible theories as to how they were had From Business Week (hat tip reader Barbara):

Morgan Stanley was accused in a lawsuit of defrauding investors in a collateralized-debt obligation, called the Libertas CDO, by collaborating with ratings companies to place triple-A ratings on the notes.

Morgan Stanley, the sixth-biggest U.S. lender by assets, arranged the offering as it was short-selling almost the entire $1.2 billion worth of assets in the CDO, according to a complaint filed today in federal court in New York.

“Morgan Stanley was betting the entire investment it was promoting would fail,” the public employees’ retirement system of the Virgin Islands said in the complaint. “The firm achieved its objective.”

Yves here. The fact is that pretty much every investment bank in the second half of 2007 was trying to offload its subprime exposures into CDOs. But look at the party suing, the employees’ retirement system of the Virgin Islands. Do you think they have lots of fancy models and skilled experts to assess these deals? I’d bet not. And I’d also bet that at least some of the Abacus investors were no more sophisticated than this Morgan Stanley CDO investor. Back to the article:

“By collaborating with major credit-rating agencies to place Triple-A ratings on the rated notes, Morgan Stanley intentionally or recklessly misled investors in the Libertas CDO,” according to the complaint. “But for Morgan Stanley’s violations of law, the rated notes never would have been issued.”

CDOs typically repackage bonds and other assets into new securities. The Libertas CDO didn’t buy the mortgage-backed securities, according to the complaint. Instead, it entered into credit-default swaps that referenced mortgage-backed securities. Credit-default swaps are financial instruments that function as insurance for bondholders. As the credit-protection buyer, Morgan Stanley was shorting the securities, or betting they would fall in value.

“Morgan Stanley was highly motivated to defraud investors,” the retirement system said.

The bank also had an unfair advantage because it had access to information on the assets the investors didn’t have, according to the complaint. The securities were riskier than the bank let on and in fact were impaired at the time Libertas was created, the retirement system said.

Yves here. I am not a lawyer, but the idea of pursuing the investment bank for fraudulent AAA ratings could be a promising line of attack. Now this is only one suit, but if this theory prevails, this could do considerable damage to industry balance sheets. And right on the heels of record looting, um, 2009 bonuses.

An editorial in the New York Times today indicates that the pursuit of the CDO dead bodies could prove costly to other powerful parties:

To be thorough, investigations of these and other questions would have to reach into the Obama Treasury Department. One of the most aggressive creators of the questionable investments was a firm called Tricadia, whose parent firm was overseen by Lewis Sachs, now a senior adviser to Treasury Secretary Timothy Geithner.

We might finally get some answers, as well as some good theater.

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  1. Robespierre

    Here is a little quote of something that to me is very similar to what the IBs did. Where it says smoking put CDOs and IMO the DOJ most likely has a case. no?

    Tobacco Class Action Suit & DOJ – Recently, the United States Department of Justice won a great victory in that suit. Federal District Court Judge Gladys Kessler held that, if proved, the government’s charge that the companies deliberately conspired to conceal the truth about the dangers of smoking would constitute a violation of the federal racketeering statute, “RICO” (Racketeer Influenced and Corrupt Organizations Act). Judge Kessler ruled that if the companies misrepresented and suppressed research regarding the carcinogenic effect and addictive nature of cigarettes, and “aggressively targeted their [marketing] campaigns to children,” as the government alleged, the tobacco companies could be liable for RICO damages.

  2. jck

    What is clear is that you have never read a synthetic CDO prospectus. It is standard for the issuer to be the counterparty to the spv and disclosed in the prospectus. We are dealing with professional investors who are supposed to read prospectuses, not idiot widows and orphans relying on the SEC.
    Here is a sample of one of the Libertas deal from Bear Stearns.
    “Bear, Stearns International Limited, (“BSIL”), an affiliate of the Initial Purchaser, will act as the
    counterparty with respect to all of the Credit Default Swaps, which are expected to be all of the Synthetic
    Securities which the Issuer will enter into (or commit to enter into) on the Closing Date. This relationship
    will create certain conflicts of interest for BSIL and expose investors to the credit risk of BSIL. Each of
    the Synthetic Securities into which the Issuer is expected to enter (or commit to enter) on the Closing
    Date will be Credit Default Swaps under which the Issuer assumes the risk of a Reference Obligation.”

    1. Skippy

      The SEC job is to over see construction and implantation of financial’s, to protect against predatory-malicious or accidental wrong doing on both party’s parts.

      •FAS No. 161 – Disclosures about Derivative Instruments and Hedging Activities an amendment of FASB Statement No. 133.

      This will be interesting as a back drop to the past, will it not.

      Skippy…there are gel tabs now, that in medicine remove memory, facilitate pain management, have you taken one / need one?

    2. Richard Smith

      Puzzling comment there, jck. Thought you were in the “caveat emptor” camp. You tax Yves with not doing the homework, yet the example wording you provide seems, at first blush, to confirm her conclusions. Consider:

      First, Bear states up front that they reserve the right to completely screw anyone signing up to their deal – do you disagree that this is the import of the “certain conflicts of interest” clause? I think my reformulation is more to the point, and, to use a phrase from the post, less disingenuous.

      Second, “professional investors” signed up to such contracts. More fool them, as you correctly remark.

      Third, and generalizing based on your claim that these types of provisions were universal, the IBs not only wrote the contracts, but operated the entire underlying business model, on the basis that there was a supply of bozos, wrongly classified as expert investors, prepared to sign up to these deals. In a narrow sense, the IBs got it right.

      So – what is the point of the “professional investor” construct? The IBs appear to assent to it when it suits them (for instance when assigning blame) and not when it doesn’t (for instance, when they are actually doing their business).

      All looks disingenuous to me.

      I am familiar with your excellent blog and your ferocious style. I hope you will tell me (rather tersely I imagine) where I am going wrong.

      1. jck

        I have done my homework i.e. read the prospectus and she has not. Yves appears to be claiming that these CDOs carried risks that were undisclosed: FALSE. The prospectuses show (and that’s standard for synthetic CDOs) that the so-called “professional” investors, assuming they can read of course, should have known that the IBs were on the other side of the trade + “this will create certain conflicts of interest…” as this is on balxck on white in the prospectus.

        1. subprime lawyer


          I do not understand your caveat emptor argument. Investors can be faulted for being ignorant but can they be faulted for not being lied to.

          When it comes to rating corporate debt there are a lot of customers. Therefore there is not a lot of pressure on ratings agencies. In the subprime sphere there was a small set of customers (issuers) and they were offering the ratings agencies a lot of money. The issuers could effectively force the ratings agencies to give the bonds certain ratings. It seems incredible that many bonds went from AAA to junk in a matter of months.

          jck, are you saying that investors should have assumed that the banks were operating in their in interest and that they were manipulating ratings?

          1. subprime lawyer

            Sorry for the typos. I repost.


            I do not understand your caveat emptor argument. Investors can be faulted for being ignorant but can they be faulted for being lied to.

            When it comes to rating corporate debt there are a lot of customers. Therefore there is not a lot of pressure on ratings agencies. In the subprime sphere there was a small set of customers (issuers) and they were offering the ratings agencies a lot of money. The issuers could effectively force the ratings agencies to give the bonds certain ratings. It seems incredible that many bonds went from AAA to junk in a matter of months.

            jck, are you saying that investors should have assumed that the banks were operating in their best interests and that they were manipulating ratings?

          2. Eagle

            jck is saying that contrary to the paragraphs Yves spent posting otherwise, the IBs did disclose, possibly more clearly than they had to per applicable securities laws, that they may have a conflict of interest.

            Ratings manipulation is separate topic and should be investigated thoroughly. Most likely tho, the ratings agencies did what anyone who understands incentives should have assumed – they played to the hand that was feeding them.

        2. Yves Smith Post author


          With all due respect, I am WELL aware of of the fact that the dealer is the initial counterparty. You accusations are misplaced.

          There is a BIG difference between buying a CDO on the assumption that the dealer is merely acting as an intermediary (acting as CDS counterparty on a short-term basis) versus creating the CDO with the intent to act as a principal as regards the short position and therefore can be assumed to have designed it to fail.

          You are also omitting the fact that these deals were typically sold as being the economic equivalent of cash CDOs, where the assets would in most cases be sourced from third parties, and if the dealer owned a mortgage broker, that would be public knowledge.

          1. jck

            Yves, thx for your reply, mine will be short:
            “Never attribute to malice that which can be adequately explained by stupidity.”

          2. Anal_yst

            Agreed with JCK’s malice/stupidity quote, 100%, and in addition, “no man has ever gone broke underestimating the intelligence of the American (or whichever) people.”

            Your defense of the lazy, the indifferent, the negligent, and the proud in this case is puzzling. You’re a smart person, why are you going out of your way to defend those who effectively begged to be had?

        3. Ram

          While a prospectus usually caveats anything and everything and hence arent guilty of misrepresentation, its the rest of the marketing material and the sales conversations where misreps usually take place. Claims such as “these are safe bonds since we dont expect many subprime bonds to default” are either implicitly or explicitly part of presentations and conversations. That is fine if the bank (the sales/syndicate desks) believed that to be true, but is fraudulent if they knew/were betting on that being false while marketing the CDO.

      2. David

        I’m not especially sympathetic to the argument that buyers were provided with inferior models. Who provided the models anyway? FEA? Bloomberg? The dealers themselves?

        If the bank gave them a model for pricing its CDOs, they must have known the model would be inferior to what the bank used internally. If you want a better model, develop it yourself. Of course there’s model arbitrage. It’s one of the accepted weapons in the trading of structured products.

      3. jake chase


        What exactly were the legitimate expectations of the buy side? Why would anyone sell a synthetic CDO of ABS for any reason except to short the underlying market? What makes these contracts ANYTHING except insurance for the benefit of those without an insurable interest? Why isn’t everyone who participated in the ISDA cheerleading or who understood this as a market participant and failed to object to the obvious consequences (which many people did) not similarly responsible for the resulting disaster?

        Isn’t it true that these OTC derivative constacts were entirely UNREGULATED? Did Goldman have ANY disclosure obligations to the buy side beyond disclosure of the terms? When did it become fraud to understand the CONSEQUENCES of a security and not provide a road map to those unwilling to think for themselves. You can say that the rating agencies misrepresented the risk; they will claim they only ventured an opinion. What Goldman did was understand the consequences of synthetic CDOs. What the buy side did was ignore them.

        1. Richard Smith

          Haven’t changed my view of the buy side since yesterday. The buy side has a giant agency problem. Overlay a speculative mania on top of that, add some smart spivs, and it can only end in tears.

        2. Yves Smith Post author

          The buy side was told these were designed to be the economic equivalent of cash CDOs, and they could be launched much faster than cash CDOs. If you were worried about rate moves, the speed would be a plus.

          Agreed re the short issue, but investors had been buying synthetic bonds for years (recall how CDS in corporate bonds is a multiple of the underlying). That probably desensitized them to the issue.

    3. scraping_by

      An old saying claims salesmanship happens in two parts: First is getting the customer to say ‘yes’, second is telling him what he’s agreed to. Here we have a conflict between the ratings and the caution clause. What’s supposed to be mathematical and, one assumes, verifiable, has turned into patter.

      Very few investment models I’ve seen take into account paragraphs in the prospectus. They usually quantify the ratings and accept that as an absolute expression of the risk. Otherwise, you’ve strayed into opinion and experience and that’s risky.

      I hope the caveat crowd’s not relying on envy from the people clinging to their guns and religion to push aside the blame. This is main street money, eventually, that’s disappearing in these black holes. The fact that one suit flim flammed another is cold comfort.

      1. Fraud Guy

        And I have negotiated terms in contracts that did not appear in the final version, and had stuff like this inserted to override the negotiations.

        How dense are these agreements? And if previously vetted, how possible is it for one side to make changes in the final text that were not caught?

    4. MichaelC

      I had a look at the Fitch press release re ABACUS 2005-7 (as a sample, I don’t know which Abacus Deal Gretchen M was referencing in her article)
      “ABACUS 2005-7 is a leveraged super senior transaction that has issued $130 million in credit linked notes. The note proceeds collateralize a credit default swap with Goldman Sachs Capital Markets, L.P. THE PROTECTION BUYER. The credit default swap synthetically transfers credit risk on the portion of the $6 billion reference portfolio from GSCM to the ISSUER with respect to credit events.”

      I think (sadly)that the NYTs claim that
      “Goldman was not merely the structurer of these deals; unbeknownst to its investors, it was usually the ONLY protection buyer in these deals” is inaccurate.

      Unfortunately for this argument it WAS known, at least to
      any investor( and NYT fact checker) who looked at the Fitch ratings report or the propspectus.

      It needs to be demonstrated that GS went massively short in their prop book at some point after 2006 for this story to have any legs. Otherwise, they can credibly claim that these deals were business as usual and that any efforts to suggest fraud and dirty dealing are pure speculation.

