And more ...
rcyran says:
December 24, 2009 at 10:59 am
Reminds me of M. Lewis’ excellent article:
portfolio.com
excerpt:
Not only did he not mind that Eisman took a dim view of his C.D.O.’s; he saw it as a basis for friendship. “Then he said something that blew my mind,” Eisman tells me. “He says, ‘I love guys like you who short my market. Without you, I don’t have anything to buy.’”
That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage.”
Siggy says:
December 24, 2009 at 11:37 am
A very long time ago I worked as a phone clerk on the floor of the CBOT. That was an open outcry, ticker tape and tote board market. Sell orders were written on red slips, buys on blue. Phone clerks were taught to fold them over to hide the color. When delivering the order slips, always walk, never run. Since then, the world has turned over several times and the markets are now dominated by electronic trading. Electronic front running is common and the scalping that it engenders is flat out theft. So long as regulators abrogate their responsibilities, you will have more of the same. It may be that we have reached a point of conduct where cheating is considered normal and acceptable.
Creating synthetic trading instruments is going to be proven to be a great scam. Going short those very same synthetic instruments by way of CDS comes very close to being a felony. Most assuredly it can be tortous.
The NYT article is enlightening and clearly only part of a larger story. There are hearings scheduled and they should be closely followed. What should be watched is how the major players spin their admissions and denials. This will be theater of dissembly in the extreme.
What continually appears in the media is the concept that the instruments that are being traded are complex and hard to understand. That is a lie. A nine year old can apprehend the nature of a single contract. What is moderately complex is the coupling of concurrent and sequential trades that in their aggregate have a common purpose; to take a profit from the Market, not over time but immediately.
Your blogs to this issue have been excellent and much of commentary has been informative. Keep up the very good work; and, do take some time to savor the holidays.
Merry Christmas (to you) Yves.
Yves Smith's Naked Capitalism Article 12.24.09
Read the letters enclosd below ...
For reference : nakedcapitalism.com
Thursday, December 24, 2009
Goldman, Deutsche, and the Destructive Use of Synthetic CDOs Come Into Focus
Gretchen Morgenson and Louise Story have a good article up at the New York Times on synthetic CDOs (or more accurately, synthetic ABS CDOs, for “asset backed securities” CDOs). The press is finally starting to turn some lights onto one of the activities that played an important role in the crisis, but has not gotten the attention it deserved.
There has been a tendency to lionize subprime shorts, with no consideration to the destruction they left in their wake. While I am not opposed to stock shorting (all it takes is the uptick rule to prevent bear raids), shorting via CDS is quite another matter, particularly since, with CDS, the exposures are typically a multiple of the value of the cash bonds. Given the levered nature of a short via CDS, this creates a very big incentive for the CDS holders to see if they can take action to make events turn out their way.
Now that may seem like a peculiar characterization; how could people who shorted subprime have done damage? After all, the housing market is huge. But CDS made the exposures to subprime going bad much bigger than the size of the market, and the parties on the wrong side of the bet were often highly levered players like big capital markets firms (per the BIS, with only 3-4% equity on average) and insurers.
The part that has surprised me is that the John Paulson story, which Gregory Zuckermann attempted to tell glowingly in his book The Greatest Trade, is actually quite damning. Deutsche Bank and Goldman come off badly too. To make a much longer story short, credit default swaps on mortgages became possible starting in June 2005 when ISDA came up with a protocol. Zuckermann credits Greg Lippmann of Deutsche, a particularly aggressive derivatives salesman, as the moving force behind this effort:
Lippmann’s radical thought was, What if an investment could be created to mimic the existing mortgages? That way, new mortgages wouldn’t have to be created to satisfy hungry investors; rather, a “synthetic” mortgage could be sold to them.[emphasis in original]
In February, Lippmann called traders from Bear Stearns, Goldman Sachs, and a few other firms struggling with the same issues, inviting them, along with a battalion of lawyers, to a conference room at Deutsche. Sitting around a blond-wood conference table, they debated ideas into the night, while picking at take-out Chinese food. Their light-bulb idea: Create a standardized, easily traded CDS contract to insure mortgage-backed securities made up of subprime loans
Yves here. Zuckermann contends that Paulson went to Wall Street to create synthetic CDOs so Paulson could short subprime. Paulson was open about his intention: he wanted to create the deal (by funding the equity tranche, typically 4-5%) and go short the ENTIRE deal, that is, buy all the CDS used in the synthetic CDO (well probably not all; even subprime CDOs had to have a certain potion be less drecky stuff). This was an out and out plan to toast the party on the other side, particularly since the party funding the equity layer had (at a minimum) veto rights (which in this case could be used to exclude better quality exposures!).
Bear Stearns, ironically, thought the Paulson plan did not pass the smell test, but Deutsche and Goldman were eager. Paulson was responsible for creating $5 billion in synthetic CDOs, but in the end this was not his main mechanism for shorting the subprime.
To the New York Times article. It’s good yet odd. It does signal very clearly the destructive potential of synthetic CDOs. It presents Goldman’s synthetic CDO program as first a way to lay off its exposures, later a way to get short for fun and profit. It has a graphic that shows a sampling of deals. Reading between the lines, it looks as if the authors are on the Goldman-AIG trial, but going where the story and their sources take them, which was into the bigger question of the use of synthetics:
Pension funds and insurance companies lost billions of dollars on securities that they believed were solid investments, according to former Goldman employees with direct knowledge of the deals who asked not to be identified because they have confidentiality agreements with the firm.
