Tuesday, April 27, 2010

Goldman Again - a post to please no-one

As I watch the senators grill the Goldman folk I have to say that I am both impressed with the way they have gotten up to speed on the industry and yet displeased about how much they seem yet not to understand. Their lack of understanding is their undoing. I have been listening to this testimony today for over nine hours and I would not describe the questions as targeting the key issues like a laser.

Levin is compulsive about Goldman's large - HUGE short (the absolute size of the short); he is also compulsive about the idea that Goldman 'should' be an advocate of the assets Goldman sells to customers. These are two misguided positions by Senator Levin. Sorry, Carl, my fellow Michigander.

If the raw size of Goldman's 'short' in the mortgage market is an issue because it can impact the whole market then the issue should be one of governing market positions in instruments:instrument by instrument. Goldman had a huge short FOR THE PURPOSE OF hedging its huge 'long' in a weak and declining market. I don't think that is/was Carl's point. I don;t think Carl ever really made a damaging point on this subject. Testimonies began at 10AM and this point emerged early on; Yet it took us until Blankfein's commentary late in the day for it to be explained to Levin that the act of being a principle necessarily puts the dealer and his customer on different sides of the trade and with completely opposite risks, at least initially.

If a dealer is selling to a customer in a rising market or buying securities from customers in a falling market both circumstances put the dealer firm at great risk to 'service' the desires of his customer. These risks or interests cannot be 'aligned'. But that IS the business of the securities firm. Hedging that risk and managing it is the crux of the business. If firms sought out clients with the same market views it had, it would never do business with them!

As for transparency, a friend of mine who has been a trader on Wall Street for a long time says the best skill l to being a trader is to play poker. If you played poker would you want your opponent to know what you held in your hand? Of course not. Dealers can't (read that as meaning 'ought not be required to'...) disclose their positions. Some of their customers are very sophisticated and would use that information against a dealer. Senators need to know that. Markets are adversarial. Each transactor needs to look after his or her own interests. Buyer beware! At the same time there are rules to promote fair play. That is the complication of markets; that the point the Senators are missing. 'Caveat emptor', yes, but seller be fair.

There are other business in in which firms undertake a true fiduciary responsibility for their clients. And Goldman is in some of those businesses. But those businesses are not about the deals the that the senators were taking about today.

Now all of this is very different from the charge that Goldman did not just trade securities but it created a security for a client that wanted the price of that security to fall. Now let's point out that while that is peculiar and seems reprehensible, if the deal is properly described there is nothing 'wrong' with it (it's not illegal).

Abacus 2007-AC1 (maybe they should have called it 'Icarus')
Goldman is accused in this one deal (Abacus) of not making a material disclosure related to the deal. Two aspects of this have emerged. Not only does Goldman argue that the role of Paulson need not be revealed- it was material. It was also said by Blankfein today said that he thinks ACA knew what Paulson was doing. We have earlier testimony that points out that Paulson was not in the end listed as being in the equity part of the deal something ACA would have known as it underwrote a good portion of the deal for which it had the responsibility for asset selection and which it insured. Even though there are allegations that Paulson had been originally represented as being an equity player in the end he was not there. Most of the discussion today has not been about that at all.

This Abacus structure is allegedly a security formed with the objective of having it fall in value. This conclusion about the intended performance of the security follows from the fact that the deal was being designed for a Goldman client who wanted to bet against the housing market. A Goldman committee described the deal as being like Goldman 'working an order' for their client, Paulson. The telling aspect of that phrase is that we know the client wanted to short the housing market and that when Goldman works an order it does so without putting it's capital at risk. So Goldman wanted to sell it all.

Yet Goldman operatives deny that the deal was designed to produce a weak security that would fail, although Goldman operatives admit that the firm did not plan to own any of it- it did get stuck with a piece it could not sell. That fact does not allow Goldman to say it was blameless.