      The argument against the product is still valid and should be persued, and the pieces that were bought by AIG are still relevant.

      1. Yves Smith Post author


        Per my comment above, the dealer ALWAYS acted as the initial CDS counterparty. The normal protocol was that the dealer would set up an auction of sorts, taking bids on the CDS.

        It is considered material information in the world of equities when insiders sell. Similarly, in stock offering, the company must disclose who the selling shareholders are, as in whether the owners are cashing out, or whether the company in raising money. But this is derivatives-land, the disclosure requirements are much lower.

        Here, the dealer kept the CDS exposure via happenstance or change in plans, but having intended to do so from the very outset. That meant the dealer can be assumed to have designed the deal to fail.

        Most investors would have wanted to know that the dealer (and more important, packager/structurer) was going short, and I am sure they would have regarded CDOs differently had they realized Goldman in particular was going short, but in this realm, the disclosures Goldman made were adequate.

        1. jake chase


          While I disagree with you this is a great post, because it finally explains what these CDOs really are. Now, let’s suppose the buy side indeed would have wanted to know that Goldman intended to short the market. Where is it written that Goldman was obligated to disclose this? I think you are confusing OTC derivative trading (unregulated) with securities trading (which involves several grades of disclosure laws, i.e. SEC registration, 10b-5 ‘securities fraud’, etc.)

          The synthetic CDO of MBS never should have existed in the first place. Nobody thinking about the problem could have believed that facilitating overwhelming and cascading shorts on the US residential mortgage market was a good thing, or that it was sensible to write insurance (without limit and favoring any gambler whether he owned mortgage securities or not) against subprime defaults under any circumstances, since housing prices could not rise to the sky and, indeed, they had pretty much outrun by 2005 the ability of US consumers suffering stagnant wages to pay for them. Not to mention the impending ARM resets, which made it clear that none of the borrowers intended to pay for the houses, only to pass them along to the next idiot.

          The blame for this lies squarely on all those who pretended that financial innovation was a blessing and that regulation was unnecessary. Blame Summers, Greenspan, Phil Gramm, several hundred idiots in Congress, fund managers who thought they could buy things without understanding them and keep coining money by realising some benchmark yield. Everyone involved in the OTC derivatives market was a pawn of the dealers, who understood how the game was really played and scammed the customers relentlessly.

          There is a quote from the early Nineties involving a Bankers Trust derivatives salesmen who denuded some big corporation, perhaps P&G. It goes something like:

          “Funny business we’re in; lull people into that calm and then just totally F**K ’em!”

          1. Yves Smith Post author


            I never said that Goldman was required to make these disclosures. I was working with O’Connor & Associates (major OTC derivatives player) in the early 1990s, the virtual beginning of that market, so I am aware of the lower disclosure requirements (and the abuses also started early. The folks at O’Connor were often horrified at some of the tricks their competitors were playing. They were telling me repeatedly the deals BT in particular was doing would burn customers, and they thought it would damage the market longer term. They greatly underestimated the ease of not simply fleecing clients, but keeping them from recognizing they had been had).

            I should have been more clear in the post, but my view is that derivatives need to be regulated like securities. This synthetic CDOs illustrate why.

      2. Yves Smith Post author


        I have heard from multiple sources who prefer to remain anonymous that Goldman used Abacus (this was a big program) first to hedge its long position, then to go net short. It wasn’t just RMBS; they also had Abacus trades that were CMBS). The NYT story is consistent with what I have heard. I have been noising about Abacus but did not have enough detail to do more than offer the occasional remark (as opposed to a full post).

        1. MichaelC

          That would be the normal evolution, I think. Once the “brand” is established, later deals are easier to sell, and easier for GS to retain larger pieces of the short side without attracting attention.

          A timeline may be useful to focus attention on the deals where GS intended to retain the short side.
          There were 25 Abacus deals from 2004-2008 per the NYT. Its likely the shorts on the earlier deals were hedges or largely sold off. GM identifies the Hudson deals (done in 10/06) as retained and extremely profitable for GS. This suggests that 10/06 is the point where GS decided to go short. I’d focus on the Abacus deals done post 10/06. She discusses the Abacus deal done in April 07 as seriously underwater by 9/07 (I expect this was the, or one of the last), so the subset of Abacus deals done post 10/06 are key.
          It’s hard to imagine it now but the rating agencies were still publishing research reports as late as 3/07 which basically said, don’t worry nothing to see here, AAA tranches are unlikely to tank.
          Then HSBC announced it was getting out of the business in 2q07 and took huge writedowns on their positions (as of 12/06, which gave them a 1 year head start on their competition. They looked stellar by comparison to their peers in 07. It also indicates that they may have been wary at the end of 06 as well, and they were big players in this space). That was the shot across the bow, at least in the MSM. Many called them nuts, refused to acknowledge what the collapse in the ABX was telling them, rating agencies stood by their analysis and sellers of CDOs still found buyers till June/July07, when collateral calls started coming in and the game was up by August.
          Also, by 3Q06 GS was aggressivly demanding collaterral form AIG.
          So, if GS was selling during this period 10/06-2Q07, and made a lot of money as a result it’s clear their customers got screwed. The timing of Mr Egol’s elevation to MD is telling, 10/07. The followup question is, What was his bonus in 07? Given that number we might calculate how much GS earned on the program.
          There are statistics available specific to the deals (like WARP) that would indicate if these deals were much riskier when structured than the earlier deals in the program. A comparison of those statistics vs the stats on the earlier deals would be relevant to the argument.
          Making the case based on circumstantial evidence shouldn’t be too hard. Perhaps the gov’t inquiries will obtain the evidence needed to prove they packaged the most risky securities into these CDOs, but there’s a good chance that they won’t be able to “prove” anything criminal was done, after all they met their disclosure requirements.
          At this point I’ll settle for proof that something despicable was done and see what changes can be wrung from that.

          Follow the money.

          It may be enough to show that GS is nothing more than a bucket shop managed by the country’s best and brightest.

          1. MichaelC

            One other thought that may be useful.

            Goldman was the source for pricing the widely held illiquid CDOs it originated. Many of these CDOs were used as reference assets for synthetics as well.

            GS didn’t need to design them to fail. By virtue of its control of the valuations it had an outsized influence on the fate of the holders of the CDOs, including the synthetics, and ultimately the market as a whole as a result of its position as a market leader in this space.

            Since the banks were required to MTM they needed to get the values from GS, and as we saw with the AIG collateral calls GS was agressive in their markdowns. Who was qualified to challenge the prices?

            It would be useful to know how much of the CDO paper extant was marked by GS. A lot of the Europeans, and apparently a good chunk of AIG were at the mercy of GS marks. Buyers of the Abacus and Hudson deals were also in the same position.

            If GS provided truly fair values then this idea is irrelevant. But its not unreasonable to imagine that if one has a monopoly on price setting, one might use that power for maximum self interest.

            Its plausible GS could have designed the synthetics to fail and taken the short positions as you describe but it will be difficult to prove.

            It’s also plausible that GS took the short side when they were designed because they had a view the market was going to tank. In that case they would want to get out quickly and had a huge incentive to mark down and collect quickly.

            If they abused this power in AIG’s case and forced the Gov’ts hand to collect on the AIG exposures relating to the Abacus shorts then I think there’s a readily understandable story there. Till now the AIG paid 100c spin has been that GS was merely the passthrough for bailing out the European banks who dealt indirectly with AIG through GS. This story is tolerable (barely) in the context that the banking system was at the precipice.

            But, if it turns out that a chunk of the bailout money paid to AIG went to pay off GS shorts through these deals, and the pricing of those shorts was in GS control then all hell should break loose and clawback and penalties are in the realm of politically possible.

            Its easy for everyone, not just finance mavens, to grasp that if the price is what GS says it is and that price triggers a systemic collapse and also happens to deliver a windfall to GS, then GS has a lot of explaining to do.

            Maybe setting CDO prices is the God’s work LB was talking about.

    5. Yves Smith Post author


      With all due respect, I am WELL aware of of the fact that the dealer is initial counterparty. There is a big difference between buying a CDO on the assumption that the dealer is merely acting as an intermediary versus creating the CDO with the intent to act as a principal as regards the short position.

      You are also omitting the fact that these deals were typically sold as being the economic equivalent of cash CDOs, where the assets would in most cases be sourced from third parties, and if the dealer owned a mortgage broker, that would be public knowledge.

      1. MutantCapitalism


        With all due respect to you as well, I do think your naïveté is showing a bit here. Dealers and market makers are a very exclusive private club. Ooh! Did I just hear someone say consortium? cartel? They ALL own or have established pipelines to mortgage brokers but that’s not the point. Point is they ALL have subsidiary mortgage servicers and in the big picture of this scheme, it’s here that the rubber meets the road. This insider trading scheme is one of complicity and timing in which they all played their parts to a fairthewell but servicer malfeasance, fabricating defaults where none existed will come to be known as the most poisonous ingredient in this toxic stew.

        1. Yves Smith Post author


          You are overstating your case. The dealers started back integrating into origination and servicing, but they certainly did not get enough product from in-house sources in 2006 to fill their product pipelines. Goldman did not agree to buy Litton until October 2007, I’m not sure when the closing occurred, but it would be a minimum of 60 days later. Merrill acquired First Franklin in early 2007, they were mainly interested in the mortgage origination, not the servicing. UBS owned an servicer, not a very big one. JPM was not in that game.

          In late 2006, early 2007, IBs were looking to add to mortgage origination capacity because most viewed the downturn as short-term and they thought they were bottom fishing. Per a Feb 2007 post:

          Despite the carnage in the subprime sector, analysts don’t yet see a threat to other sectors of the credit market. Indeed, as a Bloomberg article describes, Merrill Lynch, along with Deustche Bank, Barclays, and Morgan Stanley, have taken advantage of the distress to acquire subprime mortgage companies, hoping to make headway on Bear Stearns as the leader in the subprime origination market. The Wall Street firms earn handsome fees from packaging the loans and selling them to other investors.

          I noted that Merrill et al might indeed be smart bottom fishers, or catching a falling safe.


          1. MutantCapitalism

            No doubt there were many marriages of convenience within origination process and securitization process at that time. Aside from nice “processing” fees, this made for more expedient channeling of subprime “product” through servicing slaughter houses under deal makers’ control. While your are most correct in asserting that GS did not acquire Litton Loan Servicing until late 2007, GSAMP Trusts for years had contracted mortgage servicing that was not performed by GS subsidiary Avelo Mortgage LLC to Litton, Select Portfolio Servicing owned by Credit Suisse and Wells Fargo, among others with equally egregious servicing records. Getting back to the meat of my initial comment, Yves, are you seriously denying that predatory mortgage servicing has anything to do with the big picture here? or are you just shifting focus because that’s a more convenient thing to do?

          2. Yves Smith Post author


            This post is about Goldman’s and Morgan Stanley’s use of synthetic CDOs to dump their risks (and in the case of Goldman) onto investors who were not aware that the dealers were not simply acting as intermediaries, but had created the deals as a way to put on a short position. You seem to want the post to be about another topic. I cannot write the definitive tome on CDO abuses in a single post.

            A lot of ink has been spilled and continues to be spilled on the behavior of servicers. Yes, owning or having access to a servicer would give one early insight into the deterioration of the mortgage market, and that could most assuredly be used to the advantage of anyone with access to that information versus investors who were not as plugged in. But by your logic, if that was such a big competitive advantage, why did Merrill TRIPLE its ABS CDO origination in 2006 versus 2005, leaving its with a huge amount of inventory that it was unable to offload? Why was UBS, also a large CDO originator with a servicer, stuck with so much product?

            If your point is that that the dealers through their servicers would have reason to behave so that defaults would be higher, the fact is that (save Goldman) the Street was net long mortgage exposure, big time, which would create the reverse incentives.

            Dealers, as I pointed out elsewhere in the thread, were keenly buying up both mortgage originators and services in late 2006 and early 2007. The early 2007 weakness in the market was seen as a buying opportunity, and subprime had one last hurrah before the wheels started coming off in July 2007. That would suggest, for the most part, that they did not use their G2 as well as you seem to believe. They might have used it well tactically (as in helping identify certain products or regions.

            Again, I think you are overstating your case. It would be hard to call mortgage servicing “predatory” in 2005 and 2006, when the real estate market was rising and the exit for a stressed borrower was a refi. Origination was obviously a different matter.

          3. MutantCapitalism


            I am very much aware of subject matter of this post and sensitive to staying on point. My point is simply that servicers are very much part of this process as J. Tavakoli has written and been quoted in a comment here. Servicers can affect CDO collateral whether it is synthetic or not. We know that these deals were created in such a way to put on short positions. Again, servicers impact which way these positions turn out. Curious that you have an issue acknowledging role of servicers.

