Tom Adams: Goldman Not Exonerated on CDOs

By Tom Adams, an attorney and former monoline executive

Felix Salmon at Reuters and Steve Gandel at Curious Capitalist used some of the analysis in Michael Lewis’s The Big Short as an opportunity to attempt to exonerate Goldman Sachs for the charge of deliberately constructing CDOs to go bad for their own profit. In particular, Mr. Gandel notes that the data of AK Barnett-Hart, the now famous Harvard student who wrote a paper on CDOs, shows that the CDOs on which Goldman Sachs was the banker performed better than most of the CDOs offered by other bankers. As a result, he concludes that that Goldman might not be bad as some people have claimed when it comes to their CDOs. He goes so far as to suggest that this data may even exonerate Goldman of some of the vampire squid mythology.

The problem is Ms. Barnett-Hart’s data offers no conclusive proofs of CDO performace.

First, her data only went through the end of 2008, as Mr. Gandel acknowledges. Very few CDOs defaulted by this point (though some did hit events of termination) even though the collateral underlying the deals has already plummeted in value.

A shortcoming here is that her thesis, which criticizes rating agency ratings, nevertheless also uses them to assess how well or badly a particular CDO fared. For a variety of reasons, including the complexity of the deals and perhaps pressures from outside forces, the rating agencies took a remarkably long time to downgrade many of the CDOs backed by mortgage collateral and this process continued throughout 2009. As a stand-in for defaults, Ms. Barnett-Hart relied on significant downgrades to the CDO bonds as a measure of implied default. This, too, has some problems as a measure, since the rating agencies were, in many cases, wildly divergent. I performed extensive analysis on the CDOs in AIG Financial Product’s portfolio and was surprised to find numerous instances where one rating agency would have the ratings of AIG’s CDO at a A or AA level while the other had it at CCC levels, even at the beginning of this year, when I was performing my analysis.

Another issue I found when examining AIG’s portfolio is that very little data was available for Goldman Sachs Abacus program, the synthetic CDOs that were the subject of the December 2009 New York Times article Mr. Gandel cites. I have also been unable to find transaction-level detail about these deals from other public sources.

If the Abacus transactions (25 in total) are missing from Ms. Barnett-Hart’s data set for these deals, as it was for my own analysis, then it is certainly possible that her analysis of Goldman was incomplete. If they are not present in her data set, that means the impact of Goldman creating bad CDOs to bet against them was not addressed in any way by her analysis.

This discussion prompted me to go back and look at the CDOs in the Maiden Lane III portfolio for AIG, as we previously discussed here at Naked Capitalism. I was able to track down the CUSIPS, transaction parties and ratings, as of January 2010, for all of the ABS CDOs in AIG’s portfolio and the Maiden Lane III transaction. Goldman Sachs was the banker for the largest percentage of CDOs in this portfolio, contributing just over $18 billion worth of bonds to the AIG cause. Merrill Lynch was the banker for the second largest amount, with $12.4 billion. I went back and looked at the current Moody’s ratings (Moody’s was generally more conservative than S&P), as of January, and learned that of the top four bankers Goldman, Merrill, Deutsche Bank and UBS), who were responsible for over $44 billion of the $62 billion portfolio, Merrill’s deals had the worst weighted average rating. Their deals come out at Caa2. The CDOs of Goldman Sachs were the second worse, with a weighted average rating of B1 and ranging between C and A1 (for a 2002 transaction).

In addition, for the deals on which Goldman Sachs was a counterparty, which represented approximately $14 billion, the weighted average rating was quite a bit worse than the deals for which they were just the banker (meaning they had created the CDO but a different bank owned it and insured it with AIG). On these deals, the weighted average rating was Caa2. This means that the deals which Goldman chose to retain, either on their own behalf or for the benefit of clients, performed much worse than the deals they sold to others. Of course, it was for these deals which Goldman received insurance from AIG. And when AIG was bailed out, Goldman kept the collateral which AIG had already posted (approximately $8 billion) and got paid out on the remaining amount from the Federal Reserve via the Maiden Lane III transaction.

Since Goldman was the most aggressive bank when it came to seeking collateral from AIG, it stands to reason that the deals on which they could require such posting would be particularly bad (and of course, Goldman may have also been more realistic about the likely value of the AIG insured CDOs, compared to the other banks).

This data analysis does not prove that Goldman actively created bad CDOs so that they could profit when the deals failed. However, since it is based on more current ratings and relates to a specific strategy that Goldman apparently had with AIG, it provides a more detailed viewed into how Goldman managed their CDOs. Because the CDOs underwritten by Goldman in AIG’s portfolio were among the worst in this portfolio, and because the CDOs on which Goldman was the counterparty performed even worse than the banked deals, I feel confident in saying that Goldman has not been exonerated.