When Goldman put Abacus together, the developing information from todays testimonies suggests, it sought a novice firm to insure the deal and to pick the securities, a firm that may have felt 'honored' to have been chosen to do a deal with Goldman. The real client, the Paulson-run hedge fund , the intended short-seller who wanted the deal to fail, was put in meetings with the asset insurer who wanted the deal to succeed. Germane to the case, we have seen documents leading us to believe that the Insurer for Abacus, ACA, thought Goldman's customer, Paulson had a equity position - not that he was a short-seller. Though Goldman puts this allegation in dispute.

We now have for the first time in today's testimony an allegation by the 'Fabulous Fab' that he told ACA that Paulson would be short. We also, interestingly have had a case of the 'fab fab' making errors in statements possibly because of his less-than-stellar grasp of English. He also has described some of his emails as inaccurate because he was in a hurry and being less than completely 'accurate' in his haste. These are two possible lines of defense he can use later on.

Various background documents produced, have quoted Goldman operatives as saying that Goldman did not want to do more business with sophisticated customers but that it wanted to transact more with others since the sophisticated customers were more likely to be on the same side of the trade as what Goldman wanted. That's a nice revelation.

Beyond Abacus
Goldman is confusing the issues in the case and so are the senators by not getting to the facts of the deal that has prompted this investigation and the charges by the SEC about Goldman's wrong-doing. The Senators are going beyond this deal and getting tripped up by confusing Goldman's role in this transaction with the idea of what a dealer does. There is no fiduciary responsibility for a dealer per-se, but there are securities laws. Goldman only has fiduciary responsibility when its firm undertakes that in some of the roles it does play apart from its role as dealer. But in the role of dealer it does not have its client's interests at heart. It is trying to trade and make money, but it still has rules it must follow. On the other hand when it underwrites or originates securities its participation is controlled by other securities laws. Being a dealer is not a license to engage in a free-for-all. The rules depend on whether the firm is trading listed securities or originating new paper or being an investment advisor, and so on.

Goldman is a complicated firm-as are most securities firms. Securities laws are complex. Derivative products are a rat's nest of troubles. Goldman had a number of emails whose contents once disclosed reflected badly on it. Some of this is just the stuff of securities markets and people who are under pressure and letting their guard down, blowing off steam, more than being underhanded. The talk about Goldman selling 'crap' is talk you'll find in every shop in Wall Street, as well as in used car lots and elsewhere. And... one man's crap is another man's fertilizer. It's hard to tell in these emails what is truth and what is just blowing off steam.

No trader thinks he is holding crap but he might call a security that after he sells it, especially if it falls in price. 'Crap' is often made obvious only after the fact. Salesman often have views that differ from that of the firm. Salesmen often think a company has underwritten or has created a security his customers don't want to buy and as a consequence, he does not want to be pushed to sell them. Sometimes the salesmen are right. Sometimes they are not.

The question is - in the case of Abacus - not was there 'pro and con' chatter nor 'did Goldman salesmen ever call it 'crap' (or a more vulgar term),' but was something illegal done? The senators lost their way. Michael Lewis's "Liar's Poker" would be a good book for the senators to read to get some perspective on how salesman work with customers and how they talk. I have worked on the assembly lines in Detroit and on Wall Street at a bank and at a securities firm as well as at the central bank, the Fed. I find the language used in on Wall Street as well as on Detroit's assembly lines has a lot in common.

The key here should be for the senators to pursue those charges that have to do with securities law violations or that have real moral character problems. They seem to have lost their way although they did score some points today.

One of the keys here is to poke through the complications to get at the real issues. The more we get into the complications of the industry, complications of the securities and complications of 'the deal' the more likely it is that Goldman wins. Complication works in Goldman's favor. When things are complex other things go wrong and sometimes that is seen as a result of the complication itself instead of being viewed as being the fault of those who were the transactors or deal architects who may have well understood the complex structure and used it to do no good and shield themselves.

Most disturbing to me is that Blankfein said he heard nothing today that makes him think that Goldman did anything wrong- really? Was he listening to the same stuff I was listening to? Or does he just have lower standards?


Tuesday, April 20, 2010


Several disparate and conflicting thoughts come to mind over he the SEC allegations against Goldman Sachs.