          4. Mike Dillon

            Yves, I’ll be the first to admit it, and anyone that knows me will corroborate that I simply don’t have enough RAM left in my head to even attempt to have any kind of intelligent conversation about CDOs. That said, and with no intention of hijacking things here I’d like to address a couple of your statements that concern me rather greatly.

            Yves – “Yes, owning or having access to a servicer would give one early insight into the deterioration of the mortgage market, and that could most assuredly be used to the advantage of anyone with access to that information versus investors who were not as plugged in.”

            For decades now, the same trusts, securitizers and depositors have used the same servicers whether the trusts owned them or not. From a Mortgage Servicing Fraud POV, it’s not a question of having “early insight in the deterioration of the mortgage market”. Servicers have been CAUSING many of the problems in the mortgage market – most recently front and center with loan modifications but that’s another thread entirely. All one needs to do is grab either a PACER account or use Justia.com to get a feel for the vast amount of litigation filed just at the federal level against any number of servicers. Justia only goes back to 2004 but I think the combined total of just FEDERAL cases JUST against Fairbanks/SPS in that time frame is up over 200. Imagine what the state level cases would add up to if they could be tracked.

            Whether you’re talking about Litton, Saxon, Fairbanks/SPS, EMC, Ocwen, C-wide, Argent, A-quest, Wilshire, GMAC or any of the other major players (try using the latest HAMP report for additional names) the horror stories stay the same. On-time payments being held until past due, force placed insurance when homeowners policies are in place, excessive BPOs being conducted, etc ad naseum. The stories simply do not change.

            Oh, and the “kick back” suits are out there as well. The Third Circuit recently remanded a class action against C-wide and Balboa alleging kickbacks on private mortgage insurance. I’ve got a Memorandum of Interview posted as part of my GAO review request of the FTC wherein the “interviewee” states that Balboa was known for kickbacks on force placed insurance and that it was an industry wide practice. Fairbanks was supposedly concerned that they were “charging too much” for their kickbacks if I’m interpreting the statement correctly…

            It’s not a question of anyone having an inside track with a servicer to have “early insight” into the carnage as if servicers are merely bystanders doing real time color commentary. Servicers have the power, ability and incentive to *control* which tranches and trusts actually tank. It’s really no different than rigging a prize fight, a basketball game or shooting craps with loaded dice. It’s just that the sheer profit volume is 10-100x greater.

            Yves – “It would be hard to call mortgage servicing “predatory” in 2005 and 2006, when the real estate market was rising and the exit for a stressed borrower was a refi.”
            Nothing could be further from the truth than this statement, Yves. A rising market was perfect – *PERFECT* – for Mortgage Servicing Fraud. You cite 2005-2006. This is one year after USA/Curry v. Fairbanks settled. According to the FTC’s own admission, between June ’05 and Nov ’06 alone they received an additional 455 complaints against Fairbanks/SPS. Step things out another two years, and FTC v. EMC/Bear was settled in 2008. When did that investigation START? Those two cases alone account for more than 360,000 victims of Mortgage Servicing Fraud spanning a scant 4 years from settlement date to settlement date…

            And “stressed borrowers” could only refi and relieve their stress if their servicer hadn’t tanked their credit rating while piling on fraudulent fee after fraudulent fee. Took a contempt order a year after a permanent injunction and FIVE years after the initial problems began for anyone to address the problems Fairbanks/SPS caused with my credit rating and I don’t believe that it’s fully fixed to this day. Tough to refinance when your servicer is manufacturing defaults against you at 12:30p on Monday and calling them in to Experian, TRU, and Equifax before COB. Yes, that may be a bit of an exaggeration but you get my point I’m sure.

            Now, the reason that a rising market is prime MSF fodder. After generating as many bogus fees as possible and sucking the borrower dry, the servicer goes in for the kill by foreclosing. Equity is rising at exponential rates. It wasn’t uncommon to see properties with huge equity. $100k loans on properties with $250k value. PERFECT for a servicer to tank. Tack on $20k in fees. Force a foreclosure – and here’s the key – AT WHICH THE SERVICER MANY TIMES PURCHASES THE PROPERTY FOR THE OUTSTANDING BALANCE. This immediately wipes out any ownership claims that the FC’d borrower may have had to any overage. So the servicer purchases a $250k property for $120k. Turns around and puts it on the market and realizes an immediate $50-$100k profit. The amounts of money that note holders/servicers were/are making in the FL foreclosure markets when they scare off other prospective buyers and purchase properties for $100.00… My god…

            NOW – to get back on track a bit. Imagine what CDO players could do if they knew ahead of time which trusts were going to tank – because they not only had “early insight” but because they could say “let’s tank THIS one.” It’s like knowing that Red 12 is going to pay out EVERY time because you put the magnets in the wheel yourself.

            Yves, talk to me about “note insurance”. I have yet to get a definitive answer on this concept but if I’m correct, note holders are recouping somewhere around 100% of any outstanding note by placing claims against “note insurance” policies covering trusts. If such is the case, then note holders are at the VERY least double dipping on properties. And if the notes are being satisfied before the properties go to foreclosure then there is no default and no need to foreclose on a borrower. If anything, the “note insurance” underwriters should be the ones going after borrowers for the losses they are paying out on. But then they’re trying to recoup losses on unsecured debts…

            Sorry. Didn’t mean for this to go this long. But I think you, much like the vast majority of others in MSM, legislative, regulatory and prosecutorial capacities have and are seriously underestimating the role that servicers have played in this fiasco over the course of the last decade or two and continue to play to this day.

          5. Yves Smith Post author

            Mike and Mutant,

            Frankly, your theories do not hold water. All you have to do is understand how many mortgages are fractionally contained in or referenced by an ABS CDO (well over a half a million. It’s wildly impractical to go taking out homeowners one by one to have an impact on the deal. The homeowner already has to be delniquent, a little fact you choose ignore.

            I ran your theories by an attorney who was most recently employed in a senior role at a monoline, and hence has no vested interest either way. He does not buy it either, and is of the opinion you have a vested interest. I have NO interest parties using this comments thread to pursue their own business agenda, particularly for ideas that have no factual foundation. Her remarks:

            i am not a big believer in the whole servicing angle. i have probably visit one hundred servicers over the years. i spent a great deal of time scrutinizing the issue of predatory servicing long before 2007. it wasn’t that prevalent. in addition, Litton was one of the best servicers in the subprime business – they understood the economics of short sales vs. foreclosure as well as anyone and they understood that servicing subprime loans was not a “for profit” business because it was too expensive to service a bunch of seriously delinquent borrowers.

            there were a few “high touch” (ie distressed borrower) servicers that tried to be a stand alone business – and they ran into trouble because they had to keep feeding the machine, given the amortizing nature of their income stream. to keep fees up, one or two of these companies started charging outrageous fees to already defaulted borrowers. but it didn’t last long.

            the problem servicers are experiencing is that they are overwhelmed with problem borrowers and were never built for such a large pipeline. the legitimate fees they earn for servicing are fixed, and they were set assuming a much lower default rate. the servicers don’t generate enough cash to staff up the way the need to, especially with the crazy HAMP rules. the Fairbanks reference is the tip off. Fairbanks was a stand alone servicer of impaired borrowers and they had problems with “predatory servicing” where they overcharged borrowers and aggressively harassed them. their technique was called “combat” servicing. it created a bit of turmoil for the market. in 2002! by 2003 they had fired the management, settled charges with the FTC and gotten themselves sold at a steep discount to Credit Suisse. Pretty much end of story. but a small team of aggressive class action lawyers had made a small business out of suing them and posting nasty reports about anyone connected to them on a website and flooding yahoo chat boards with complaints about them and ocwen and others.

            i think this group of self styled “activists” were both nutty and financially vested in the Fairbanks as the devil scenario.

            this seems like a return of those folks. i have recently seen the allegation that servicers are fabricating defaults to boost the loss numbers to improve the short bet on CDOs. it just makes no sense. the idea that loans could be singled out for their impact on CDOs is truly crazy talk.

    6. Michel Delving

      Any serious discussion of a particular CDO must specifically address the collateral breakdown of underlying assets in order to know exactly WHAT is in these CDOs and WHO is involved regarding MBS and mortgage servicers. Mortgage servicing fraud is the dirty backroom, behind the curtain story here, perhaps best addressed in recent Janet Tavakoli comment:

      “Several people asked about Goldman’s Abacus 2005-2 CDO mentioned in the article below. It is a synthetic CDO, the first one ever managed by C-Bass. Much reviled Litton is the servicer. Goldman purchased Litton from C-Bass in 2007. Servicers are part of the process, since servicers can influence the disposition of the collateral of any mortgage security backed by mortgage assets, whether it is cash, synthetic, or a hybrid of both.

      There should be fraud audits of the securitization units of several firms. The audit should encompass the relationships with mortgage lenders, servicers, hedge funds, SIVs, and more.” http://www.economicpolicyjournal.com/2009/12/goldmans-abacus-deals-new-york-times.html

    7. Doug Terpstra

      Oh, okay, it’s all good then, but what about those “idiot widows and orphans relying on the SEC”? Are they idiots for relying on the SEC, or just idiots dismissable on general principle?

  3. Ram

    I think the proof of any misrepresentation would lie in the investor presentations that structuring/syndicating banks would have shown to investors around specific CDOs or on the generic CDO product backed by MBS. If the presentations did highlight that these were low risk investments or that the likelihood of subprime bonds defaulting in large numbers was low, while internally the banks trading desks were shorting the market through CDOs with the diametrically opposite view, it would be proof of potential misrepresntation. In that case the bank’s usual defense is that the risk takers (trading desks) are different from the syndicate/sales desks and hence opposing views are not abnormal. But anyone working in a bank could tell you that thats nonsense.

  4. Sechel

    The argument that this was merely a trade ignores that Goldman went to the GSE’S and argued Abacus bonds were a AAA credit when in fact they were betting otherwise is either duplicitous or fraudulent.
    It’s also fair to say that Goldman did not enter into this without a comfort letter from counsel. Any conjecture on the language Goldman’s counsel would have used in giving their ( I assume) approval?

  5. Ted K

    This is terrific stuff (I mean it doesn’t make me happy but it’s very informative). Outstanding post. Hope you’re not offended if I said “You’ve done a man’s job.” Freaking awesome post.

  6. paper mac

    “The pets that died from pet food laced with melamine from China?”

    To say nothing of the kids who died from the diluted milk spiked with it. I think they ended up executing some of the responsible executives. An interesting contrast with the conduct and consequences of GS and their ilk. I don’t suppose anyone’s figured out how many people have died as a direct result of GS or any other corporation’s actions over the last few years, but for reference, the milk scandal resulted in, I believe, six deaths.

    1. DownSouth

      It’s a cardinal rule of human behavior. If a drift into social chaos and social disintegration is to be avoided, punishment is absolutely necessary. This is a slippery slope the US is on, as I’ve witnessed firsthand here in Mexico. First the white-collar criminals are given license to operate with impunity, and then later come the blue-collar criminals.

      Here’s how Hannah Arendt put it in Crises of the Republic:

      The simple and rather frightening truth is that under circumstances of legal and social permissiveness people will engage in the most outrageous criminal behavior who under normal circumstances perhaps dreamed of such but never considered actually committing them.

      I also like how the 19th-century British parliamentarian Sydney Smith put it:

      From what motive but fear, I should like to know, have all the improvements in our constitution proceeded? If I say, Give this people what they ask because it is just, do you think I should get ten people to listen to me? The only way to make the mass of mankind see the beauty of justice is by showing them in pretty plain terms the consequence of injustice.

    2. Sam in NY

      In this way, China’s commitment to justice is greater than that of the US. They seem to apply common sense! One doesn’t get off on pure legal technicalities, and the people being punished badly seem to have done some really bad things and deserve the punishment.

  7. moneta

    One of the things that has been frustrating in watching this debate is the peculiar propensity of quite a few observers to defend Goldman and its brethren, and to argue, effectively, caveat emptor
    That is why it is so hard to get anything changed. And the thieves thrive on it!

    1. i on the ball patriot

      Goldman thrives on buying puppet politicians and rotating staff into positions in government so as to write favorable legislation into the scam ‘rule of law’ that will allow them to plunder unfairly. Do you not think they would be as equally aggressive in putting shill plants in the court of public opinion, especially well informed financial web sites like NC, to sway the public away from giving them the Chinese treatment which they so justly deserve.

      Take the defending GSBS with a more than skeptical eye.

      Deception is the strongest political force on the planet.

      1. DownSouth

        i on the ball patriot,

        You make a very important point here, that is consonant with Yves’ assertion that “To pretend otherwise is an insult to a reader’s intelligence.”

        Of course the arguments put forth by Goldman’s defenders are nonsensical.

        But as you so aptly point out, they are not playing to an unbiased jury here. Quite the contrary, they are playing to a jury that is bought and paid for.

        But that jury extends much farther than the Bush-Obama administration or the halls of congress. For the Goldmans of the world, this is full court press.