One way to determine whether Goldman is innocent would be to examine the performance of the Abacus synthetic CDOs, on which Goldman presumably would have held a short position from the outset. One would assume that since Goldman devised these deals with the intention of profiting from its short position, those CDOs would have performed even worse than the other Goldman deals. Unfortunately, Goldman has declined to make this data available.

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  1. i on the ball patriot

    To measure current in a circuit,
    You must have a trusty meter,
    To measure the value of a CDO,
    You must not rely on a cheater …


    “Moody’s and the other bond-rating agencies have featured prominently in the build-up to the financial crisis. These agencies gave investment grade ratings to complex financial instruments filled with subprime mortgages and other bad assets. These ratings allowed Goldman Sachs and other investment banks to sell this trash around the country and the world, ensuring that the effects of the collapse of the housing bubble would reverberate throughout the financial system.

    It was not just incompetence that caused Moody’s to misunderstand the quality of the issues it was rating; it was corruption. Moody’s and the other bond-rating agencies were getting paid by the banks whose assets that they were rating. The bond-rating agencies knew that these companies wanted investment grade ratings for their issues. As one examiner for Standard & Poor’s said in an e-mail, they would give investment grade ratings to products “structured by cows.””

    More here …

    Deception is the strongest political force on the planet.

  2. MichaelC


    There’s another odd aspect the Felix/Gandel “Goldman is Not a vampire” meme.

    Have a look at the comments on the link to Gandel’s article. Barnet Hart joins in to respond to question about the data and promises to review and rerun it, Tavakoli remarks that Gandel’s misquoted/misrepresented her view and therefore his conclusion is wrong, which supports your analysis.

    The comments were made on 3/20-3/21. The origninal article was posted 3/20. Felix wrote his piece on 3/25. Perhaps he overlooked the comments, since its pretty clear none of the people mentioned in the article supported Gandel’s conclusion.

    They both need to retract their stories.

  3. akbarnetthart

    Thank you for the article Yves.

    In response to your concern about the ABACUS deals, 24 out of 25 of them were included in my data. Furthermore, I used several measures to look at performance, as my paper clearly acknowledges the shortcomings of looking at the ratings.

    Not only did GS have lower rating downgrades, but their CDOs also had lower default rates of the collateral (while having similar credit support to other CDO bonds for the rated tranches) and also had less synthetic and subprime collateral than their peers.

    While I agree that it is dangerous to use my 2008 study to exonerate or make conclusive arguments about specific banks, it at least seems to call for further empirical study to back up claims that are now taken as fact in the media.

    1. Anonymous

      “seems to call for further empirical study to back up claims that are now taken as fact in the media”

      This statement seems curious to me. What claims are you concerning about being misreported in the media?

  4. akbarnetthart

    My apologies, I see that Tom Adams was the author of the article. I would be happy to discuss my thesis with anybody that has questions about my data and/or methods.

    My hope is that my paper can spark the kind of debate that has already been occurring in order to shed new light on the incentives and regulatory structure that allowed the creation of this CDO mess.

    1. sgt_doom

      I appreciate Ms. Barnett-Hart’s outstanding paper, but don’t consider it to be the end-all or be-all on this subject.

      Your conclusion demonstrates a lack of understanding of the entire securitization and credit derivatives history and markets and exchanges.

      Hopefully, in your time at Morgan Stanley and on the Street you will understand that securitized credit derivatives of various flavors, hedge funds, and leveraged buyouts are all effectively the same financial configuration using the same pass-through tax structures and destroying real wealth creation and acting as one continuous Ponzi scheme.

    2. Gbestor

      Ms. Barnett-Hart: truly excellent paper and I appreciate your willingness to raise your head above the ramparts. I do have a question about your data: can we see it? That is the only way to test your conclusions. The somewhat misnamed “Open Source Model” appears to be the most significant data source and it was apparently only open for a week or so.

  5. VenusVictrix

    It’s erroneous to conclude that Goldman’s CDOs were of any greater quality merely because the underlying loans took longer to default. A more accurate analysis would include factoring in the extent to which second mortgage equity extractions were used to keep the first mortgage afloat, and thus delay the inevitable.

    1. Yves Smith Post author


      The issue isn’t merely time to default, which is a valid point you raise. It’s that the ratings agencies were slow to downgrade. Moreover, given the considerable ratings disparities that Tom cited, it also appears that there has been some arbitrariness in how they are going about reviewing the deals. Thus Goldman’s deals looking “better” before the downgrades were complete may not be a function of their deals being “better” but simply that the rating agencies got around to reviewing enough of them late that some were carrying outdated (high) ratings.

