Wednesday, April 21, 2010

What You Probably Don't Know About Goldman Sachs, John Paulson and the Financial Regulation Bill

Like most blog posts, I got to responding to something someone said on Facebook and kind of got carried away. So rather than boring everyone in that thread, I will reserve my boring for people specifically looking to be bored, by me, about something esoteric.

To recap, on April 16, Goldman Sachs was charged with fraud by the SEC (a civil charge, not a criminal one) for selling mortgage-backed securities that the SEC believes Goldman knew would lose value. The SEC charges that Goldman allowed a hedge fund run by John Paulson to choose the components of the CDO, or Collateralized Debt Obligation, called 'Abacus 2007-AC1' that was then sold to European banks and other investors. Paulson's firm bought insurance against those mortgages declining in value. When they did decline in value, his company made a billion (with a 'b') dollars from the insurance contracts they held against the decline in value of Abacus 2007 AC-1.

Just for a vocabulary review:

Mortgage-Backed Security: A stream of income and capital that comes from the repayment of mortgages issued by banks. Also called a MBS or a RMBS (residential MBS). Many mortgages are sold, and by 'buying' a mortgage the new mortgage owner gets the income and capital repayment coming from the original loan. If you bundle up enough of these, they act like a bond -- interest comes in, the capital is repaid over time, people get to pay monthly for their house and investors get their capital and interest repaid. Also, since banks are selling the mortgages they write and getting their capital replenished, they can offer more mortgages. Otherwise, the bank could only make as many loans as they have capital to support. A MBS is a bundle of hundreds or even thousands of mortgages, the bundles are traded.

Subprime Mortgage: A mortgage written to someone who is not considered an ideal credit risk, either because they have issues in the past with paying people back, or they are borrowing more money than their income would otherwise support. Not everyone who gets a subprime mortgage is a deadbeat, some self-employed people may have plenty of income to pay their mortgage but the bank or credit agency does not consider their income to be as reliable as someone with a 9 to 5 job. Unfortunately, a lot of people got subprime loans in the 2000s who should not have gotten any loans at all. Because the risk of default is higher, subprime mortgages generally have higher interest rates. From the investor standpoint, the risk is higher but the income is higher as well.

Credit-default swap: A kind of insurance against the risk of an investment going bad. This originally came from the municipal bond world, because if Peoria defaults on their sewer bonds, nobody really wants to try to claim their sewage plant back. The idea was that like any unlikely but damaging event, you could buy insurance against the risk of default. The CDS industry exploded in the 2000s as the utility of being able to insure against almost anything became popular. Unlike traditional insurance that you purchase to protect your assets, CDS can be purchased for almost anything that you can find someone else to have an agreement with. People with agreements are called 'counterparties'. CDS are not regulated and you don't even have to own the asset you are insuring against a loss. At one point, the dollar value in CDS was over $60 trillion dollars, more than the entire economic output of the world in a given year. Of course, a lot of those CDS were counteracting CDS -- I insure you against your value declining, and then I go and find someone else to insure me against your value declining so I don't have to pay the full amount. If this sounds like off-track betting with billions of dollars, it kind of is. The fact that respectable insurance companies like AIG were big players in this market is unsurprising, since the factor that decides who makes money is an assessment of the risks involved. Unfortunately, the amount of risk in the 2000s was inappropriately priced.

Collateralized Debt Obligation (CDO):
A Structured Investment Vehicle (SIV, another acronym) composed of various MBS of varying quality. This is the next order of complexity beyond just bundling up mortgages. CDOs were designed to minimize risk by getting chunks of MBS from various regions of the country and various levels of risk, the idea being that it was silly to think the whole economy would tank at once. Well, silly before 2007-8. If one region or segment of the market tanked, the rest could carry the CDO and still make payments. CDOs were divided into 'tranches', slices of the income from the best, second-best, not-so-best and worst bundles of MBS. The ones in the worst bundle had the highest interest, because they were the riskiest. The ones in the top tranche had the lowest return, but the least risk. Synthetic CDOs, like the Abacus 2007-AC1 deal, were made of tranches bought from other CDOs. If this seems confusing, it's because this is the kind of thing (along with CDS) that Warren Buffet called 'the WMD of the financial markets'. Basically, a CDO tranche owner would not be cashing your checks each month. The money from residential mortgages went into a mixmaster that makes the most complex highway interchange look like a single thread by comparison. Money came in, swirled around, and ended up in CDO accounts each month.

Others have pointed out that the timing of this news release was suspicious. I find the news release interesting for a few reasons.

1. It was a 3-2 decision whether or not to go ahead with the suit. The Republicans voted against, the Democrats voted for, and the sole independent voted to go ahead with the suit. Assuming the SEC are professionals, this is not the highest endorsement of the validity of the claim. Not that it shouldn't be pursued, but the PR damage is done. The SEC alleges, and must prove, these charges. Most likely, there will never be a courtroom resolution regarding this -- there will be a negotiated settlement so the SEC doesn't have to advance what 40% of its commissioners believes is an unwinnable case, and so that GS can take a smaller hit.

