Goldman and “hope”

On Friday, Goldman published a letter called Goldman Sachs: Risk Management and the Residential Mortgage Market . Here’s a bit of it:

In a “synthetic” CDO, two parties enter into a derivative transaction, which references particular assets. By the very nature of a synthetic CDO, one counterparty must be long the risk (i.e., hoping to benefit from an increase in the value of the referenced assets), and the other counterparty must be short the risk (i.e., hoping to benefit from a decrease in the value of the referenced assets).

I have made this point before, but I will bore with repetition. Both in theory and in practice, there need be no identifiable party “hoping to benefit from a decrease in the value of the referenced assets”. Historically, in the vast majority of deals, there was no such party. Does anybody wish to dispute this as a factual matter? Mr. Blankfein?

Synthetic CDOs began as a tool for balance sheet management by banks. In these deals, a bank issues a synthetic CDO whose reference portfolio is composed of debt that the bank actually holds. The bank retains the first-loss “equity” tranche, but sells mezzanine and senior tranches. It may or may not retain the risk of the “super senior” tranches.

Banks derive two advantages from this arrangement:

  1. They limit losses with respect to their loan portfolio. When all senior tranches have been sold away, banks total exposure to loan losses is limited to the size of the first-loss tranche, usually a very small fraction of the total assets. It is as if they have bought insurance on their loan portfolio, but the policy includes a small deductible. When banks retain the risk of “super senior” tranches, the structure becomes analogous to an insurance policy with a small deductible and a lifetime cap that is less than the total value of the loans. In either case, banks effectively lay off some of the risk of their porfolio.

  2. Banks don’t need to hold regulatory capital against debt that is insured by a CDO with sufficient collateral to guarantee that insured losses will actually be covered. If investors in a CDO require a smaller premium than a bank pays to holders of regulatory capital, the bank profits by shifting credit risk to the structure (either by redeeming excess capital or, more likely, by using the capital to make new loans). This is called “regulatory capital arbitrage”.

As long as the yield investors demand is not too high, banks gain from issuing synthetic CDOs. If investors and rating agencies pay more attention to the correlation structure of portfolios than the characteristics of the underlying debt, the ability to cheaply lay off risk to CDOs might encourage banks to make riskier loans than they otherwise would. Like a John Paulson, banks doing these deals would try to cram the riskiest debt they could into reference portfolios. (Rating agencies are said to be particularly attentive to the debt selection process in bank balance sheet deals.) But in no sense do banks, the short counterparty, hope the deals go bad. Their best case scenario by a long shot is that every penny of debt gets paid, so that they earn a good yield on the equity tranche.

During the 2000s, for a lot of familiar reasons, AAA debt with a yield premium to Treasuries could be sold very easily, so entrepreneurs began structuring synthetic CDO deals based on debt they did not actually hold. In these deals, arrangers sold credit protection to investment banks, who may then have been economically short the credit, depending on how they were initially positioned. If investment banks retained those unhedged short positions, then there would, as Goldman alleges, have been a party “hoping to benefit from a decrease in the value of the referenced assets”. But investment banks were market makers and underwriters for these deals; they were not typically speculative counterparties. If you don’t believe me, here’s Goldman:

Goldman Sachs did not engage in some type of massive “bet” against our clients. The risk management of the firm’s exposures and the activities of our clients dictated the firm’s overall actions, not any view of what might or might not happen to any security or market…We maintained appropriately high standards with regard to client selection, suitability and disclosure as a market maker and underwriter. As a market maker in the mortgage market, we are primarily engaged in the business of assisting clients in executing their desired transactions. As an underwriter, the firm is expected to assist the issuer in providing an offering document to investors that discloses all material information relevant to the offering.

A market maker takes reactive positions dictated by customers who seek liquidity. The essence of market-making is accepting a risk that one might not otherwise choose in exchange for a fee or a spread. Since another party forces ones positions, and that other party might know something that the market maker does not, market makers usually strive to avoid carrying “inventory”, risk that accumulates as a byproduct of taking the other side of customer trades. The business of market-making is the art of hedging, of laying off risk forced onto the market maker by her customers. For large, complex positions, it is rarely possible for a market maker to find a single party to take the other side after it has assumed the risk of a client-initiated bet. [1] The market maker’s expertise is decomposing risk forced upon it by clients into smaller, more easily marketed positions, and neutralizing that risk via arms-length exchanges.