Goldman was not the only firm that peddled these complex securities — known as synthetic collateralized debt obligations, or C.D.O.’s — and then made financial bets against them, called selling short in Wall Street parlance. Others that created similar securities and then bet they would fail, according to Wall Street traders, include Deutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc., an investment company whose parent firm was overseen by Lewis A. Sachs, who this year became a special counselor to Treasury Secretary Timothy F. Geithner….
But Goldman and other firms eventually used the C.D.O.’s to place unusually large negative bets that were not mainly for hedging purposes, and investors and industry experts say that put the firms at odds with their own clients’ interests.
The article also indicates that Goldman engaged in Paulson-like behavior, teeing up the deals (presumably providing the equity tranche) and took pretty much the entire short side (the reason we highlight this issue is we believe some firms were stealthier and teed up CDOs without buying all the CDS protection created by the deal):
Rather than persuading his customers to make negative bets on Abacus, Mr. Egol kept most of these wagers for his firm, said five former Goldman employees who spoke on the condition of anonymity. On occasion, he allowed some hedge funds to take some of the short trades.
The piece also indicates that official investigations are honing in on the key question:
One focus of the inquiry is whether the firms creating the securities purposely helped to select especially risky mortgage-linked assets that would be most likely to crater, setting their clients up to lose billions of dollars if the housing market imploded.
Yves here. Um, exhibit one is the Zuckermann book…I cannot believe Paulson gave out so much ammo to critics, and that no one in the officialdom (yet) seems to have decided to make use of it.
The story also mentions how the dealers stacked the deck in their favor:
In early 2005, a group of prominent traders met at Deutsche Bank’s office in New York and drew up a new system, called Pay as You Go. This meant the insurance for those betting against mortgages would pay out more quickly. The traders then went to the International Swaps and Derivatives Association, the group that governs trading in derivatives like C.D.O.’s. The new system was presented as a fait accompli, and adopted.
Other changes also increased the likelihood that investors would suffer losses if the mortgage market tanked. Previously, investors took losses only in certain dire “credit events,” as when the mortgages associated with the C.D.O. defaulted or their issuers went bankrupt.
But the new rules meant that C.D.O. holders would have to make payments to short sellers under less onerous outcomes, or “triggers,” like a ratings downgrade on a bond. This meant that anyone who bet against a C.D.O. could collect on the bet more easily.
“In the early deals you see none of these triggers,” said one investor who asked for anonymity to preserve relationships. “These things were built in to provide the dealers with a big payoff when something bad happened.”
Yves here. The New York Times is running this as a front page story, but on one of the slowest business days of the year, which means it may have less impact than it should. Design or an accident of timing?
.
Topics: Banking industry, Credit markets, Derivatives, Real estate
Email This Post Posted by Yves Smith at 8:27 am
33 Comments » Links to this post
33 Comments:
• Michael M. Thomas says:
December 24, 2009 at 9:10 am
I found the NYT account somewhat hard to follow. Two days ago, on HuffPo, Janet Tavakoli posted Goldman’s Abacus 2005-2. There’s nothing to indicate that what we’re looking at is a list of CDS bets on a series of CDOs, and not CDOs themselves. If this is so, then Goldman was buying (largely from AIG) protection on on a portfolio already consisting of protection, and how could they keep the bets internal to this Abacus fund for themselves if these were what investors were paying for? It needs to made clear that we are dealing with two sets of investors here. The investors who bought the original CDOs “proxied”in Abacus, who are at least one step back in the starvation chain, and the investors who counterpartied the CDS that make up Abacus itself.I think descriptions of Abacus-type transactions need to be very careful in the use of the word “short.”
Reply
• Yves Smith says:
December 24, 2009 at 9:42 am
As I am sure you know, the CDO is a separate legal entity, with its own liability and asset side of its balance sheet. Most people forget about the liability side when they think of them.
AAA buyers (who were protection sellers) often hedged some or all of their risk with the monolines or ÅIG , usually for not the best reasons (reg or bonus gaming). Some monolines would not provide guarantees for pure synthetic CDOs, BTW.
Anyone who bought an ABS CDO (they were heavily composed of subprime because they were “spready”) was betting subprime would be fine. So if it was synthetic, you were effectively a protection seller and stood to take a loss if the market cratered. The protection buyers were the shorts that made the synthetics possible. I agree you have a nomenclature issue if you are taking correlation trades (going long one tranche and constructing a short on another) but this is a pretty arcane area and most laypeople’s understanding will be pretty approximate.
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? Michael M Thomas says:
December 24, 2009 at 10:09 am
“So if it was synthetic, you were effectively a protection seller and stood to take a loss if the market cratered. The protection buyers were the shorts that made the synthetics possible.”
This is what needs to be understood. Goldman was buying protection from the same investors to whom it was flogging these synthetic CDOs. This would add X basis points of notional pass-through yield from the “underlying” CDOs. Probably while expressing a grudging willingness to do so in the interest of facilitating its customers’ thirst for yield. And permitting GS to assert, when and if, that it was sharing the risk with its customers.
This is a process that needs to be made comprehensible to an intelligent tenth-grader. It deserves more outrage than it can possibly generate if explications remain obtuse and confusing.
See: this Amazon listing below for Michael M. Thomas's books ... each one better than the last by the way.
amazon.com
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• Michael M Thomas says:
December 24, 2009 at 9:21 am
Regarding your final comment, Yves, I think this is important to recognize. Mainstream media people – and their editors – will not give credit to, or work with, or supplement other journalists’ efforts. I learned this all too well in the 20 + years I wrote a weekly col for The New York Observer. Stories that should be simultaneously burning fiercely on the front page and lead-in screen of every bigtime medium will be limited to the originating outfit. Pitiful |
