Since most of our legislators, bureaucrats, and White House residents have no idea what caused the Great Recession, they are itching to blame it on someone, and that “someone” is Goldman Sachs, the arch-capitalist of our time. As if fraud was the cause of all of our problems. It’s like blaming greed.
Let me first get it on the table: I am not defending Goldman Sachs. The point of this article is to defend free market capitalism which has been incorrectly branded as the villain in our economic crisis. If Goldman defrauded their clients, they should pay the price.
The information on this case is too new to evaluate, and without further analysis of the complaint and the facts, I will withhold judgment. I would like to review the Abacus 2007-AC1 prospectus or PPM and the allegations of misrepresentation and fraud before I condemn Goldman. I have analyzed similar deals in the past and I would like to compare this one to what I believe was the norm for disclosure.
It sounds bad for Goldman now, and while it may very well be all true, the government loves to trot out the juicy bits for press conferences which the press loves, such as Mr. Tourre’s email. As you all know, (i) you can’t always trust what prosecutors say and (ii) there’s always more to the story.
I also have a healthy suspicion of “economic crimes.” These are crimes not based on ethics, traditional crimes, or a violation of someones rights by the perpetrator, but are crimes “against the people” as defined by legislators or some economic czar. Not to stir up a debate here, but insider trading is one example of the government trying to create a “level playing field.” The distinguished economist Henry Manne has spent a lifetime showing why that is incorrect and irrelevant.
Yet today many pro-capitalism economic writers were quick to criticize Goldman. Mish Shedlock came out with an article today that blasted Wall Street ethics:
Sadly, this business screws the client for a fee time and time again because there is no ethics, no sense of fiduciary responsibility, and no walls on separation of duty to prevent fraud. …
You might wish to read his piece since it’s very critical.
I don’t mean to be blasé about this or be overly critical of Mish because I think he’s one of the best economics writers, but anyone who has ever worked on Wall Street knows that the first thing anyone thinks about is how much money they can make off of deals. That’s the goal, the motive, the driving force. And it’s not new. Of course that doesn’t excuse civil or criminal wrongs. But what it does mean is that you’ve got to look out for your own position and your due dil better be more than good. Caveat emptor. That’s just the way it is and everyone knows it. I am sure you are all shocked by this revelation.
Yes, there are many fine people in the business who do put their clients’ interests before their own. But so what. Do I wish that ethics were better? Of course. But don’t be surprised when in a world where people lie awake at night thinking about how to make more money, some very big players lose money in a deal.
Here is the gist of the complaint as reported in the SEC press release:
According to the SEC’s complaint, filed in U.S. District Court for the Southern District of New York, the marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. The SEC alleges that undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.
The SEC’s complaint alleges that after participating in the portfolio selection, Paulson & Co. effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure. Given that financial short interest, Paulson & Co. had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson & Co.’s short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors.
The SEC alleges that Goldman Sachs Vice President Fabrice Tourre was principally responsible for ABACUS 2007-AC1. Tourre structured the transaction, prepared the marketing materials, and communicated directly with investors. Tourre allegedly knew of Paulson & Co.’s undisclosed short interest and role in the collateral selection process. In addition, he misled ACA into believing that Paulson & Co. invested approximately $200 million in the equity of ABACUS, indicating that Paulson & Co.’s interests in the collateral selection process were closely aligned with ACA’s interests. In reality, however, their interests were sharply conflicting.
According to the SEC’s complaint, the deal closed on April 26, 2007, and Paulson & Co. paid Goldman Sachs approximately $15 million for structuring and marketing ABACUS. By Oct. 24, 2007, 83 percent of the RMBS in the ABACUS portfolio had been downgraded and 17 percent were on negative watch. By Jan. 29, 2008, 99 percent of the portfolio had been downgraded.
Investors in the liabilities of ABACUS are alleged to have lost more than $1 billion.
Today Goldman sent this email out to their clients explaining their version of the case:
NEW YORK, April 16, 2010 — The Goldman Sachs Group, Inc. (NYSE: GS) said today:
We are disappointed that the SEC would bring this action related to a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact.
We want to emphasize the following four critical points which were missing from the SEC’s complaint.
- Goldman Sachs Lost Money On The Transaction. Goldman Sachs, itself, lost more than $90 million. Our fee was $15 million. We were subject to losses and we did not structure a portfolio that was designed to lose money.
- Extensive Disclosure Was Provided. IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities. The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side.
- ACA, the Largest Investor, Selected The Portfolio. The portfolio of mortgage backed securities in this investment was selected by an independent and experienced portfolio selection agent after a series of discussions, including with Paulson & Co., which were entirely typical of these types of transactions. ACA had the largest exposure to the transaction, investing $951 million. It had an obligation and every incentive to select appropriate securities.
- Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor. The SEC’s complaint accuses the firm of fraud because it didn’t disclose to one party of the transaction who was on the other side of that transaction. As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor.
