financial quixotics

Posted on Wednesday 28 April 2010

For reasons that I don’t understand, I seem to want to know what the Synthetic CDO that Goldman Sachs is being prosecuted for really was, and that’s not easy, I’m discovering. The blurb in Wikipedia about Synthetic CDOs seems clear, until I try to say it back to myself:
A synthetic CDO is a complex financial security used to speculate or manage the risk that an obligation will not be paid. It is a derivative, meaning its value is derived from events related to a defined set of reference securities that may or may not be owned by the parties involved. A synthetic CDO is typically negotiated between two or more counterparties that have different viewpoints about what will ultimately happen with respect to the underlying reference securities. Various financial intermediaries, such as investment banks and hedge funds, may be involved in selecting the reference securities to be wagered upon and finding the counterparties. Complex legal entities such as structured investment vehicles may be created to facilitate and administer the deal. One counterparty typically pays a premium to another counterparty in exchange for a large payment if certain events related to the reference securities occur, similar to an insurance arrangement. It represents a leveraged bet, meaning it may result in a potentially large payout without requiring that a large amount of funds [collateral] be set aside. These securities are not typically traded on stock exchanges.
GS&CO contends that "investors already understood and therefore required no disclosure that (i) a synthetic CDO transaction could not occur absent market participants absorbing both the long and short side of the exposure, and (ii) it is a regular aspect of the market for those participants to make reverse inquiries about transactions and express their views as to the reference portfolio." The SEC contends that ACA was given the impression that John Paulsen was on the "long" side of the bet when he was, in fact, on the "short" side. That’s for the courts to decide. But it brings up the question – Who did ACA think was on the short side?
Blankfein Plays Dumb, But Did Tourre Just Sink Wall Street?
Huffington Post

by Martin Lutz
April 28, 2010

The most important moment of the day came at the end of Sen. McCaskill’s 20 minutes of pontification, which was impressive, if somewhat unfocused. She was railing against the Abacus deal and asking Mr. Tourre whether it was common-sensical to let short sellers [i.e., "protection buyers"] pick the securities in a pool that would be sold to investors… without telling the investors how the securities were picked. She kept rubbing her face with her palms, maybe hoping a genie would materialize and explain what she just didn’t understand: how do you justify selling a security that’s designed to fail, designed in fact by the guy who is betting against it?

She asked whether that was common practice. And here is when the SEC was surely taking notes and smiling … and when every major market maker in CDOs got on the phone to their lawyers.

Mr. Tourre replied: "In every synthetic CDO transaction, the protection buyer [i.e., short seller] has to be involved in some shape or form in creating the portfolio, otherwise there would be no transaction … Without a protection buyer, there is no deal."
Martin Lutz of Huffington Post thinks that Fabrice Tourre just let out a big secret here. But he’s just stating the facts that both sides of the bet are involved in picking the contents of the portfolio.  I think that Mr. Tourre is dodging the question. Tourre is saying that ACA should’ve known that Paulsen was on the ‘short side’ of the deal [but they didn’t.] In fact, the "short" side of the deal, called the "protection buyer" is listed in the literature on Abacus as Goldman Sachs Capital Markets. What the SEC charges is that Fabrice Tourre let ACA think they were betting with Paulsen rather than against him.

My point here is that the Senators, the purchasers, the sellers, the persons creating the deal, the Huffington Post author, you, and I don’t really have a clue what this thing really is. Indeed, Mr. Tourre wrote in an email, "… standing in the middle of these complex, highly leveraged, exotic trades [I] created without necessarily understanding all of the implications of those monstruosities!!!"

The best analogy I can think of is that it’s a side bet. It’s supposed to be like two guys are watching a crap shoot, and one says, "I’ll bet you $10 he makes his number." The other guy says, "okay." Neither is really in the game. But in a Synthetic CDO, it is much more complex because it’s a hundred different packages of loans. So it matters who picks the package, and what their interest in the thing is. I guess it matters who you’re betting against. But my main point is that I’m beginning to think that in this sentence, "A synthetic CDO is a complex financial security used to speculate or manage the risk that an obligation will not be paid" the word complex means "unknowable." It seems to me that it’s like "insider trading" – whoever knows the most secrets wins. Why would anyone mess around in this kind of world? Goldman Sachs and ACA put their good names to this "monstruosit[y]" which was constructed to fail but sold as a winner. The real purpose of the thing was hidden both by deceit and by the complexity. And as I pointed out below, they snuck this thing between the time the housing bubble burst and the time when people realized what had happened [a humble, noble and ethical reason for my job].Using my side bet analogy, GS&CO said, "I’ll give you some amount each month to insure that this guy makes his number." The guy rolled a seven on the next roll and the purchasers were quickly in hoc for a huge payout [and the dice were loaded].

They like to call these things exotics. They should call them quixotics. I don’t really get what a synthetic CDO is when it’s played straight, much less when it’s part of a crooked deal. In this case, the real end of the story is pretty sad:
60. Within months of closing, ABACUS 2007-AC1’s Class A-1 and A-2 Notes were nearly worthless. IKB lost almost all of its $150 million investment. Most of this money was ultimately paid to Paulson in a series of transactions between GS&Co and Paulson…

65. At the end of 2007, ACA Capital was experiencing severe financial difficulties. In early 2008, ACA Capital entered into a global settlement agreement with its counterparties to effectively unwind approximately $69 billion worth of CDSs, approximately $26 billion of which were related to 2005-06 vintage subprime RMBS. ACA Capital is currently operating as a run-off financial guaranty insurance company.
66. In late 2007, ABN was acquired by a consortium of banks that included the Royal Bank of Scotland (“RBS”). On or about August 7, 2008, RBS unwound ABN’s super senior position in ABACUS 2007-AC1 by paying GS&Co $840,909,090. Most of this money was subsequently paid by GS&Co to Paulson…
    April 29, 2010 | 4:56 PM

    The great thing about this hearing and all the publicity is that the ordinary guy doesn’t have to understand it all to know that it’s just plain wrong. Blankfein and Tourre may not be convicted of crimes, because technicalities may get them off. But that matters little. It’s the greatest thing that could happen to get regulatory reform passed. Even the Repubs in the Senate can see that it has turned public opinion against anybody who supports these robbers and opposes regulation. So they gave up on the filibuster. I’m almost sorry they did so soon, because every day they obstructed reform, they would lose more and more voters.

    April 29, 2010 | 6:43 PM

    I wish they’d disgraced themselves longer too. There’s a good momentum here…

    April 29, 2010 | 9:33 PM

    Tourre’s tortured explanation of how this worked — both the long and short sides are necessary (which make this all right, supposedly) — makes it clear that they had really become, not a financial investment house, but a gambling bookie.

    It’s time to stop calling them investments and admit that this is just betting, like any other gambling game. Well, like any other betting game that the organizer gets to fix and make a huge profit from.

    May 16, 2010 | 7:07 PM

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