        For in addition to their bought-and-paid-for politicians, they have their millionaire economists, their millionaire scientists, their millionaire preachers, their millionaire artists and their millionaire reporters and publishers, fame and fortune dangled in front of them if only they trumpet the financiers’ party line.

        Money is their God, and it is their only God. One must always keep in mind that that is the assumption that lies at the heart of classical and neoclassical economic theory.

  8. mitchw

    Everyone here does know that Goldman also lost the bet. When AIG went down, only the US made sure the shorts paid.

    1. Skippy

      A bet lost[?], yet made hole by others monies. AIG had some nice back rubs if I remember and on others monies, bets me thinks not, rather purse snatching from a car whilst pulling granny along, after a drug deal gone wrong.

      Skippy…drug deal gone wrong yet some one must pony up….yep that about says it all…eh.

      1. marc fleury

        All monies disbursed in 2009 through AIG to make GS whole on speculative bets should be reclaimed. Forget the fact that the treasury didn’t get a haircut, just get 100% back.

  9. JKH

    Excellent post from a descriptive perspective.

    But agree with jck; your argument against caveat emptor is not convincing. Any buyer who couldn’t get the drift from reading such a prospective that it was a casino type bet with the seller taking the other side had no business playing.

  10. jdmckay

    (…)if sellers were not held responsible for product quality to some degree, commerce would become impractical.

    Well, sellers of all kinds of “stuff” here have indeed become not responsible for quality of what they sell. I’ve got a few shelves in garage w/products to prove it, some of it bordering on absurd.
    * BeautyRest (BR) (branded, but as it turned out they only sold license to use the moniker) electric blanket: went toes up in 7 weeks. Since found out BR is on it’s 3rd US rep for remediation of these things. BR explained the circuit board in controller “had problems”, and promised “satisfaction” from latest licensee. Said licensee told me that I had to turn the heat in room up to 55 deg or higher (WTF?)… told me I was an “idiot” (via email) for questioning this proposition. Forwarded said email to BR… nothing.
    * Bought a ceiling mount pot & pan rack for our kitchen (Costco). Ran some new wiring (it had built in light), and added bracing in ceiling joints to support the thing. Well made, good nickel plating. Got it up, it was supported by one chain from ceiling mount to rack on each end… one!!! Eg. hang a pot on either side, and it tilts wildly. Completely unusable… seems US distributor never actually tested this thing. And just as w/BR above, distributor knew nothing of my account of this thing nor of the product itself, and essentially told me to GFM.

    Again, I’ve got 15 or so similar junk products stashed, used as a reminder these days that, if I’m going to spend more than $20 on something I want to depend upon, I’m either going to GOOGLE until I find reliable reports or make it myself.

    In a pure “buyer beware”, dog-eat-dog world, every transaction would require extensive and prohibitively costly due diligence.

    See above… my time allocation has tilted dramatically towards “due dilligence” activities in damn near everything.

  11. Jim in MN

    So the caveat emptor view is that if you sell a Bag O’ Glass with the words ‘Improved–Totally Safe!’ on the front and the words ‘may cripple or kill’ on the back then what is there to cry about…and in this construction I think I am actually giving a huge advantage by assuming the language is clear…

    Sorry. Jail time. The perps always laugh until the collar is made.

    I also think these firms’ shares are radioactive waste that will hit critical mass once the real criminal stuff starts.

    (nod to Dan Ackroyd for the Chicago scum toy maker Bag O’ Glass exampleon the old SNL-if you’ve never seen it it is incredibly relevant to this topic)

    1. Jim in MN

      OK, can’t help it: Saturday Night Live, 1976!!!

      Consumer Probe

      Consumer Reporter…..Candice Bergen
      Irwin Mainway…..Dan Aykroyd

      Consumer Reporter: Good evening, and welcome to the holiday edition of “Consumer Probe”. Our topic tonight is unsafe toys for children. For instance, this little bow and arrow set. [ holds up ] Pull the rubber suctions off, and the arrows become deadly missiles.

      [ cut to full shot, showing Irwin Mainway seated to Joan’s right ]

      We have with us tonight, Mr. Irwin Mainway, President of Mainway Toys. Uh, Mr. Mainway, your company manufactures the following so-called harmless playthings: Pretty Peggy Ear-Piercing Set, Mr. Skin-Grafter, General Tron’s Secret Police Confession Kit, and Doggie Dentist. And what about this innocent rubber doll, which you market under the name Johnny Switchblade? [ holds up doll ] Press his head, and two sharp knives spring from his arms. [ demonstrates ] Mr. Mainway, I’m afraid this is, by no means, a very safe toy.

      Irwin Mainway: Okay, Miss, I wanna correct you, alright. The full name of this product, as it appears in stores all over the county, is Johnny Switchblade: Adventure Punk. I mean, nothing goes wrong.. little girls buy ’em, you know, they play games, they make up stories, nobody gets hurt. I mean, so Barbie takes a knife once in a while, or Ken gets cut. You know, there’s no harm in that. I mean, as far as I can see, you know?

      Consumer Reporter: Alright. Fine. Fine. Well, we’d like to show you another one of Mr. Mainway’s products. It retails for $1.98, and it’s called Bag O’ Glass. [ holds up bag of glass ] Mr. Mainway, this is simply a bag of jagged, dangerous, glass bits.

      Irwin Mainway: Yeah, right, it’s you know, it’s glass, it’s broken glass, you know? It sells very well, as a matter of fact, you know? It’s just broken glass, you know?

      Consumer Reporter: [ laughs ] I don’t understand. I mean, children could seriously cut themselves on any one of these pieces!

      Irwin Mainway: Yeah, well, look – you know, the average kid, he picks up, you know, broken glass anywhere, you know? The beach, the street, garbage cans, parking lots, all over the place in any big city. We’re just packaging what the kids want! I mean, it’s a creative toy, you know? If you hold this up, you know, you see colors, every color of the rainbow! I mean, it teaches him about light refraction, you know? Prisms, and that stuff! You know what I mean?

      Consumer Reporter: So, you don’t feel that this product is dangerous?

      Irwin Mainway: No! Look, we put a label on every bag that says, “Kid! Be careful – broken glass!” I mean, we sell a lot of products in the “Bag O'” line.. like Bag O’ Glass, Bag O’ Nails, Bag O’ Bugs, Bag O’ Vipers, Bag O’ Sulfuric Acid. They’re decent toys, you know what I mean?

      Consumer Reporter: Well, I guess we could say that all of your toys are really unsafe and should rightfully be banned from the market. I guess I would just like to know what happened to the good ol’ teddy bear.

      Irwin Mainway: Hold on a minute, sister. I mean, we make a teddy bear. It’s right here. [ picks up giant teddy bear ] It’s got a nice little feature here, you see? I’ll hold it up here. We call it a Teddy Chainsaw Bear. [ revs chainsaw in teddy bear’s stomach ] I mean, a kid plays with saws, he can cut logs with it, you know what I mean.

      Consumer Reporter: Well, this is certainly a very sad situation. One of the precious joys of Christmas warped by a ruthless profiteer like yourself.

      Irwin Mainway: Well, that’s just your opinion, you know what I mean?

      Consumer Reporter: Well, I just don’t understand why you can’t make harmelss toys like these alphabet blocks. [ points to blocks ]

      Irwin Mainway: C’mon, this is harmless? Alright, okay, you call this harmless? [ holds block in hand ] I mean.. [ plays with block and fakes injury ] Aagghh!! I got a splinter in here, look at that! This is wood! This is unsanded wood, it’s rough!

      Consumer Reporter: Alright, that’s enough of this ridiculous display. [ holds toy phone ] Here is another creative toy, safe enough for a baby!

      Irwin Mainway: [ grabs phone ] You say it’s safe, I mean, look at this cord.. the kid is on the phone – “Hello? Hello?” – then.. [ twists cord around his neck, screams, and falls backward in chair ] You know what I mean? It’s an example! You see my point, a dangerous toy like that?

      Consumer Reporter: Well, let’s try this one. What about this little foam play ball? I mean, even you, Mr. Mainway, can’t find anything dangerous about this. Huh?

      Irwin Mainway: [ takes ball, bounces it on table, then shoves it in his throat and feigns choking ]

      Consumer Reporter: That’s all the time we have for “Consumer Probe” this week.

      [ show fades black ]

      1. craazyman

        that is hilarious! I remember as a kid watching some of the first SNLs broadcast from a glorious kind of scary magical weird place called New York. Little did I know fate would take me there, to make it my weird home, and to become one of THEM somehow.

        The Bag of Glass sums it up better than any contorted flow chart diagram or multi-variate equations.

        What is society to do about folks who are addicted to buying bags of glass, hoping to play with them and profit from them, without cutting themselves?

        I don’t know.

        But the rest of us are now paying their medical bills. And their doctors, raking it in, are the same frauds who sold the bags.

        As much as I loathe the bag salesmen, I suspect their documentation is clever enough that it would be hard to convince a jury to find them guilty of fraud. Some forms of social cooperation rely, it seems to me, on some intangible quality called integrity. I think the best than can be hoped for here is a slow buildup of journalism and commentary that reveals the ultimate sleaze of the glass bag operators, and convinces clients to drop them as financial services suppliers — similar, to some degree, to the boycotts of firms whose operations supported Apartheid in S. Africa.

        I am not a lawyer, so I can’t say if fraud cases could be credibly prosecuted, but based on insider trading cases and other white collar frauds, it would likely be a tough slog, it seems to me.

        I do have a sense of compassion and empathy for the low-level employees of these firms. The retail staff at Citibank branches — my one business relationship with the financial parasites, in the form of a penny ante checking account — are invariably courteous, helpful and competent. They’re only there for their small paycheck and have no power and no nothing about the machinations of their “leaders”. I feel bad they have to suffer from the depravity of the braintrusts who’ve looted all of us.

        Yves wrote some good stuff recently on the necessity of broad social cooperation for any business or businessman to be successful. No one does it alone. This insightful notion is utterly lost in the form of the unwillingness of the Bush/Obama crisis response to take a heavier hand with bonus looters. I was recently having social drinks with a woman who works as a international aid operative in miserable global hell holes and war zones. The social collapse that leads to these realities, in her assessment, results exclusively from the ability of their “elites” to systematically get away with corruption on a daily basis. The societies become so exhaustingly inured to it that it becomes as natural as the weather, it becomes a form of nature. At that point, a refined consciousness, one that prizes supression of instinct as a method of erecting a civilization (not to get too Freudian) becomes dead. So as we tolerate and even reward looting, it is very much at our peril and risks disintegration of our assumptions about the social contract in a way that is very perilous. Sad that the Big O team seems so lost on this point, caught up as they are in the math of it all.

    2. DownSouth

      Jim in MN,

      Great analogy.

      Another analogy that is quite germane can be found in art forgeries. And of course in the world of art, the caveat emptor defense, at least in countries other than banana republics, has never worked too well.

      Errol Morris wrote an insightful series
      entitled “Bamboozling Ourselves” for the NY Times a few months back. “Why do people believe in imaginary returns, frauds and fakes?” he asks. His article concerns probably the most successful art forger of all time, Han van Meegeren:

      “If the rumors prove to be true,” the newspaper [“Volkskrant”] said, “then the best experts and completely reputable persons have been the dupes of a deception which was fashioned with unparalleled skill and in which, besides the forger himself, many middlemen must have taken part…” Van Meegeren and other major figures in the Netherlands charged with collaboration have yet to be brought to trial.

      Of course the fact that van Meegeren was able to fool “the best experts,” and as Morris goes on to explain, some of the forgeries were obviously quite atrocious, did not keep van Meegeren out of prison.

      1. DownSouth

        Ha! Ha!

        Well I can’t help it either.

        When van Meegeren ran his art forgery scam, the Nazis were in control of the Dutch government, just like Goldman and its Libertarian-Austrian-Neoliberal minions are in control of the US government now.

        And, as mitchw points out above, the ultimate victim of Golman’s scams is the American people, just like, as Morris points out, the ultimate victim of the Nazis and their Dutch collaborators was the Dutch people.

        So if the American people ever get the upper hand again, what can we expect?

        The interrogations in the aftermath of the war are surreal, almost comical. Everybody, of course, describes themselves as good guys, despite what they had done. Jan Dik and Ten Broeck claimed that they had held the Goudstikker business together in difficult times; Miedl presented himself as an ethical businessman who had protected many Jews (including Goudstikker’s mother) from the Nazis; Rienstra represented himself as a patriotic Dutchman trapped in Van Meegeren’s Nazi machinations, and Van Meegeren aped Rienstra’s story, of being an anti-Nazi Dutchman who would never have sold his forgeries to Göring. Of course, they were all collaborators of one stripe or another. (And some were not just collaborators, but actual members of the Nazi party.) But doesn’t everybody see himself as the hero of his own biography? Don’t we all live in a self-contrived narrative bubble, where we describe ourselves to our best advantage? Who knows what fabrications the Nazis constructed for themselves to allow them to see their actions as heroic rather than criminal?