Background
In 2006, Paulson & Co. indicated its interest in positioning itself for a decline in housing prices. The firm structured a synthetic CDO through which Paulson benefited from a decline in the value of the underlying securities. Those on the other side of the transaction, IKB and ACA Capital Management, the portfolio selection agent, would benefit from an increase in the value of the securities. ACA had a long established track record as a CDO manager, having 26 separate transactions before the transaction. Goldman Sachs retained a significant residual long risk position in the transaction.
IKB, ACA and Paulson all provided their input regarding the composition of the underlying securities. ACA ultimately and independently approved the selection of 90 Residential Mortgage Backed Securities, which it stood behind as the portfolio selection agent and the largest investor in the transaction.
The offering documents for the transaction included every underlying mortgage security. The offering documents for each of these RMBS in turn disclosed the various categories of information required by the SEC, including detailed information concerning the mortgages held by the trust that issued the RMBS.
Any investor losses result from the overall negative performance of the entire sector, not because of which particular securities ended in the reference portfolio or how they were selected.
The transaction was not created as a way for Goldman Sachs to short the subprime market. To the contrary, Goldman Sachs’s substantial long position in the transaction lost money for the firm.
Goldman isn’t going to role over on this one so the SEC has a huge fight on its hands.
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Jim Willie mentioned this possibiliyt already in his february Hat Trick Report.
Extract from his report (with his permission) is published here:
http://www.pro-investory.cz/hat_trick_report_jim_willie/unor_2010_february_2010/
[...] dailycapitalist: The Goldman Thing [...]
Jeff:
You stated: “The point of this article is to defend free market capitalism which has been incorrectly branded as the villain in our economic crisis. If Goldman defrauded their clients, they should pay the price.”
You point out that Capitalism is driven by the profit motive. I agree with this. But where the system failed is that every regulator that could stop the fraud and excesses in housing and mortgage finance from multiplying turned their back on the problems. Why?
I can be cynical and believe that homebuilders, bankers and investment bankers were such big political contributors that both the legislative and judicial branch of government at all levels turned their back on the problems. I can also believe that no one wanted to reign in the housing market and its finances because housing was “the engine of growth” coming out of 9/11 all the way through 2007.
If regulators or Congress stopped these excesses in housing from playing out, the economy would have slowed sooner and elected officials always know they are facing the risk of not getting re-elected in a slowing economy. I think there would have been massive cries about regulators “tinkering with the economy” if the Fed, the SEC , state Attorney Generals or Congress had played a role in stopping the housing market from over-heating.
So I guess the question is, “If the regulators (in search of political contributions) are just as greedy as the Capitalists running businesses, can we ever stop excesses from damaging the economy?” I think as things are structured today the answer is no.
Couple this with the fact that “liquidity goes to what is working, even though Fed induced liquidity is injected in the system to fix problems.” My point being that the liquidity never goes to where it is needed–it goes to where it can make the highest short term profit. If you agree with this point, the question then becomes: can we ever believe that we will ever have a Fed head. like Volcker, who has the will to take the punch bowl away? My view is no–the Fed is now too political to ever take away the punch bowl before excesses do major damage to the economy.
Sad to say, but what happened in 2008 (in terms of financial armageddon) is very likely to happen again and again and again. And we depend on the SEC to bring their lawsuits (like the current Goldman case) well after the problem has already blown up. Where was the SEC playing its regulatory role when many of us knew these CDOs (in 2006-07) were worthless?
Since greed always exists as an operating factor in markets, then why did this boom start? Animal spirits? There is a reason that you overlook.
please delete my previous post.
Are you suggesting theat the initial catalyst for the boom was government intervention into the housing market (E.g. the GSE’s, low interest rates, etc?)
I would agree that these played a role. BUT imagine they weren’t there. Some financial wizard would have still come up with a valuation model (http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all)(great article btw). The rating agencies would have still given these bonds fake AAA ratings and the blow up would have been just as big. I just don’t see how free market capitalism would have prevented this, or the incredible fraud that had infested the industry. I would be very interested to find out how in completely free market these problems would have been prevented?
There was nothing basically wrong with RMBS or CDOs. The problem was with what caused the bubble in the first place. Assume we have a market where money supply is stable and the government didn’t game the system by guaranteeing subprime loans. No one in their right mind would lend to someone with a 500 credit score, liar financials, and 3% down. It just isn’t fiscally prudent. All bubbles start with the Fed or some central bank flooding the market with money. The Austrian economists, Mises especially figured this out in 1912! This cheap money makes bad deals look good, but they aren’t, it’s just a fiat paper money trick. Money then flows into the current hot asset, in this cycle it was housing, last cycle it was tech stocks, before that it was commercial real estate. Now, this is not to dismiss the culpability of Wall Street which created faulty risk models. But you can’t build a cycle based on bas models, greed, fraud because they always exist. You have to dig a little deeper and ask what caused the boom. It’s always fiat money expansion. CDOs can be useful in providing capital to the housing market and reducing risk to lenders of individual loans. And I think they’ll be used again in the future. With better risk models.
I’ll check out the article. Thanks. I’m a fan of Taleb and Mandelbrot who reject Gaussian based risk models.
Jeff:
I agree with all of your points, above. However, will you stipulate with me that the reason CMBS/RMBS works is that the premise is “the sum of the pieces is greater than the value of the whole (loan)?”