First, is this the best that the SEC could do? After all this time is this their flagship prosecution? It is essentially a case about improper disclosure.

Second, While Goldman makes a number of statements about how it did nothing wrong and that shielding the counter party identities is par for the course, this is the sort of partial-truth blather that makes them seem more culpable, at least to me.

Third, what it is: What Goldman did, as far as I know, is a first in markets. It set out to design a security that would fall in value almost from Day One and it got investors to buy it. We have seen high-risk initial securities offerings before (interestingly, Michael Milken pioneered original issue junk bonds), but in the past the risk was fully disclosed and was reflected in a higher yield and/or an initially discounted issue price. How do you sell such a thing that is not discounted? Goldman apparently intended to make the issue viable by mining the fact that market participants had vastly different views of the market's path and by not making that facet clear. Goldman's internal meeting describes this deal as accommodating a trade for hedge fund investor, Paulson (aspiring short-seller). An internal memo says that Goldman was effectively working an order for Paulson to buy protection on specific layers of the deal's capital structure.

Red badge of innocence, isn't -- While Goldman lost money in the deal, something it now wears as a red badge of innocence, the wound was self inflicted. Goldman seems to have been bearish on housing at the time it arranged the deal. It may have used securities it already had on its books it wanted to hedge or it just may have been caught holding the deal it could not sell. None of that adds to its 'innocence.' Some old expression about playing with fire comes to mind.

Goldman selected ACA, the credit expert company with a low credit rating itself (the smallest and weakest in its country) to be the independent analyst and selector of assets for the deal. ACA was a self-described expert that seems to have lacked a strong market profile despite describing itself as 'expert.' Arguably Goldman picked a weak 'expert' that could be pushed around. ACA would also insure the $909mln of the deal. But ACA collaborated on asset selection, nonetheless, with Paulson for whom the deal was arranged and intended as a short. ACA did not know that. The trader who arranged the ACA Paulson meeting left the meeting between the two calling it 'surreal.' IKB Deutsche industriebank AG bought a $150 mln slice of the deal it said it would only buy if an independent body picked the assets for it. So ACA's participation and control was crucial, at least to IKB. But due to ACA's weakness when the deal went sour its backing was insufficient as a backstop. Only Paulson seems to have gotten what he wanted, despite being described as being not the party with the authority to pick the assets. No wonder the young Goldman trader Fabbrice Tourre described the ACA-Paulson meeting as 'surreal'. One wonders what else that meeting could have been, given the very different objectives of these two participants one of whom did not know that the other was the enemy.

What ever really happened, whatever people were told or not told, it is pretty clear that Goldman put two adversaries together and did not disclose that to one of them. Two of the main parties to the transaction that worked on it together had very different interests in the design of this product and even though 'only one' had the mandate to select assets, as the other would be involved, it's possible that that ACA felt that some accommodation was called for to placate the other, Paulson. It was a sort of kabuki in which nothing was at it seemed.

One thing seems clear, this was not a normal above the board deal. There was a a lot of surreptitiousness here. While Goldman may have buried everyone with technical details on the securities involved and may wish to wash its hands of any further obligation, there seems to have been an underlying objective that was hidden from some of the key participants that Goldman herded together and some had mis-information about the goals of the others. The case in a legal sense will turn on the issue of, was there a material omission or not.

This deal is very tangled. As we learn more, it may not become that much clearer. One thing we know is the that the very complicated structure of theses deals, from the complex roles of the various counter parties, to the math that defines the security itself, gives all participants some degree of cover. But this is hardly the kind of deal we'd expect an expert market maker like Goldman to have championed. One could have looked at theses participants and at this deal and seen that this was not going to turn out well right from the start. But Wall Street is about doing the deal and raking in the commission. At the end of the day that is what Goldman did. What it took to get them there -guilty verdict, plea bargain, or 'vindication'- it does not matter, it has damaged the Goldman reputation. One thing Goldman has been very good at has been protecting itself. That skill is about to be tested.