Is there a Goldman CDO scandal?

By Felix Salmon
December 24, 2009
3000-word story on Goldman and synthetic CDOs, which now has a formal response from Goldman itself.

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The big story on this slow news day is the NYT’s 3000-word story on Goldman and synthetic CDOs, which now has a formal response from Goldman itself.

Here’s what I think is the most interesting new information in the story:

Beginning in 2004, with housing prices soaring and the mortgage mania in full swing, Mr. Egol began creating the deals known as Abacus. From 2004 to 2008, Goldman issued 25 Abacus deals, according to Bloomberg, with a total value of $10.9 billion…

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…

Goldman’s bets against the performances of the Abacus C.D.O.’s were not worth much in 2005 and 2006, but they soared in value in 2007 and 2008 when the mortgage market collapsed. The trades gave Mr. Egol a higher profile at the bank, and he was among a group promoted to managing director on Oct. 24, 2007.

There are a couple of things which jump out, here: firstly that Goldman was structuring synthetic mortgage-backed CDOs as early as 2004, and secondly that it held on to the short side of those deals for years.

Remember that by their nature, synthetic CDOs have equal-and-opposite long sides and short sides. Anybody buying these things from Goldman knew that someone else was betting the opposite way. And they knew that someone was Goldman, at least in the first instance.

Over 2004, 2005, and 2006, and even into the first half of 2007, demand for mortgage-backed credit assets was insatiable. That’s why so many originators started churning out low-quality paper, and that’s why Goldman got into the origination business too, both on the real-money side (although it was never a huge player there) and on the synthetic side.

Goldman’s synthetic CDOs involved it paying millions of dollars in insurance premiums every year to the investors who bought them. Because of the balance of power between buyers and sellers of credit during the boom, the people buying bonds had very little bargaining power, and the people issuing debt had a lot. As a result, private-equity shops were able to issue billions of dollars in cov-lite loans, and the likes of Goldman Sachs were able to put all manner of triggers into their CDOs — things like ratings downgrades — which would stop the money flowing from Goldman to the buyers, and start sending money flowing back in the opposite direction.

Goldman was certainly in a good position here. It had a substantial portfolio of mortgage-backed securities — so substantial, in fact, that it wrote down $1.7 billion on its residential-mortgage exposure in 2008. As a result, it had a lot of appetite for hedges against those securities, and happily held on to those hedges in 2004-7 when they were losing, rather than making, money. It liked holding the position because it had structured the hedges itself, and knew exactly how profitable they might be if and when the housing market turned.

But does that mean, as the NYT article says, that Goldman’s decision to take the short side of the CDOs “put the firms at odds with their own clients’ interests”? No, it doesn’t. In fact, I’m a bit depressed that we’re still having this argument, a full two years after everybody derided Ben Stein for saying the same thing. I may as well simply disinter what I wrote back then:

If I sell you something – whether it’s a car or a house or a stock or a ham sandwich – I have no fiduciary responsibility to you. Caveat emptor, and all that. If I am investing your money on your behalf, then I have a fiduciary duty. But if you’re looking for fiduciaries, you’re not going to find them on the sell side, only on the buy side.

When Stein accuses Wall Street banks of “betraying their clients’ trust,” he’s simply confused about who the clients are, in these transactions. If I’m an investor and I buy a stock from a broker, then I’m buying it because I think the total amount of money I’m paying is a fair amount for that security. I’m completely agnostic about whom, exactly, I’m buying the stock from: if a different broker has the same security for a lower price, I’ll go there instead. And I’m certainly not trusting the broker to assure me that my security will go up rather than down in value. In fact, at the margin I actually like it if my broker is shorting that stock and thinks it will go down in value – because that just means that I get to buy it at a slightly cheaper level.

It’s just ridiculous to think that “basic fairness” means that Goldman should be exposed to exactly the same risks as anybody who it sells securities to. Goldman Sachs isn’t Berkshire Hathaway, investing money on behalf of shareholders. It’s an investment bank: an intermediary between issuers and investors. If an investor buys any kind of financial security, he’s deliberately buying a risk product. He gets all the upside if that security rises in value. But he also gets all the downside if that security falls in value. It’s not the job of any securities firm to bail him out.

The 30,000-foot view of what happened here is that there was an enormous amount of mortgage paper flooding the market over the course of the 2000s. Goldman Sachs, as a sell-side institution which manages its risk book on a daily basis and doesn’t want to take long-term directional bets, hedged its mortgage exposure with short positions it created by structuring synthetic CDOs. The buy-side, by contrast, had an enormous amount of appetite for long positions in mortgages, and it was the job of banks like Goldman to feed that appetite: again by structuring synthetic CDOs. Goldman was killing two birds with one stone: no wonder Jonathan Egol, who was in charge of these deals, did so well there.

When the mortgage market started to turn, Goldman was smart and nimble enough to realize that it could make money on the way down as well as on the way up. That’s what traders do, and Goldman is the world’s largest and most successful trading shop.

Henry Blodget adds another important point:

Don’t forget that everything is obvious in hindsight. Goldman could have been wrong about the housing market, and its clients could have been right. In that case, we wouldn’t be talking about a scandal. We would be talking about how Goldman got greedy and made dumb bets.