2. The release was during trading hours, rather than after, to insure the media would have plenty of time to dwell on the story. Note that the blog post on MoneyWatch is timed 1:59 pm on April 16, 2010. the release was during the trading day. Goldman Sachs lost 14% of its value and the whole Dow Jones Industrial Average shrank 1%. All you have to do is look at the Goldman Sachs price graph for 4/16/2010 to see that the press conference was around 11AM Eastern. I believe the SEC knew they would cause a stink, and did so despite any disruption in the market that might occur. If this was released on Friday at 4pm, after trading, the weekend might have been spent in reflection, with a more muted stock market response on Monday morning. As it is, the SEC made at least a minor panic in order to seem like they're doing something.

3. This just happens to involve John Paulson (no relation to Hank the Former Treasury Secretary), hedge fund manager and poster boy for profiting on credit-default swaps (basically, insurance) on something he didn't even own. Neither he nor his firm are charged, yet putting John Paulson in your press release will put the financial press in a tizzy. It's kind of like mentioning Brad Pitt in a salacious story for TMZ, but then not saying he did any salacious things.

Paulson made a billion dollars on this credit-default swap because his counterparty(ies) believed he was wrong about subprime mortgages. By comparison, his firm made $15 billion in profit in 2007. The Abacus deal was just 7% of the profits he made by betting that all the other smart guys in the room (including Bear Sterns, Lehman Brothers, and the entire credit rating industry) were wrong. Interesting times when being a contrarian is considered not just suspicious, but enough to indict. At least indict a counterparty. So far. Two other contrarians you might have heard of who thought the subprime mortgage market at derivatives were crazy: Warren Buffet and George Soros. Suspicious persons, indeed.

4. In fact, the CDS that Paulson & Co. bought were from Goldman Sachs -- kind of like buying insurance on a house you don't own, then collecting when it burns down. The insurance company gets screwed, yes, but in this case Goldman Sachs is the insurance company. Most likely GS offset its own risk with CDS that paid it if the Abacus 2007-AC1 went south and it had to pay Paulson, but like everything else, it's a bet and the outcome is not known. Very few people were betting against subprime mortgages in 2007. The folks who bought Abacus, mainly European bankers, are not stupid people. This is not an example of stealing money from Mom & Pop. This is big-boy business with a whole lot of money on the line, and if Abacus had gone long and made money, would the SEC be investigating GS for selling what proved to be worthless CDS to Paulson & Co.? I think not. If Paulson & Co. had collapsed taking all of its investors' assets with it as many other hedge funds did there would be no investigation.

5. Retrospectively they can identify something fishy with Abacus 2007 AC-1, but they can't find Bernie Madoff prospectively after he steals between $12 and $20 billion? And after they were sent a 21-page detailed memo that there was something fishy going on? Top of their game, these guys.

6. Then there is the curious timing of this release followed immediately by a broadside of criticism against the GOP for opposing a bill strongly supported by a Senator who received significant personal support from a subprime lender (Countrywide), a bill that contains not only a built-in fund for bailouts with a large advertised number ($50 billion), insuring that the government will continue to serve as a backstop for more risky investments than the market would otherwise bear, but a bill that vests in the Executive the ability to respond with almost unlimited resources to any future bailout/systemic risk situation. It's not that President Obama will have this power that bothers me. It's that any President has the ability to raid the Fed for whatever seems to be needed in the financial sector. Moral hazard out the wazoo. If you don't want business to try to manipulate government, then don't manipulate business from the government. The last thing the "Masters of the Universe", Tom Wolfe's phrase from The Bonfire of the Vanities need is the idea that profits are private and losses are public, because they can get a low-interest bailout from Uncle Sugar. No way. Take away the net, and they probably won't string the tightrope so high.

7. The timing is on the face suspicious because the press conference (unusual for the SEC) on April 16, immediately preceded the White House announcement Monday that he would be speaking at Cooper Union in NYC on Thursday. Look for the Goldman Sachs charges to be featured prominently. Oh, and floor debate on the Financial Regulatory Reform Bill begins just 10 days after the SEC's announcement, on April 26.

Now, the President denies that there was any coordination with the SEC, but even the press figured out that maybe GS wasn't the only ones cooking the books. Here's a quote from that CBS News link:

"Well, I think now that there has been a lot of momentum behind the financial reform bill, and I think that that momentum is only going to increase," Freeland said. "The charges on Friday will give the Democrats who wanted a tougher bill a lot more energy."

Wow. Ain't it great when things just happen to go your way? And that article in itself is a veritable masterpiece of innuendo and possibly-designed ignorance. Note how the reporter elides everything I've spent the last couple of thousand words explaining and simply implies theft:

Goldman took in $15 million in fees for arranging the transaction, while its investors lost over a billion dollars that became profit at Paulson & Co.

Now, quiz time: did the money from Abacus 2007-AC1 really go to John Paulson? Or did John Paulson find someone willing to bet that the assets in the Abacus 2007-AC1 investment would not decrease in value? And who was John Paulson's counterparty, the folks who paid Paulson & Co. when Abacus 2007-AC1 tanked? (Answer: Goldman Sachs)

The press is so willing to carry water on this one they might as well show up in Washington with buckets in hand. I understand the frustration. But I also understand that things are often far more complex than they seem. I don't see this story as an attempt to make complex things simple for anything other than political reasons.

More background on John Paulson here, from the Wall Street Journal. Excellent article.

NOTE: I do not own any Goldman Sachs shares.

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