        The spirit of the times is admirably captured in the first transcribed interrogation of Rienstra and Van Meegeren. Van Meegeren insists that he never knew that the painting would be sold to the Germans, most certainly not to Göring; Rienstra that he had never met Miedl and didn’t know that Germans were involved in the transaction. (This despite a deposition from Rienstra’s chauffeur reporting that he routinely delivered paintings for Miedl, including deliveries to Hofer, the manager of Göring’s art collections, and Hoffman, Hitler’s photographer and confidant.) Lies compounded by further lies, compounded by finger-pointing, pathetic attempts to deflect blame, totally unconvincing protestations of innocence, and convoluted narratives of self-absolution.

      2. jake chase

        For me, it is too bad Wiliam Gaddis didn’t live to write about synthetic CDO of ABS.

        I seriously doubt that anybody participating on the buy side of these things even knew he was selling insurance against subprime downgrade risk. It is one thing to believe it was unlikely that the bonds would go to zero; quite another that there was not a huge principal risk which made reaching for the yield involved in no sense justifiable.

        In saying this I do not defend Goldman. All the OTC derivative dealers seem to me to have been RICO criminal enterprises since the early nineties. Frank Partnoy’s book, Infectious Greed provides an excellent summary up through 2002.

    3. Eagle

      So in your opinion, all transactions should be covered by the strict liability laws that manufacturers are subject to?

      I’m game if you are. Let’s see how well this works in the legal, medical, and teaching professions as well.

      1. Jim in MN

        Folks who play close to the line for the big rewards (oh sooooo much smarter then the rubes!) are just that much more pathetic if they cry when the axe comes down.

        In a perfect world we would long ago have struck the perfect balance. In this world, a good overreaction would be healthy about now. No Pangloss, I!

        Doctors and lawyers go to the pen, pay fines, lose licenses all the time. Note the self-policing, state-based disciplinary systems in which judgement of one’s peers is based partly on the credibility of the whole profession. Interesting. Professors, eh, not so much. But the academie has some standards….

        1. Eagle

          Needless to say, I disagree that a good reaction is a positive step in the direction of getting us to an ideal state.

          1. DownSouth

            An “ideal state” is something that only exists in classical, neoclassical and Marxist fairytales.
            And of course it should surprise no one that you believe an “overreaction” is an inappropriate response to the abuses of Goldman et al.

            But “overreaction” is absolutely necessary when that mythical “equilibrium” becomes illusive. As Hannah Arendt wrote in Crises of the Republic:

            Hence, in domestic affairs, violence functions as the last resort of power against criminals or rebels—that is, against single individuals who, as it were, refuse to be overpowered by the consensus of the majority…

            Since men live in a world of appearances and, in their dealing with it, depend on manifestation, hypocrisy’s conceits…cannot be met by so-called reasonable behavior. Words can be relied on only if one is sure that their function is to reveal and not to conceal. It is the semblance of rationality, much more than the interests behind it, that provokes rage. To use reason when reason is used as a trap is not “rational”; just as to use a gun in self-defense is not “irrational.”

            The Christian theologian Reinhold Niebuhr in Moral Man & Immoral Society pointed out the blatant hypocrisy inherent in the fiction peddled by the Libertarian-Austrian-Neoliberal axis:

            Thus, for instance, a laissez faire economic theory is maintained in an industrial era through the ignorant belief that the general welfare is best served by placing the least possible political restraints upon economic activity. The history of the past hundred years is a refutation of the theory; but it is still maintained, or is dying a too lingering death, particularly in nations as politically incompetent as our own. Its survival is due to the ignorance of those who suffer injustice from the application of this theory to modern industrial life but fail to attribute their difficulties to the social anarchy and political irresponsibility which the theory sanctions. Their ignorance permits the beneficiaries of the present anarchic industrial system to make dishonest use of the waning prestige of laissez faire economics….

            When economic power desires to be left alone it uses the philosophy of laissez faire to discourage political restraint upon economic freedom. When it wants to make use of the police power of the state to subdue rebellions and discontent in the ranks of its helots, it justifies the use of political coercion and the resulting suppression of liberties by insisting that peace is more precious than freedom and that its only desire is social peace.

            Niebuhr wrote that in 1932, when classical economic theory was in full retreat. Unfortunately, beginning in the 70s, classical economic theory experienced a revival. It reminds me of Freddy Kruger: this evil creature just keeps coming back from the grave.

          2. Eagle

            I’m sorry, how presumptuous of me to have an opinion contradicting that of Hannah Arendt.

            If I were to take a page out of your book, assuming the worst possible of motives others, I would think her publisher is paying you to post here.

        2. Fraud Guy


          Having known some patients dealing with medical liability suits, a doctor losing their license is a very rare thing, regardless of their actions.

          In fact, your beautician (in IL) is far more likely to lose their license, and you can know far more about the suit history of your car mechanic than your doctor.

  12. jdmckay

    People who were in that business have consistently said that very few people are competent in the product. One estimated 1000, another even fewer. This is in the world, mind you. No matter how you cut and slice it, this is far fewer than were dealing in the product.

    AFAIC, this only further hi-lites malfeasance of rating agencies in this affair. Aside from your stats (1 in a 1000), given what GS had to say (sophisticated) as you discuss, what does it say about disbursement (sales) of their securities when S&P, Moody etc… presumably in this “sophisticated” category, didn’t get it right (or even try to)?

    Huge % of the remaining 999 “sophisticated” pros were relying on these agencies. I believe CALPERS has filed suit against at least one of ’em, no? How many more are suing… ///???

    And what does it say about an SEC that pretty much is on the sidelines through all this?

    1. Yves Smith Post author

      Just to be clear, not 1 in 1000, but 1000 total competent in the world.

      To give a sense of proportion, AIG’s financial products group was 400 people. I am sure not many of them would be included in that 1000. :-)

      1. jdmckay

        Just to be clear, not 1 in 1000, but 1000 total competent in the world.

        Ya, based on anecdotal experience I thought that .01 ratio a bit optimistic. But hey, why beat a dead horse (nor, really!!!)?

        Which brings to mind (just curious)… who came up w/that 1000 # ? Seems a bit fat, round and even to me. Maybe someone got all the candidates in a room and asked for a show of hands?

        Kind’a reminds of of Barry Ritholtz’ latest look at hemisery index… eg. given state of our finance/economy stats, we don’t even have means to know how miserable we are!!!

        HAPPY NY, and may the farce be with you.

  13. onwee

    One thing to keep in mind is Goldman’s statement that its initial short was either a hedge of another long or would be covered by trades with other investors. That is a question of fact, and central to whether the evil Goldman theme is somewhat specious. It would be unlike a modern, sophisticated investment bank to make massive one-way bets and just ride them, yet that is what you are saying they did when they created the initial short. Instead, IBs were at their best when they made bid/ask spread on massive volume (plus arranging fees) and walked away with the profit. Derivatives were ideal for creating a wide spread. So were those initial shorts offset elsewhere or not? Without that knowledge you don’t have anything.

    That said, there is an argument that creating structures where you just don’t care which way they go because you are hedged is not good for society either. It’s not as bad as shorting what you know to be bad and riding that bet, but it’s at least notable. If someone with the highest level of knowledge of the granular quality in a structured product has no skin in the game, is that good? That’s really what I think was happening here. Almost got nailed anyway via AIG’s collapse.

    Finally, the ABS subprime market blew up by July 2007. Were ANY structures sold in the fall of 2007? Are you claiming Goldman was short structures from, say, 2005 on (a multi-year short)? Does not sound like them. But in between the two, that’s another interesting avenue. Normally, I’d expect GS to create structures and hedge away their exposure to put money in the bank, but the real estate market started sliding in 2006. At some point (what did you know and when did you know it), it must have occurred that outright shorting without hedging would be more profitable, that it was worth the extra balance sheet risk to make that trade, that maybe rigorous hedging was not the highest priority. If I were looking for smoking guns, I would not look at the whole history of the market, nor would I be confused by the fact that the arranger initially provided all the shorts to get the deal done, I would look at the offsetting trades balance and see if it tilted at some point to be something other than a hedge. Getting access to GS’s risk book in an auditing sense might be difficult – suspect there are some secrets in there.

  14. jedwards

    I don’t understand how what GS did differs from the “pump-and-dump” Internet fraudsters that the SEC goes against. Pump-and-dump’ers give fraudulent information to investors and get them to buy in, knowing that they’re going to sell into the subsequent rise in value.

    Is the only difference the fact that their counter-party position is laid out in the terms of the contract?

    Regardless of that, why on earth would anyone ever use GS as their counterparty going forward? Anyone would be utter fools to accept any deal where GS is the counterparty. They clearly on take deals where they will make money.

  15. Claire

    Sorry to be dense, but:

    1. If people couldn’t value such deals, why would they buy them? I am not saying that GS or MS aren’t at least partly to blame, but offhand, I’m pretty sure that the buyers must have realised that they were taking additional risk to get a higher potential return. Perhaps I should rephrase this as: if the buyers were clearly incompetent and in over their heads, aren’t they setting themselves up for lawsuits from their own investors?

    2. Why are the rating agencies not mentioned in the suit?

    3. (this one I really don’t understand): why does anybody do any business with Goldman at all, knowing full well the IBs’ track records for screwing over clients.

    4. I think the Supreme Court has been pretty consistent in shielding the entire investment/banking industry from lawsuits. I don’t like it and I hope I’m wrong on this one, but I’d be highly sceptical of anybody recovering a penny from this (and even if they did, it’ll likely be taxpayer money anyway)

  16. Siggy

    “Yves here. Please. If these deals were regulated by the SEC, Goldman’s role in the deal would have had to be disclosed and it would have made a CONSIDERABLE difference in the pricing. To pretend otherwise is an insult to a reader’s intelligence.”

    That’s an interesting comment. Not entirely sure if it’s absolutely correct. The Prospectus should have informed of the seller’s position. On the other hand, since 2000 or thereabouts, neither the SEC nor the CFTC had jurisdiction over dervatives trading. Securities issuance would come under review by the SEC, however, that review is generally limited to: are all material facts presented”.

    What does appear to be the fact is that the sellers of these derivatives were simultaneously on both sides of the trade. It is also clear that the larger and more probable profit would be obtained when the underlying security failed. It is also important to know the degree to which the sellers of the CDO’s were acting as agent or principal. It appears from these description that each CDO offerred by a seller was done so in partnership with another party wherein the seller is the other party’s agent.

    As to caveat emptor, there is merit to the GS position that the buyers were sophisticated investors and speculators. That said, I see it as being equally relevent that what carried a AAA rating was, intruth, a junk bond and that sale upon such representation to be at least a serious tort and quite probably a financial fraud.

    The fact that the sell side of this fiasco prefers to cloak the discourse in spin is indicative of something larger than a failure of governance.

    This post is exceptionally helpful to me in understanding what transpired relative to the so called credit crunch. The general public outrage regarding bonuses is not that far off the mark. The MSM is missing the boat on a crucial story. Either they are not competent, or, they have a vested interest in obfuscating what is somewhat complicated but most assuredly not rocket science.

    1. Yves Smith Post author


      Sorry for not making the point explicit in a long post.

      The securities laws of 1933 and 1934 proved to be durable reforms. They were not perfect, but they comported themselves well for a very long period of time. The US securities markets were long seen as the most open, fairest, and safest in the world, and that was to the benefit of issuers and investors.

      I think we need SEC type rules for derivatives and related products. Frank Partnoy, former derivatives salesman turned law professor, has long been of this view.

  17. Hu Flung Pu

    I’m torn here…

    On the one hand, Goldman was clearly incredibly sleazy – although apparently it didn’t break any laws – in its dealings with the buyers of its mortgage securities. (I’m sure Goldman’s attorneys foresaw a day when just this sort of information came to light, and they structured the offering docs with this in mind.)

    On the other hand, the buyers were clearly unsophisticated with respect to these particular securities and had no business speculating in them. They deserved to lose money.

    Both parties are clearly at fault. But absent engaging in illegal conduct, I can’t see making Goldman financially responsible for the losses despite the high level of sleazoid behavior.

    What SHOULD happen going forward is that any firms dealing with Goldman, et al should assume that the selling firms are betting against the deal in some way. Further, they should simply stay away from these esoteric products – just take a pass on stuff they don’t understand. Like that’s likely to happen…

    1. moneta

      What SHOULD happen going forward is that any firms dealing with Goldman, et al should assume that the selling firms are betting against the deal in some way. Further, they should simply stay away from these esoteric products – just take a pass on stuff they don’t understand. Like that’s likely to happen…
      Good luck!

      In case you haven’t noticed they are everywhere.

      In Canada, the government is using them to evaluate the IPO of public cash cows. Yes, governments are broke and will be liquidating assets and GS will be there every step of the way.

      They’re like the Fed or the US consumers, nobody wants to bet against them.