In synthetic CDO deals prior to 2006, the investment banks that served as market makers and took the initial short position on the CDO credit usually strove to be neutral or long the deals. They did as market makers do, and laid off their initial exposure by hedging, statically when possible, dynamically when necessary. Investment banks also frequently went long the deals they issued by retaining exposure to the super senior tranches. Out there, somewhere in the world, there may have been parties that stood to gain from events that would also have harmed CDO investors. But there was literally no one “hoping to benefit from a decrease in the value of the referenced assets” in totality. If you die, a whole bunch of people whom you don’t know and who don’t know you might benefit from buying your crap cheaply at your estate sale. There are even professional estate sale vultures, who make a business of taking the other side of estate liquidations. But it’s quite a jump from dispersed market interest to a claim that there is someone out there hoping to benefit specifically from your death. Dispersed market interest by estate sale junkies is not “material” to how you conduct your life. But if someone in particular really hopes you will die so that they can take your shit, you’d want to look over your shoulder.

I won’t go so far as to say that Goldman is lying, when it claims that “[b]y the very nature of a synthetic CDO”, one party hopes to benefit from an increase and another party hopes to gain from a decrease in the value of the referenced assets. But I will say that that the statement is factually wrong, and that Goldman knows very well it is factually wrong. If we are generous, we might categorize the statement as a sloppy simplification, a rhetorical imprecision that happens to flatter Goldman Sachs.


[1] If a position is not client-initiated, but initiated by the bank in response to some other party’s wishes, then the bank is not acting as a market maker but as an agent for the initiating party. An investment bank is free to act as an agent for a client when it trades at arms-length in public markets. But it may not act as an agent of a client while transacting with underwriting clients, unless it discloses the nature of the relationship. This failure to disclose is the essence of Goldman’s ethical foul in the ABACUS deal. It is also, I think, why Goldman is fighting the case so hard. Goldman gains competitive advantage by letting underwriting-driven demand take on customer risk that Goldman itself is unwilling to accept. There is, in the lingo, a synergy. But it is also an unethical practice, in violation of Goldman’s duty to its underwriting clients. I think Goldman is fighting so hard because it benefits from this synergy and wants to keep it. Goldman wants to normalize the practice, and rhetorically attempts to do so every time it protests that market makers don’t disclose the identity of counterparties. When Goldman is shifting risk that it did not wish to bear or hedge to an underwriting client, it is not acting as a market maker. Rather it is acting as an agent for a client wishing to take a position, while imposing the burden of liquidity provision on uncompensated and uninformed underwriting clients. When a bank arranges and underwrites deals to meet its own hedging needs, or especially to take an opposing speculative position, that is also ethically questionable if not plainly disclosed.

 
 

14 Responses to “Goldman and “hope””

  1. Jon W writes:

    Steve,

    Doesn’t your point on this mean that what matters is how people in the market at that point in time? Sure these derivatives were originally created for a purpose, but how they are being used at a given time may be very different. CDSs for instance were created for hedging / transfering credit risk. The HF I worked at, and many of the other ones I have worked with use CDSs now for the specific purpose of expressing a long or short position. It’s mostly because finding the underlying to short or long may be difficult. The same thing with options and futures. Their original purposes were also to hedge out risk for owners of the underlyers. Nowadays I would bet the bulk of activity in both markets has nothing to do with possessors of the cash/real assets.

    Of course CDOs and other instruments were intended for a specific purpose. But as the markets and uses evolve it often has nothing to do with the original intention. The question is if the participants understood it as such.

    While Blankfein’s total statement may not be perfectly true, it may true in the context of the time and the frame of reference in which these deals were occuring. If 80% of all synthetic CDO activity at the time resulted from speculative trades then shouldnt parties entering them assume that there is a gross addition to long / short rather than someone hedging? I have no idea of the exact number, but my guess is that in this period the bulk of these transactions would be more on the speculative side.

    It’s really difficult for me to believe that IKB or any other financial institution which had participated in multiple deals like this wouldn’t have a pretty good idea of this. With the way the financial community operates (sharing ideas, banks pitcing multiple ways of expressing trades etc.) it would very difficult for someone active in the CDO, CDS markets to not get wind of the current state of market mechanisms.

    If the offering were pitched to you for instance then I would agree… You could not possibly have the information to correctly assess these types of securities and the market dynamics involved. This is why GS is using the sophisticated investor defense. It has to do with the rules and expectations involved with being a qualifed/accredited investor as it pertains both to the specific legal guidelines in securities laws and how these differ from the average investor. Whether or not this is on one side of that line or the other is something that a jury/judge will decide.