      Put it more simply: the paper argues that ratings agencies mis-rated the deals initially. Yet it relies on ratings to determine how the deals performed. That seems contradictory; the ratings were unreliable, yet are used to benchmark performance? The same political and intellectual failings that applied to the initial ratings likely also applied to the downgrade process. For instance, one could argue that who got downgraded fastest was a function of their effectiveness in lobbying against downgrades, not just deal quality.

      1. VenusVictrix

        Thank you for clarifying that point. I suppose I should read the paper, but I admit that with Michael Lewis pimping it to the media, I’ve already dismissed it as being in the same category of drivel that he produces.

        With what you’ve just told me about her thesis, I think drivel might be too generous an estimation.

        1. Yves Smith Post author


          That’s unfair. Her paper is a very serious effort by an undergraduate. Lewis (and now Salmon and Gandel) made it out to be something more than it is or could be, which is not her fault.

          Its shortcomings reflect lack of market knowledge, and more important, a predilection in the economics profession to know the price of everything and the value of nothing, to favor elaborate analyses with clean data sets without asking sufficiently tough questions about the relevance of the data.

      2. akbarnetthart

        I agree that the ratings were lacking as a proxy for performance (which I explicitly state in my paper) and therefore most of my analysis is based upon the default rate of the CDO collateral (while controlling for the liability characteristics such as credit support).

        Overall, my paper was not meant to yield any ground-breaking new conclusions about the CDO market. I was simply trying to gather the data and come to my own conclusions as I felt that many people in the media had simply been repeating what they presumed to be true from their own experience with the markets. As an outsider, I knew next to nothing about CDOs when I began and really set out to explain to myself what had happened with these arcane securities that allowed them to contribute to the massive writedowns we saw in 2008.

        Even if you do not buy any of my statistical analysis (I agree that economics often times relies too much upon this kind of regression analysis), most of my paper is simply presenting the data in summary format. It is meant to give a clear picture of what was going on in terms of CDO collateral, underwriters, and credit ratings. There are multiple pages of summary statistics in the back, so you can bypass any regression sections and simply glean some insight from the summary statistics.

        Clearly when I wrote this paper I never could have anticipated it getting so much attention. While I am the first to admit that there are multiple limitations to my work, I nevertheless see it as one of the only papers that aggregates empirical data on CDOs and presents evidence based on the numbers and not on preconceived notions.

        1. VenusVictrix

          Thank you for your response, and I apologize if I have unfairly prejudged you on account of Michael Lewis’s exploiting your paper for his own purposes. Unfortunately, because of the numerous large, and gaping holes in his supposed “investigative reports” in support of AIG’s incompetence, and Goldman Sach’s genius, I’ve concluded he is a Wall Street shill, and therefore not very credible.

          I’m sorry if you are not likewise a shill, but rumor has it you’ve gone to work for the object of the public’s disdain, so I’m afraid you are already marked with an aura of suspicion.

          Nonetheless, I wish you well, and I realize you are young and need to establish a career in order to have some stability in your life. However, if you one day wake up and realize you’re on the wrong side of the fence, we will welcome you back. I myself walked away from a long and profitable mortgage career back in 2003, and I’ve never regretted my decision for a single moment.

          PS – I’ve located your paper and will read it before commenting any further.

  6. steelhead23

    You state: “I have also been unable to find transaction-level detail about these deals (abacus CDOs) from other public sources.”

    It is completely understandable that contract details between two parties can remain confidential. What I do not understand is that when one party becomes majority-owned by an entitty, why that entity cannot choose to disclose the information? That is, the CDS deals between the vampire squid and AIG should be known by the U.S. Government and its agents. There are some significant limits on government secrecy. Thus, if you want to know what’s what at AIG, file a FOIA request with U.S. Treasury. They may blow you off, but it would be a bit of fun.

  7. Noisetrader

    Ms. Barnett-Hart, I wouldn’t waste my time trying to lay forward constructive arguments backed by facts in the comments section of this blog. While it’s author and other contributors often provide refreshing perspectives and insights, the blog has also unfortunately attracted more than a few from the “Vampire squid”-crowd.

  8. one from the “Vampire squid”-crowd

    It doesn’t bother me much that GS created rotten CODs (I’m pretty sure they were not such bad than those of other guys since GS tends to make stuff right) but that GS took advantage of its own poor deals and shorted them.

    You know if a trader knows that something is a sure deal he/she can make a killing (by leveraging it). And GS knew for sure that those deals were bad.