      And GS is banking on this.

  18. Doc Holiday

    Goldman, et al: See: CONFLICTS OF INTEREST.

    Any material conflict between our interests and those of a client will be resolved in the best interests of our client. In the event we become aware of such a conflict, we will (a) disclose the conflict and obtain the client’s consent before voting its shares, (b) vote in accordance with a pre-determined policy based on the independent analysis and recommendation of our voting agent, or (c) make other voting arrangements consistent with our fiduciary obligations.

    It’s shit like that, which was never addressed in this systemic meltdown we are still involved in — but when you have systemic corruption, there is no way for the kettle to call the pot black. The Bush Coup destroyed DOJ, FBI, SEC, FTC and every branch of American government, as they spread their financial virus and corruption around the globe. Now, with Obama, we seem to simply have a new package wrapped around the failed system.

    If the CDO problems and cancer-like connections to our financial system are not managed in an honest way today, the chaos that is around us today will grow more and more out of control!

    Also see (very old CDO/Hedge Fund topic):

    Statutory Exemption for Cross-Trading of Securities http://www.dol.gov/federalregister/HtmlDisplay.aspx?DocId=21589&AgencyId=8&DocumentType=2

  19. Economics of Contempt

    “And who were these “market participants” who were so keen to get synthetic CDOs done? Not the long investors, but none other than John Paulson, the famed subprime short. To pretend that the growth of subprime ABS CDOs was driven by the long side is a misrepresentation.”

    No, that is a misrepresentation. The growth of synthetic CDO was absolutely driven by the long investors — that’s just indisputable. Ask literally anyone in the market at the time. Investors were clamoring for long mezz subprime CDO exposure, but there weren’t nearly enough cash mezz tranches to go around. Why do you think Deutsche, Goldman, JPM et al. were working so hard to develop the ISDA template? It was because investors were demanding mezz exposure. (Yes, I read Zuckerman’s book, but he doesn’t ever say that Paulson was the driving force behind the development of the ISDA template for synthetics….because that would be laughably untrue.)

    “Please. If these deals were regulated by the SEC, Goldman’s role in the deal would have had to be disclosed and it would have made a CONSIDERABLE difference in the pricing. To pretend otherwise is an insult to a reader’s intelligence.”

    Huh? I can only assume you misread Goldman’s response, because it said its role was “fully disclosed.” How could it not be? The arranging bank necessarily takes the initial short position in synthetic CDOs — someone has to be on the other side of derivatives contracts. Goldman’s role was fully disclosed, and it didn’t make a difference in pricing, so your argument is just plain wrong.

    Among numerous other serious errors in this post….

    1. moneta

      Ask literally anyone in the market at the time. Investors were clamoring for long mezz subprime CDO exposure, but there weren’t nearly enough cash mezz tranches to go around.
      So basically you are saying that GS knew that the system was running out of suckers and was preparing itself for it.

    2. Yves Smith Post author


      You and jck are choosing to obfuscate the key point.

      The dealer ALWAYS was the initial CDS counterparty. That sort of language would exist in any synthetic CDO transaction.

      My point is the additional fact that Goldman was going to retain the short position was not disclosed. Oh, yes, you can argue the language was broad enough to allow for that, but that had not been routine behavior and investors would have regarded the market differently had they been aware that Goldman (and Deutsche via its Start program) were going short.

      It has become acceptable for dealers to work actively against their clients, as opposed to on the occasional nickel and dime basis. The sort of behavior that took place here would have been considered heinous in my day. And I must note that (of all people) Bear Stearns turned down doing synthetic CDOs with Paulson because they did not like the ethics of setting up a CDO designed to suit the interests of the short side. Similarly, many of the monolines would not write guarantees on pure synthetic deals.

      That is the point you and others are choosing to ignore. Do you think Goldman was capable of engineering a CDO of particularly bad exposures? That would be the point of the exercise. Yet this was presented to customers as being like other CDOs, and these customers were unlikely to have had the analytical sophistication to see these CDOs were designed for failure.

    3. Yves Smith Post author


      This product, like stocks, distressed debt, and story paper, to use the old securities line, was (typically) sold, not bought. It had the richest new issue margins of any investment grade debt product.

      Gillian Tett was writing about CDOs with some frequency since 2004. Her articles in 2005 show that even back then that the deals were becoming riskier to produce the needed yield premium, and more and more investors were having doubts about CDOs. It was clear that some of the early investors in the product were pulling back.

      She wrote little about them for a spell, then picked up her reporting pretty dramatically in later 2006 and 2007. Her sources were telling her the product was increasingly being sold to clueless parties. And if you look at the later deals, I have not doubt that a good deal of the incremental demand came from buyers who were sophisticated in name only (Landesbanken were a big outlet), dealers engaging in negative basis trades, and dealers with clogged new issue pipelines. If there was such robust demand for CDOs, why did Merrill wind up with burgeoning underwriting inventory that is could not offload?

      1. Economics of Contempt


        Ah, I see what you’re saying regarding disclosure now. You’re essentially arguing that Goldman should’ve disclosed that they were planning to hold onto the short positions. (Correct me if I’m wrong.) First of all, the Abacus shelf started in 2004, and Goldman didn’t start going short the housing market as a firm until December 2006. So for the 2004-2006 deals, Goldman wasn’t necessarily planning to hold onto the short positions for longer than usual.

        Second, investors don’t have a right to know Goldman’s internal positions, and they never have (and no one was under any illusions here). For the 2007 deals, you think every time an investor bought a synthetic CDO from Goldman, Goldman should’ve disclosed in writing that it was shorting the housing market via the synthetic CDO? Of course not. That would’ve been a departure from historical norms, not the other way around. Dealers design derivatives for investors that they (the dealers) plan to hold onto all the time (e.g., lots of rates swaps), so it’s not like Goldman was doing anything unusual that would have required an additional disclosure — and investors had no reasonable expectation that an additional disclosure would be given if Goldman was planning to hold onto the short position. Standard disclosures in synthetic ABS CDO docs make it very clear that once the CDO is launched, the dealer is free to manage its CDS contracts however it wants. Goldman isn’t required to disclose its innermost thoughts on the future of synthetic CDOs. In any event, the fund managers who were buying synthetic CDOs have a legal duty to do their own homework.

        My point regarding investor demand was that at the beginning synthetics were absolutely not story paper (although I appreciate your using the language of my/our generation!). Synthetic CDOs eventually became story paper, starting around the end of 2006, but that’s not what you claimed. You claimed that the development of the ISDA template in 2005 was driven by the shorts like Paulson — the not-so-subtle implication being that synthetic deals were designed from the beginning to screw the buyers. That’s simply untrue. Bond funds, pension funds, etc., were indisputably the driving force behind the development of the ISDA template for synthetic CDOs. I agree that the later synthetics were story paper — which is the reason why Merrill (who, as usual, did whatever it thought Goldman had been doing) ended up with such a huge inventory of synthetics they couldn’t unload. (You also have to wonder how Merrill, which doesn’t have a very long institutional client list (being king of the retail brokerage world instead), ever thought it would be able to unload a large investory of synthetic CDOs. It’s not like they’ve ever been drowning in 144A-eligible clients to sell to. I guess they’ll do anything to win Goldman’s approval though.)

        Gillian Tett is a very hit-and-miss reporter (she sometimes makes astonishingly basic mistakes that suggest she still has only a tenuous grasp on how structured products work, but she sometimes writes thoughtful, informed pieces as well — more of the former recently, unfortunately). She wrote a long piece in 2006 where she admitted that when she attended the 2005 ESF conference, she only vaguely knew what structured finance was, and had only recently heard of something called “credit derivatives” (article here). So she can hardly be relied on to accurately portray the state of the synthetic CDO market in 2005 (which is when the ISDA template was launched).

    4. tom

      My recollection is that the people who established CDS for mortgage bonds (Lippman etc.) were not doing so to meet long demand from CDOs but to create the opportunity to short the market because the long demand was so great. Perversely, strong demand for short positions created more CDOs, which created more demand for long mezz bonds.

      It is just too simple to say that long investors were screaming for bonds unless you get to the details of who the long investors were.

      The banks had to work hard to sell the big AAA portion, they were constantly in the offices of anyone who might be remotely interested in this position, assuring them that the bonds would meet their investment objectives. In these sales pitches, they distinctly did not disclose that the deal existed because they, or the clients, were desperate to short the mortgage market. The perception of long demand for mortgage bonds was an illusion caused by CDOs which were created by Goldman and others.

      The entire market was distorted because of the CDO machine, with disastrous consequences. Had the parties responsible for the machine revealed that they were in the business of facilitating artificial demand and that their desired outcome for the CDO deals was for them to collapse in value, long investors would have been scared off. Therefore, this had to be disguised, Zuckerman provides some details on this – shorting the ABX alone would have pushed pricing down which would have ruined the economics of the trade. As a result, Paulson and others came up with a way to disguise their short position without distorting pricing – the mechanism was the synthetic or hybrid CDO.

      Many buysiders did homework on their investments but were unable to discover the full risks of the AAA CDO bonds. That was exactly the objective of the people creating such bonds. the buysiders can, and should be faulted for not being diligent enough, but that does not mean that the sellers are off the hook. Securities law is filled with examples of courts concluding that while sellers made disclosures, the disclosure was not adequate for the risks in the structure. Certainly, given the damage caused by these bonds and the deliberately secretive nature of the seller’s actions, these deals are worthy of an investigation.

      In addition, on a whole different level is the disclosure that Goldman and others made, or did not make, with respect to the AIG bailout. Had they disclosed that the reason AIG needed cash was so that Goldman etc. could get paid for their shorts on the mortgage market, and that these deals were actually responsible for distorting the mortgage market, Congress, the Fed and maybe even the Treasury might have been reluctant to fund such a bailout. I have seen no account that describes any such disclosure. Instead, months after the bailout, the information has begun to trickle out thanks to the efforts of blogs such as this.

      Those who insist that everything the sellers did was completely above board seem to be missing the bigger picture – the sellers, the banks had their hands in every aspect of the market. Rather than be held accountable for it, they have blamed the investors and been paid off by the government.

      1. marc fleury

        The AIG monies should be reimbursed at the level of the naked CDS/covered (4:1, 6:1 on abacus). All speculation there should have stopped at the bankruptcy of AIG. GS et al bankrupted AIG on speculative bets, the taxpayers gets to bail them out?

        When an economy bets that on its default it needs to get paid 6 times itself, it should be allowed to choke on its own macro absurdity, kind of like having 6 times the nukes to blow the planet up… one will do. AIG is the only real disgrace in this story…

  20. David Merkel

    I’m sorry, but I think jck is right. The risk factors were clearly disclosed. Buyers should have known that they were taking the opposite side of the trade from Goldman.

    As I sometimes say to my kids, “You can win often if you get to choose your competition,” and, “Winning in investing comes from avoiding mistakes, not making amazing wins.”

    As a bond manager, I was offered all manner of amazing derivative instruments. I turned most of them down. Most people/managers don’t read the prospectus, but only the term sheet. Not reading the prospectus is not doing due diligence.

    Since we are on the topic of Goldman Sachs, in 1994, an actuary from Goldman came to meet me at the mutual life insurer where I worked. I wanted to write floating rate GICs which were in hot demand, and all of my methods for doing it were too risky for me and the firm.

    Goldman offered a derivative instrument that would allow me to not take too risky of an investment strategy, and credit an acceptable rate on the GIC. So, as I read through the terms at our meeting, a thought occurred to me, and so I asked, “What happens to this if the yield curve inverts?”

    He answered forthrightly, “It blows up. That’s the worst environment for these instruments.” Now, if you read the docs, it was there, and when asked, he told the truth. The information was not up front and volunteered orally.

    But that’s true of almost all financial disclosures. You have to read the fine print.

    As for the derivative instruments, in early 2005, many large financial institutions took billion dollar writedowns. All of my potential competitors in the floating rate GIC market left the market. I went back to buyers, and offered the idea that I could sell them the GICs at a lower spread, which would give them a decent return, but with adequate safety for my firm. All refused. They basically said that they would wait for the day when the willingness to take risk would return.

    And it did, until the next blowup in 1998 around LTCM.

    My lesson: the craze for yield drives many derivative trades. What cannot be achieved with normal leverage and credit risk gets attempted, and blows up during hard times.

    Structure risks are significant; the give up in liquidity is significant. The big guys who play in these waters traded away liquidity too cheaply, and now they are paying for it.

  21. Matt Stiles

    I’m not really sure how enforcing misrepresentation laws run counter to “libertarian fantasies.”

    In fact, in any “libertarian fantasy” GS nor CDOs would exist as leverage and fractional reserve lending would be seen as the frauds they are – their purveyors imprisoned.

    Unless, of course, you consider Greenspan, Summers, Rubin, etc, etc as “libertarian.” In this case, the word has been successfully hijacked like the word “liberal” was before it.