  2. marc hille writes:

    The Interfluidity posts have helped the neophyte that I am understand more than I otherwis would have, even if a lot still escapes me. To reassure me I’ve really got it, would Steve (or some commenter) confirm the following simplified statement of the position:

    1. In the beginning, synthetic CDOs were banks hedging on asset portfolios they actually owned.
    2. In such CDOs, the GS claim that there’s necessarily a (speculative) short side is clearly false.
    3. The Abacus CDO was however an example of a later type of synthetic CDO, one based on a portfolio of assets that the bank didn’t possess at any point.
    5. So this is probably the what GS is referring to when it speaks of two opposing sides in a zero sum game.
    6. However even for this later type of synthetic CDO, it’s not true to say there’s necessarily a short side, as the bank had other ways of hedging its holding.

    Is that an accurate reading of what you’re saying? Or am I completely off-beam?

    Then one question:

    Q: Is it clear that the investors even knew that the credit protection they were selling via Abacus was “naked”, i.e. for a portfolio the buyer, initially GS, didn’t even own, but had notionally constructed on paper only?

    I doubt you get questions as base-level as mine too often on this blog, but I’d be really grateful for any help ! Thanks!

  3. MR writes:

    Spot on – at best Goldman could say, “By the very nature of a single-tranche synthetic CDO which I cannot or prefer not to dynamically hedge, and have sourced a static hedge for, one counterparty must be long the risk (i.e., hoping to benefit from an increase in the value of the referenced assets), and the other counterparty must be short the risk (i.e., hoping to benefit from a decrease in the value of the referenced assets).”

    As I wrote here http://www.macroresilience.com/2010/04/18/the-abacus-affair-goldmans-defence/ : “If exact matching hedges had to be found in the market for each product sold to a client, then the business of structured products would not exist. In this respect, Goldman’s assertion that each transaction includes a long and short side is technically accurate but a little bit disingenuous – most synthetic CDOs like most other structured products do not have a market counterparty other than the market-maker who is short exactly the same product.”

  4. anon writes:

    replace “hoping” with “positioned” and all is fine

    interesting that the referenced paper on SCDO’s focused on the disclosure issue relative to reference assets; we’ve come a long way in the disclosure debate

    the Levin/Blankfein exchange was hilarious; looking forward to the SNL skit with Armisan as Blankfein

  5. Cedric Regula writes:

    The whole concept that “someone needs to be on the short side” of CREDIT is ludicrous.

    That’s the same as saying we need dumb bankers and a smart counterparty for the good of the financial industry and our economy.

    I can’t say it enough. It is the crux of all our problems.

  6. [...] ABACUS deal have been written on the interfluidity blog; I recommend the posts of April 25,  April 27 and April [...]

  7. onwee writes:

    The elephant in the room: Did the longs in the SCDOs believe that Goldman’s official view and therefore its bets were for positive mortgage performance and rely on that belief in part in coming to their decision to be long by buying those SCDOs?

    I think the answer is no, they viewed Goldman as an arranger working for a fee and viewed the bets Goldman was taking on the mortgage market as irrelevant to the decision to go long. I know of nobody at a buyside institution that approaches a deal like that saying, “If it’s a Goldman deal they must like it and that’s good enough for me” (and if they did they should be fired). The predicate of the Senate hearings, that Goldman’s view is relevant to the long side of that transaction, was flawed. That “Goldman’s” opinion might have been the passing feeling of some people that happened to be right but could have been wrong was also a topic worthy of more examination.

    That said, as a society it is not good to create highly levered structures where the underwriter DOES NOT CARE how good the collateral is because it’s hedged, and that’s basically where we were.

  8. [...] As always, I draw on Steve Randy Waldman. [...]

  9. [...] interfluidity » Goldman and “hope” [...]

  10. Gene Sperling writes:

    Steve…

    Why is re-implementing the Glass Siegel statutes not an alternative at this time?

  11. I agree with MR. I go further. The business of “structured finance” should not exist.

  12. [...] Goldman and “hope” [...]

  13. [...] published at Interfluidity. [...]

  14. In the UK things have happened slightly differently from the US. When haven’t seen the big falls in house prices yet. I am sure we will but it has been put on hold. Now everyone is calling for the banks to lend more in mortgages which is crazy. There is still a bubble here!