This can’t be true over the long run: a loan is a loan. The sum of the pieces and the over-marketing of first loss, highest yielding paper (the BBB- tranche) is a dream that always ends badly. This “lie” about CMBS/RMBS marketing only works in an environment where prices are rising. As soon as prices are flat or declining, all of the CDOs created from first loss BBB- paper will blow up.
If I am right, then heavy collateral obligations for those who play in BBB- CDO paper would help to stop the abuse. Remember: AIG was AAA rated and AAA rated companies had NO OBLIGATION to post collateral. Let’s start with eliminating this “advantage” for AAA companies. Because as we saw with AIG, it is only a matter of time before the BBB- crap blows up and takes the AAA rated company down the toilet.
Konrad,
The root cause of the recent boom and bust as well as all other business cycles is from monetary pumping by the Fed which artificially lowers interest rates (Fed Funds rate held at 1% for a year and a half by Greenspan after the tech bubble of 2000). Low interest rates are typically a sign savings are at a high level and they induce entrepreneurs to invest in capital goods, but when interest rates are artificially lowered by the Fed it just causes malinvestment and screws up the capital structure of our economy. The bust following every boom cycle is the re-structuring of capital to conform to the fundamentals of the market.
So to answer your question, How would a free market have prevented these problems? A truly free market would not have had a central bank/Federal Reserve, period. While this recession has many complexities and factors leading to the exact course that history has taken, all those other factors have been enabled by the loose monetary policy of the Fed. Hence they are symptoms of inflating the money supply. The excessive lending in mortgage markets would have simply not been possible without the Fed.
The Fed says that it’s dual purpose is to keep prices stable and employment high. The real reasons it was created was to be a lender of last resort i.e. bail out banks from their bad loans and to ensure that the federal government always has a buyer for its debt.
You can read more about the business cycle at Mises.org
Excellent, Devin! You should be writing this stuff.
Jeff:
Please note my comment that “liquidity goes to what is working,” and not to what is broken. The excess liquidity from Magoo…err, Greenspan was the fuel that got the animal spirits going. From there, we had every player “lay low” because there was too much profit potential for all to perpetuate and strengthen the lies. By every player, I include homebuilders, lenders, appraisers, Congress and regulators.
A portion of the excess profits created from this shell game found its way into the pockets of politicians and power hungry State AGs, who had their sights on higher office. No doubt this was the perfect storm of “greed at work.”
BTW, you don’t know how many homebuilder analysts I had met with and tried to explain that the normal margin on a newly built home was/is 6-8%. The 20-30% and growing homebuilder margins in 2003-2007 were a function of “land profits” which are non-recurring (as we all learned in hindsight). Did anyone listen to me? No. The profits from Wall Street to keep doing debt and equity offerings for these over-priced builders was too great.
So, the boom started and continued for years because no one had an incentive to stop it. And sillier and sillier mortgage underwriting terms (liar loans, no doc loans, etc…) with little to no money down helped to stretch the housing boom 2-3 years longer than it should have continued. BTW, those of us who bet against this silliness were often the victim of SEC investigations because we were the ones calling out the problems. Remember how the SEC went after the shorts for stocks that fell in 2007-08? As always, the SEC and AGs go after the shorts FIRST and those who profited from creating the lies LAST.
Money McBags with an epic rant on GS
http://whengeniusprevailed.blogspot.com/2010/04/121610-midafternoon-report-goldman.html
To throw in my 2 cents worth, it seems what we have here is one crook telling another crook, “You’re a crook.” It’s hard for me to get excited about it all. There is a reason why there is a term such as ‘due diligence.’ Ethics is hard to legislate.
What the heck, Fannie and Freddie force the banks to take counterfeit money (high-risk mortgages) and then the government is shocked when the banks find every creative way they can to unload the bogus bills? The whole thing stinks, really.
Jim,
Amen.
‘due diligence’ is one term that seems to be awfully short on supply these days. No one with an iota of sense in dealing with Wall Street and banks can casually accept anything they proffer, at any time.
Had there been no institutional interest in garnering relatively excessive income by buying the multitude of toxic mortgages this whole debacle could never have gotten off the ground. Is it entirely their fault? No.
However, there was abundant data as to the cheesiness of these “securities” and the underlying “assets” for years before the implosion. Someone actually doing their job, doing due diligence on these securities (and not just blithely accepting a Moody’s or S&P “rating”), would have backed away from them. At least if they had some fiduciary standing.
Were there no major sources of demand for this “asset” category, there would have been little supply, far less money would have made its way to the housing market, no bubble would have ensued (assuming Fnmae didn’t become the entire market for this garbage). Maybe the last is a weak assumption but, had Fnmae been the majority holder at least that facet of the blame could have been put in total focus.
There is plenty of blame to go around. This one piece, where Goldman structured something, in some fashion, for sale to VERY sophisticated investors is a diversion (if it is meaningful at all). Maybe Goldman did something wrong here and deserves to be punished but the corporate parties that bought into their “product” without sufficient “due diligence” deserves little sympathy as well.