Goldman, Deutsche, and the Destructive Use of Synthetic CDOs Come Into Focus
By Yves Smith at Naked Capitalism
Excerpts:
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…
Bear Stearns, ironically, thought the Paulson plan did not pass the smell test, but Deutsche and Goldman were eager…
To the New York Times article. It’s good yet odd. It does signal very clearly the destructive potential of synthetic CDOs…
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..