    This is why I am personally for destruction of GS.

  9. VenusVictrix

    By the way, with regards to the Abacus synthetic CDOs, it’s unfortunate that those documents aren’t available for review, but it seems very likely that the structure of those offerings would be very similar to Goldman’s other CDO offerings which were listed on the Irish Stock Exchange – namely: Adirondack, Altius (I, II, III), Davis Square (V, VI, VII), G Street, and West Coast Funding – all of which appear to adhere to a similar template, so it’s unlikely that Abacus would have been much different.

    One important point about these CDO offerings is that the “synthetic” portion of the issues was not rated at all by any of the ratings agencies. That is clearly stated in the circulars.

    Another interesting fact is that the synthetic securities were “structured as credit default swaps”, as stated in the documents. Furthermore, Goldman Sachs was the initial credit default swap counterparty. AIG only provided interest rate, cash-flow, and in some cases, currency swaps. AIG is not listed as the credit default swap counterparty in any of these circulars.

    Perhaps we should inquire as to when, and how, AIG became party to these credit default swaps created and guaranteed by Goldman Sachs, since taxpayers wound up paying off those CDSs when AIG couldn’t perform.

    1. Yves Smith Post author

      In a word, no.

      AIG wrote CDS on CDOs.

      The Fed wanted to put a floor on losses, and it (foolishly, I would argue) thought the CDOs were undervalued. So it effectively bought the CDOs FROM THE COUNTERPARTIES by setting up Maiden Lane III and lending virtually all of the money to it. I think AIG’s equity was $5 billion, but of that $2.5 billion was overcollateralization of previous payments on the CDS. Since the Fed was lending $ to AIG at that point, the idea that AIG has any equity in Maiden Lane III is an accounting fiction to get around the fact that the Fed is supposed only to lend against collateral, not take equity positions.

      That’s how the dealers got paid 100% on the CDS. They had the CDOs purchased (at a discount to par value) and then also retained the collateral paid on the CDS.

      The Abacus-related CDS are still at AIG. On a pure synthetic CDO, there is nothing to “buy”, you are signing up to receive payments on the CDS in the CDO and pay out on losses when they occur. Apparently the Fed did not want to overfund ML III (so it could pay out on losses on the AAA tranche). That might have created some issues relative to the Fed’s charter.

      1. Gbestor

        Yves: let me see if I understand. are you saying the following: AIG had written CDS on the CDOs listed in the infamous tardily disclosed Schedule A. Goldman and the other CDS counterparties were holding about $35 billion in collateral. The gov’t set up Maiden Lane to buy the CDOs from AIG’s CDS counterparties at par minus collateral so the CDS counterparties got 100% of their insurance and the gov’t (oops, I mean AIG) ended up owning the CDOs.

        1. Yves Smith Post author

          You have the transaction order right.

          Here is the key bit:

          ML III LLC was formed in the fourth quarter of 2008. ML III LLC borrowed approximately $24.3 billion from the New York Fed in the form of a senior loan (Senior Loan). The Senior Loan proceeds, after adjustments (totaling $0.3 billion between October 31, 2008 and December 31, 2008) including principal and interest payments received by AIGFP counterparties on the CDOs, together with an equity funding of approximately $5.0 billion provided by AIG (Equity Contribution Amount), were used to purchase from certain third-party counterparties of AIGFP certain U.S. dollar denominated CDOs (Asset Portfolio) with an estimated fair value as of October 31, 2008, of approximately $29.6 billion. The counterparties agreed to sell CDOs to ML III LLC in exchange for a purchase payment from ML III LLC and their retention of collateral previously posted by AIGFP under the related credit derivative contracts, for an overall consideration of par. In connection with any such purchase, each AIGFP counterparty agreed to terminate the related credit derivative contracts between such counterparty and AIGFP.

          The par value of those CDOs was $62.1 billion. The difference between that and $29.8 billion is $32.3 billion. Add to that the $2.5 billion of overcollateralization (excess payment to dealers, presumably the amount actually paid was reduced to reflect that) and you get your $35 billion.

          1. Gbestor

            OK, now that I understand it, how do I find out who was actually writing the CDSs that were cancelled? The Fed must have the CDS documents and since the CDSs have been cancelled there is no reason why the documents need to be secret.

  10. sgt_doom

    To Gbestor:

    The method I’ve used in the best may appear hokey and circuitous, but believe me it works (or did work).

    You go through the membership list of the Bretton Woods Committee (beginning with those individuals involved with investment firms, e.g., Brady and Overseas Investors, Ltd., etc.). Google those individuals, and firms, and “counterparty” “CDS”).

    Seriously, that is the way I found them.

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