    1. Anonymous Jones

      As has been amply demonstrated by myriad “libertarian” scholars worldwide (and echoed by comment threads everywhere), self-professed “libertarians” rarely agree on what being a “libertarian” means. Whatever your strict definition of it is, I can assure you that yours is a minority opinion given the plethora of schisms that have left fractured denominations of this religion everywhere.

      That said, I love…just love…how you are going to increase liberty by *preventing* humans from engaging in fractional reserve banking through the establishment of a collective government to judge and imprison the purveyors. Precious!

      1. Eagle

        Do you also love how governments can stop theft, rape and murder? Libertarianism is not anarchism. Particularly ironic for someone lamenting the “plethora of schisms that have left fractured denominations of this religion everywhere.” How about more facts, fewer empty rhetorical flourishes?

        1. Yves Smith Post author

          Um, Milton Friedman’s son described him as an anarchist, and yet Friedman was far from the most radical of his persuasion (he backed a negative income tax). If you believe the state is the only source of coercive power (a notion I find remarkably naive), coercive power is bad, therefore any government exercise of authority (save a few very narrow categories like defense) is to be opposed, how is that not awfully close to anarchism?

          1. Eagle

            If his daughter called him a communist, would he be half communist, half anarchist? How much say do nephews and nieces get?

            The devil is in the details. I may as well equally disingenuously demand to know how liberalism is not awfully close to communism – they both believe in the primacy of the collective over the individual – it’s really just a very minor difference in degree, isn’t it?

          2. bob goodwin

            Milton Friedman was an intellectual, not a leader. He certainly was not my leader. Government *is* the most coersive force in history. But certainly not the only evil force. What you blame on libertarianism I blame on regulatory capture. Seeking rents is the opposite of what most libertarians believe in. Rubin is not against government intervention in wall street – he is the government.

  22. moneta

    While we’re on the “it was disclosed” argument…

    Anyone who has read a prospectus will know that if you bolded out all the disclosed risks and acted on these warnings, you would not touch even the safest of securities.

  23. Hugh

    Great post. The more sophisticated the mark the more sophisticated the con (or at least the greater the razzle-dazzle). One of the ways of allaying the suspicions of the mark is, in fact, to admit certain “conflicts of interest”. This not only solidifies the grifter’s “honesty”, misdirects attention away from the full implications of such conflicts, but, as we see here, can later be used as a defense for the con.

    The reality here is that a fraudulent investment vehicle was set up, period, full stop. It doesn’t matter if the grifters gave any caveat emptor warnings after this point or not. You can not steal someone’s money and make everything all right by informing them that in fact you may end up stealing, not just some but all of their money. Do the marks look stupid? Of course. But then marks always do.

    1. Claire

      “The reality here is that a fraudulent investment vehicle was set up, period, full stop. It doesn’t matter if the grifters gave any caveat emptor warnings after this point or not. You can not steal someone’s money and make everything all right by informing them that in fact you may end up stealing, not just some but all of their money.”

      Well, there were apparently a team of GS lawyers in the room while they were making the documents. I’m pretty sure those lawyers must have found a way to be reasonably sure that they were on that fine line of legality.

      If (when, imo) the market blows up again, it’ll be interesting to see if the government can even risk trying to bail out GS again.

  24. moneta

    Anyway, I didn’t have to read a prospectus to know that real estate was going to implode.

    But I also know that it was quasi impossible to go against the crowd as an asset manager or you were just ousted in that time period.

  25. Francois T

    @ David Merkel and Economics of Contempt,

    I’m asking basic questions because my job is to fix people, not money.

    If I read you correctly:

    1) in an environment of low interest rates, there is an imperative (competitive pressures?) for higher yields that drive derivative trades.

    2) There can’t be a derivative trade w/o a counterparty, and GS was (is) the initial counterparty to a lot of trades they initiated.

    Correct so far?

    A couple of things I don’t understand:

    a) Why couldn’t (wouldn’t) these investors (I assume there are people with means to analyze derivatives) hedge their trades? Were they so driven by the chase for yields that they were stoopid enough to go long only?

    b) “Goldman’s role was fully disclosed, and it didn’t make a difference in pricing…” IS that really so? Are you implying that the information was symmetrical and open between GS and their customers? And how can you be so affirmative about the pricing? What was the pricing compared to?

    I’m genuinely curious.

    Thank you

  26. bystander

    When the story of the crashes of 2000-2020, or whatever it turns out to be, gets written, comment streams like this one today will be a benchmark of insanity, like the lift boy tipsters in 1929. What does it take to put a stop to this nonsense, short of a full-on crash?

    Kind of unsettling to see that the default line of defensive argument is so hard to distinguish from that of a conman, or a rapist.

    Especially when it’s really the taxpayers and ordinary folk, American and others round the globe, who are really the ones who have ended up wearing the crappy consequences.

    1. DownSouth


      You say, “Kind of unsettling to see that the default line of defensive argument is so hard to distinguish from that of a conman, or a rapist.”

      There’s really nothing new to the arguments Goldman and its defenders are making. They’re as old as the hills. The criminal mind always tries to denigrate its victims. It always believes itself to be so “exceptional” as to be above the law. Its victims always did something that make them deserve what they got. Its criminality is always justified as being for the greater good.

      Just take a look at how similar the arguments Rodión Románovich Raskólnikov, Dostoevsky’s protagonist who murdered the old pawn dealer in Crime and Punishment, are to those made by Goldman and its defenders:

      ”I simply hinted that an ‘extraordinary’ man has the right…that is not an official right, but an inner right to decide in his own conscience to overstep…certain obstacles, and only in case it is essential for the practical fulfillment of his idea (sometimes, perhaps, of benefit to the whole of humanity)… As for my division of people into ordinary and extraordinary, I acknowledge that it’s somewhat arbitrary, but I don’t insist upon exact numbers. I only believe in my leading idea that men are in general divided by a law of nature into two categories, inferior (ordinary), that is, so to say, material that serves only to reproduce its kind, and men who have the gift or the talent to utter a new word. There are, of course, innumerable subdivisions, but the distinguishing features of both categories are fairly well marked. The first category, generally speaking, are men conservative in temperament and law-abiding, they live under control and love to be controlled. To my thinking it is their duty to be controlled, because that’s their vocation, and there is nothing humiliating in it for them. The second category all transgress the law; they are destroyers or disposed to destruction according to their caprices. The crimes of these men are of course relative and varied; for the most part they seek in very varied ways the destruction of the present for the sake of the better. But if such a one is forced for the sake of his ideas to step over a corpse or wade through blood, he can… The first category is always the man of the present, the second the man of the future. The first preserve the world and people in it, the second move the world and lead it to its goal. Each class has an equal right to exist. In fact, all have equal rights with me…”


      “Crime? What crime?” he cried in sudden fury. “That I killed a vile noxious insect, an old pawnbroker woman, of use to no one!… Killing her was atonement for forty sins. She was sucking the life out of poor people. Was that a crime? I am not thinking of it and I am not thinking of expiating it, and why are you all rubbing it in on all sides? ‘A crime! A crime!…

      Look into it more carefully and understand it! I too wanted to do good to men and would have done hundreds, thousands of good deeds to make up for that one piece of stupidity, not stupidity even, simply clumsiness, for the idea was by no means so stupid as it seems now that it has failed… If I would have succeeded I should have been crowned with glory, but now I’m trapped.”

      1. Doug Terpstra

        Wow. Raskólnikov sounds like jck above:

        “We are dealing with professional investors who are supposed to read prospectuses, not idiot widows and orphans relying on the SEC.”

      2. bystander

        That’s a nice quote, DownSouth. The sort of narcissist’s rant that one might expect to see transcribed by Cleckley or one of the modern sociopathy specialists. Fascinating to see it in FD. I must have been distracted by his crazy plots or his dubious taste first time around; his ability in literary live drawing (this must be first hand experience, mustn’t it?) completely passed me by.

  27. Uncle Billy Cunctator

    More on Tricadia…

    Interesting the op-ed throws out a name. Someone trying to scapegoat? Sachs might fit the bill, but what of Michael Barnes, the fellow that founded it and started their CDO funny business? Just as in the Oxbridge/LSE roots of the “Morgan Mafia,” Barnes hails from, LSE (also where the mysterious Peter Boone of Baseline reportedly sits).

    So now he’s an educator (Dean of the Global MBA program no less) at the S.P. Jain Center of Management in Dubai?


    Lovely! Must have a delightful view of the conflagration, something along the lines of the view at the end of “Fight Club.”


    Interesting how people who have played key roles in the GCF (Great Cluster #@#$) find cushy jobs in academia.

    He was also:

    Assistant Dean, Weatherhead School of Management
    Case Western Reserve University
    (Educational Institution; 10,001 or more employees; Higher Education industry)
    2000 — 2002 (2 years )
    Assistant Dean for Action Learning & Corporate Liaison, and Executive Director of Relationship Management for the Weatherhead School of Management

    Weatherhead, Weatherhead…

    Simon Johnson of Baseline was close to a Weatherhead something or other at Harvard University at one point too..


    Time for Stanley Webber to meet Monty?


    1. Uncle Billy Cunctator

      Sorry, different Michael Barnes’s apparently.

      The Tricadia Barnes — UBS, Paine-Webber, Bear, Columbia.

      The Jain Barnes — Case Western Reserve University – Weatherhead School of Management
      Stanford University Graduate School of Business
      London School of Economics and Political Science

      Only overlap seems to be UBS.

      This is curious… a derivatives symposium at Fordham, the Jesuit University.


  28. Uncle Billy Cunctator

    Looks like we’ve found a Tricadia rocket scientist though…

    “Mr. Inayatullah is a Director, Co-Chief Executive Officer and Co-Chief Investment Officer of Tiptree and a founding partner of Tricadia Capital. Since November 2007, Mr. Inayatullah has been a director and Co-Chief Executive Officer of Apple Creek. Mr. Inayatullah has 19 years of experience in engineering complex structured transactions in the fixed income, currency, equity, and commodities markets, with a particular emphasis on leveraged credit products. Prior to the formation of Tricadia Capital in April 2003, Mr. Inayatullah was at UBS Principal Finance LLC where he was an Executive Director responsible for the development of structured credit arbitrage transactions. Mr. Inayatullah joined UBS in March 2002. Prior to UBS, he was a partner at BroadStreet Group where he had responsibility for managing the BroadStreet Group’s structured product and CDO business lines from March 2000 to June 2001. Prior to BroadStreet, Mr. Inayatullah was a Managing Director at Crédit Agricole Indosuez where he was responsible for structured finance and proprietary credit arbitrage. Mr. Inayatullah holds a B.S. in Electrical Engineering and Materials Science from Cornell University.”


    Now, what are Apple Creek and Tiptree?

  29. Ted K

    It’s worth noting that although Yves Smith deserves a large round of applause for breaking down and analyzing this, and adds a large amount of value to the original story (pause for a large applause from the gallery)—the original piece this relates to was written by New York Times journalists Gretchen Morgenson and Louise Story. YAY GRETCHEN MORGENSON AND LOUISE STORY!!!!!!

  30. Hugh

    “Fraud is generally defined in the law as an intentional misrepresentation of material existing fact made by one person to another with knowledge of its falsity and for the purpose of inducing the other person to act, and upon which the other person relies with resulting injury or damage. Fraud may also be made by an omission or purposeful failure to state material facts, which nondisclosure makes other statements misleading.”

    I found this definition of fraud at Denninger’s and I think the last line is important to the “Caveat emptor” argument raised in this thread. It is the non-disclosure of material facts leaving a misleading impression that vitiates the argument.

  31. bob goodwin

    Contrary to the fantasies of libertarians…

    Yves, your propensity to blame libertarianism for sociopathy is really getting old. Caveat Emptor is far more likely to be quoted by Harvard grads and ex-Goldmanites than libertarians. There is nothing in libertarianism that gives people the right to steal.

    1. Biblical

      Jesus would vote against stealing. God would prohibit, and enforce it.

      Please cite line and verse when referring to libertarian and his teachings.

  32. Steve

    Are you also arguing that a homebuilder that built and sold a home at the peak “knew or should have known” that the value would drop?

    On the topic of securities:
    Shouldn’t I assume that someone who sells me a security thinks it will go down (otherwise they would have kept it)
    Didn’t Paulson tell his counterparties his intent was to go short and they still eagerly bought all the supply he could sell them?
    If as you say “AAA investors were not equal parties in negotiating” it was simply because there was so much competition to buy these securities that you couldn’t dictate terms.

    I will continue to believe Goldman is smart and/or lucky unless it is established that:
    1. Goldman was deceptive about the content of these securities.
    2. Goldman touted the benefits, safety or desireability of the securities. I can’t prove this didn’t happen but if it had I’m sure we’d all be talking about it. It seems like no marketing was required given the huge demand. Thus this is different than taking a company public or issuing a buy rating while privately calling it a dog.
    3. The AAA ratings were outside of industry norms and could clearly be connected to some secret arrangement with the ratings agencies.

    I couldn’t care less about Goldman. My only interest in this is I despise this mob mentality.

  33. Yves Smith Post author


    You did not read the thread, or at best did only casually, and it sounds like you did not read the article.

    Your homebuilder analogy is incorrect. The point of the article is that Goldman was seen and presumed by investors to be an intermediary (a broker, save that in real estate, the broker has a fiduciary duty to the buyer, while in new issue land, the intermediary is presumed to be finding a middle ground between what the people on both sides of the trade want) not only acting as a principal when that was not disclosed to investors, and therefore having every reason to create instruments that would fall in value.

    There was not huge demand for the AAA tranches in the 2006-7 era, the toxic phase. IB salesmen were all over AAA investors trying to hawk the stuff, and they still wound up with tons of inventory. This stuff was flogged very aggressively. The situation was the polar opposite of what you suggest.

    Paulson never had any dealings with “counterparties”. You are simply wrong here. He approached Goldman, Deutsche, and Bear. Bear turned him down, they didn’t like the ethics of what he proposed. No one on the other side of these trades had any inkling who were the ultimate shorts in any synthetic deal (the dealer/packager was the initial protection buyer).

    AAA investors were not equal parties in negotiating because the deals were largely structured by the time they were approached. This is not uncommon in tranched deals. The investors in the riskier classes have good reason to be tougher in structuring and composition. The AAA tranches sit on top of others who have already negotiated the deal a fair bit. The AAA investors is presumed to be significantly protected by his senior position.

    So your argument appears to boil down to rejecting the facts against Goldman, indeed, dismissing them as a “mob mentality”. I suggest you read the thread and parse out the information. All you have presented is your prejudices.

  34. Steve


    I have read both the thread and the article. I did make a mistake when I mentioned Paulson – I was thinking of Steve Eisman @ Frontpoint who was profiled in Portfolio and was very clear that those who bought his shorts were happy about the supply it created that enabled them to go more long.

    The central premise of your piece asks us to evaluate the facts in a product liability context and I’m certainly game (I don’t believe in strict caveat emptor either). I presented the homebuilder argument to show that a product dropping in value isn’t enough to prove a product “defect”. I then listed 3 conditions, any of which would seem to make the case in a product liability sense:

    1. Goldman was deceptive about the content of these securities.
    2. Goldman touted the benefits, safety or desirability of the securities while it clearly believed otherwise.
    3. The AAA ratings were outside of industry norms and could clearly be connected to some secret arrangement with the ratings agencies.

    But there’s no evidence that any of these conditions apply. In fact the only thing different about Abacus was that Goldman was acting as a principal which might supply a motive to create a defective product but doesn’t prove that it did create a defective product.

    You say that AAA tranches needed to be flogged aggressively in the 2006-7 era. If that’s true then it’s more likely we’ll see some smoking gun sales document where Goldman expresses opinions that are clearly at odds with their true beliefs. But what I’ve been exposed to suggests most of this stuff wasn’t hard to sell.

    I haven’t rejected the facts – I accept them and yet I am unmoved. I don’t think the product liability argument holds water.

    1. Yves Smith Post author


      I’m a bit puzzled by your argument.

      2. holds by virtue of them constructing a deal and taking 100 % or very close to that on the short side (as indicated by the New York Times, and consistent with what I have heard for some time from industry sources) and finding investors for the other sides in multiple transactions. Anyone going short will chose the securities he believes to be the most overvalued. The McClatchy piece I discussed this evening indicates Goldman went net short even earlier than they have admitted to, BTW, which suggests some sensitivity on this very issue.

      1. holds by the fact that if these deals were subject to SEC reporting standards, the failure to indicate that they intended to retain the short position would very likely be seen as an omission of a material fact. I will ping a lawyer who knows SEC regs to see if he confirms my perception from my days in the securities industry.

      So it would appear you either are rejecting facts or not operating in conformity with your stated views.

      1. Steve


        2. What I mean is did they say something like “We believe these securities provide a very low risk to principal” when Goldman felt the risk to principal was anything but low.

        If they chose the most overvalued securities and disclosed them properly then the buyer has a chance to take that into account and the ratings agency has a chance to take it into account.

        1. Whether Goldman retained a short position doesn’t change what the actual product is. It either is or isn’t defective regardless of who owns it.

        The product is the product. It already exists, has already been sold and we can find out what it was composed of and determine if it was defective. If it was defective then guilty and if not defective then not guilty. After that, the fact that they retained the short can only suggest *why* they made it defective.

        Not sure why you are persisting on the “rejecting facts” attack.

    2. mannfm11

      I think you are lost myself Steve. These were junk bonds packaged as quality investments and made that way by a secret process. If you examine the stock market, you will find that the S&P pays 2%. Sure there are some stocks out there that pay good dividends, but the sum of them is probably about 20% of the capital position in the market. The PE’s are fake and have been faked for years, the news media and socalled experts choosing to get rid of the expenses they don’t like. It would be like buying 10 stocks and getting to discard the 3 you lost on and get your money back.

      In any case, the people outside Wall Street were sold this academic portfolio theory, which was supposed to give the holder stock market returns without the risk. I took the stuff on a limited basis in college in the 1970’s and the premises was that if you bought 20 stocks with the proper betas and correllation coefficients, the portfolio would pay the expected generalized return out of the stocks. The theory was that if you priced 20 stocks to return 10% (remember you have to price the stocks to return 10% for the portfolio to return 10%, not 6% as is the current case), the bad performers and the good performers and the inverse correllation coefficients would pay you roughly the 10% return. I’m not smart enough to know how to develop betas and correllation coefficients though I would probably do so if I knew the formulas, but I do know that returns on stocks are based on dividends and growth and real growth is about 1% at best over inflation. A real portfolio of stocks that were priced to return 10% would produce a portfolio geared to return 10% (6% to 7% real rate of return). Well, if you look we have a portfolio that pays a 2% dividend in a 3% inflation environment, giving 6% and because the portfolio reflects its assets it is clear the assets are also priced to return 6% not 10%. But, people are holding this stuff waiting for 10%. When the market revalues to 10%, they will find themselves holding a bag that is no where near what they paid for it. The difference is there will be a market for the stocks that don’t go to zero (AIG, FRE, LEH, BS, ENE, WCOM are a few that used to be worth a lot of money that suddenly went to zero, all in the SPX).

      Maybe you don’t understand where I am going, but you can’t get 10% out of assets priced to return 6% and a portfolio won’t turn them into 10%. All of Wall Streets data issued the public beats the 10% drum. The 00’s were a bad decade for stocks, the 10’s will be better? How? How can you get a 9% or 10% risk to perform when it is priced to return 5% to 6% forever? First you drop the price 50% or more, that is how. Anyone that understands that will sell their entire portfolio and wait, no matter what they are going to miss in the meantime.

      Bond are the same. Subprime mortgages are an 8% item if they are underwritten to some extent. I have packaged mortgages and the package has to meet the smell test or you don’t get it by the underwriter. The underwriter has to meet the smell test or you can’t sell it out of the system in which she works. Those that are buying these mortgages see what is in the package and if they don’t they are at least negligent. To present something as AAA that hasn’t been underwritten is in itself the essense of fraud. You can’t have one without the other. Goldman knew this stuff was crap and they set out to build a doomsday machine at least to cover themselves while they were pushing massive amounts into their pockets. If I was going to buy insurance, which they did with Abacus, I would buy the plan that paid the most, which they did because they created it to pay the most. Thus if I got stuck, my stuff went to 25 while my insurance paid off 99% or 95%. 20% or 30% on a few billion is a pretty good return.

      Back to the portfolio, the CDO was really sold and rated on the same premesis. The problem was the risk was priced AAA. The reality was bonds in default. The idea was the market would hold up enough to protect the more secure tranches, thus you could own XOM and get a dividend while holding the growth crap that went along with it in the SPX. The problem was the risk was probably priced at 6% and it was 20% risk or was already in default.

      Steve Eisman is mentioned and that Michael Lewis article last year was a pretty good one. Eisman with is limited resources was able to figure out the CDO’s were crap. In fact, he was able to figure out which ones were most likely to fall to pieces. He had very limited resources and probably a portfolio that amounted to 1 weeks cash flow for Goldman. Hayman Capital put out a letter in July 2007, which I copied off the net and still have. In it, they said they were short the CDO market and that it was inside news it was going to implode while they were pushing the stuff on the streets. The whole thing was a fraud and when all is said and done, the use of portfolio theory will turn out to be a mistake, not because the idea was wrong, but because the pieces bought and put into the portfolio were priced wrong.

      The subprime crap could have never been purchased to make a AAA return. I am sure if you took the bottom half of the portfolio and paid out risk free, the top half might have flown if you priced it to return 12%. There was a 15% loss waiting to happen right off the top, which would have totally wiped out the tranches that were supposed to pass down cash flow to pay the lower tranches. Being the bubble in real estate was aided and abetted by these toxic waste securities, the reaction to the overvaluation and the creation of massive surpluses in home supplies in many areas from fraudulent purchases, much of what couldn’t be impaired was. A home is worth about 70 cents on the dollar to a lender. If you take out 30% of the value, that number drops to under 50 cents on the dollar. Places like Las Vegas, the losses are most likely 80%. Because the bigger the bubble in an area, the more subprime was used, these losses are being taken in these portfolios.

      This was not a surprise. I live in Dallas and was engaged in the real estate business throughout the 1980’s. Everyone moved to Dallas and built something and what they built couldn’t be sold long term and what was sold was financed with tricky financing that cost a lot on the front end or back end. It was the late 1990’s before real estate prices recovered and after about 5 years in the doldrums, the prices bottomed.

      My point here was the portfolio of CDO’s should have been priced to return 8% if they were well underwritten, but being they weren’t underwritten at all in a lot of cases (one bad apple destroys the entire bunch in security pools,meaning if one is not done right, you have to have concerns about all the rest), a 12% or higher return probably should have been applied. There is no way you turn such a portfolio of garbage into AAA and no part of it could be even BBB when the top 30% is literally guaranteed to disappear.

      1. Steve

        Those securities certainly could have provided AAA safety. All that was required was that housing prices never go down. Obviously it didn’t work out that way but many many people and institutions had fooled themselves into believing it was a reasonable assumption. And they were evaluating the contents, ratings and pricing of these securities through those glasses.

        Even GS, who eventually began to see the risk, didn’t place any huge short bets probably because they knew there was as much risk in being massively short as in being massively long. Abacus was only $10B which isn’t huge in the context of their balance sheet and given that some or all of it was used to offset their longs their net short position would be even smaller (for the record I don’t know if we know for a fact that GS was net short).

        The central premise of Yves piece though, is that there was some intrinsic defect in the Abacus securities. My point is that there’s no evidence of such a defect.

        1. JCH

          I keep reading the real estate “never going down” reasoning.

          People seem to be saying a tranche full of subprime would not suffer a loss until total losses exceeded a threshold – say 25%. To me that clearly indicates the bonds were designed handle real estate going down, just not to the extent it did go down.

          They had to know subprime was going to cause turmoil in the housing market. Said turmoil simply exceeded their expectations.

          I can’t imagine GS, or MS, being found guilty of anything here.

    3. mannfm11

      BTW Steve. When they bring a sample of loans out of the original portfolios, it will be easily shown that there was no due diligence done on these files. I would bet 3 to 1 Goldman loses unless they can find a way to bribe or threaten the judge. The end buyers in this stuff were in no position to see the files. I can believe AIG should have known, but I can also see that the guy running the AIG financial products office was a crook who was concerned more with how big he could make his bonus check before the thing blew up. You might research William K. Black and his knowledge of how fraud in bubbles is committed. Blow it up big, take the bonuses and get out with the loot before it collapses.

  35. mannfm11

    Good article yves. I don’t know about a lawsuit though. How about a criminal trial or should a say 1000 criminal trails. There should be plenty of surplus lawyers right now. The key component, from AAA to CCC in transactions tha didn’t include fraud almost never happened. I would recall the Parmalet failure in 2003 or 2004. The fraud revolved around $2 billion supposedly in a BAC account in the Caymans. Those pushing those top rate bonds out the door the day before that outfit collapsed could have easily known the financials were fraud. The banks would have all been wondering where the $2 billion was or at least I don’t believe that business loses track of $2 billion that easily. Maybe it is just their share they keep up with though. It astounds me every time I see what kind of crooks these people are. Also, in the majority of cases, it appears it was public pension funds or some kind of state agency that was scammed by these people.

  36. Caol Acain

    This fact that global governments share your perspective (as evinced by forthcoming regulations FAS 166/167, Basel II, etc.) is incredibly frightening.

  37. Tony Frank

    It is a “crying shame” that each one of these broke institutions weren’t run through the bankruptcy courts.

    Hopefully, the next time, they will be following this country’s next revolution against the financial mafia.

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