The real lesson here isn’t that Goldman did anything scandalous. It’s just that if you’re making a bet and Goldman is your bookmaker, don’t be surprised if you end up losing.

Comments
18 comments so far

For most of this article, I thought that Goldman’s behavior was criminal. How can you advise clients to buy assets that you are betting against? That’s almost as bad as an analyst setting unrealistic target prices he believes will never be reached (no, Henry, I’m not talking about you. Really.).

But then I read this part:

“The Goldman salesman said that C.D.O. buyers were not misled because they were advised that Goldman was placing large bets against the securities. “We were very open with all the risks that we thought we sold. When you’re facing a tidal wave of people who want to invest, it’s hard to stop them,” he said. The salesman added that investors could have placed bets against Abacus and similar C.D.O.’s if they had wanted to.”

If that is true, then it kind of shifts the blame from Goldman to their even greedier clients. I mean, you’re paying a company for investment advice, and not only are they advising against an investment, but they are shorting it. If that is true, how can you blame Goldman?

But is it true? Did they really advise their clients not to buy those CDOs?

Posted by OnTheTimes | Report as abusive

I thought it unfair of the NYT to run John Paulson’s photo alongside their story. He hadn’t been skulking around — he was openly betting against the housing market, and made a lot of money for his clients in the process.

Posted by Mega | Report as abusive

“If I sell you something – whether it’s a car or a house or a stock or a ham sandwich – I have no fiduciary responsibility to you. Caveat emptor, and all that. ”

Maybe you don’t have fiduciary duty, but it’s certainly not caveat emptor. There are certainly warranties on things like cars, even if they’re just implied. Further, you certainly can’t sell a house that has a bunch of hidden problems–you could easily be sued for misrepresentation. I don’t think caveat emptor is a strong a policy as many think.

Posted by jaherman | Report as abusive

Felix, doesn’t the analysis change if Goldman was purposely selling securities it knew would eventually tank and not disclosing that to investors? And then betting that those securities would tank?

Posted by Snyderico | Report as abusive

” he was openly betting against the housing market, and made a lot of money for his clients in the process.”

Isn’t it interesting how much is being done in the “open.”

As for the Blodget quote — stomach churning. Goldman could have been wrong about the housing market? Go sell your snake oil somewhere else, please.

Posted by Uncle_Billy | Report as abusive

“If I sell you something – whether it’s a car or a house or a stock or a ham sandwich – I have no fiduciary responsibility to you. ”

I don’t know what the laws are regarding a fiduciary duty but there is plainly a professional responsibility.

Felix, you are wrong on several of your examples, at least when it comes to professional responsibility. There are lemon laws when it comes to cars. A seller of a house is responsible if major undisclosed defects arise. If a sandwich from my deli poisons my customers, I certainly am liable.

Goldman was not some middle man. It created these toxic products which were full of fraudulent mortgages, based on false incomes and false appraisals. The fact that it traded against these products underscores that it understood these problems.

In every profession, you have a responsibility to your those who purchase your products. Goldman’s behavior has not only been highly unethical, it has been criminal.

Posted by DanHess | Report as abusive

This goes beyond insider trading – it’s insider mayhem, and should carry life without parole for the guilty parties.

It’s one thing to bet a landslide is about to happen, but a completely different thing if you take out a bet like that with the villagers who live in the shadow of your landfill which, unbeknownst to them, you then promptly unplug.

All that’s missing is for Soylent Goldman to have taken out life insurance on impoverished surviviors whose main option in the aftermath involves jumping off of nearby tall buildings. Talk about giving Capitalism a bad name…

Posted by HBC | Report as abusive

The creation of these horrible financial products by Goldman was deeply questionable, even before the CDO activity. Goldman’s best defense in passing around this financial waste would be if it really believed in these products. Clearly the opposite was true.

The other companies, which ate the cooking, at least can argue that they acted with a modicum integrity, albeit served with a heaping dollop of stupidity. Goldman appears to have acted entirely without integrity.

Posted by DanHess | Report as abusive

Your points, along with those of Goldman and Henry Blodget, make a lot of sense and are very logical. I would advise the same line of defense for drug dealers. It’s always the fault of the user, and the dealers are only providing a service that the users are demanding. It couldn’t get clearer than that.

Posted by rogueecon | Report as abusive

Many of you are coming at this from the perspective of what one might refer to as a “retail” rather than institutional or at least, qualified, client.

Differentiation between the two is critical because the latter are generally considered to be both sophisticated and sufficiently capitalized to assume whatever risks they’re taking by–knowingly–purchasing securities that are not registered with the SEC and that do not come to market with regulated disclosure requirements. That includes just about every CDO ever built. It is illegal to otherwise sell such securities directly to “retail” investors.

I’m not certain that GS is entirely without guilt, but not for most of the reasons mentioned here.

It’s also critical to differentiate between a broker/dealer (the arm of an i-bank responsible for distributing securities) and a registered investment advisor. The former, in fact, owes no fiduciary duty to its clients (though for retail purposes this is a hotly contested issue in the industry), while the latter decidedly does.

And while GS does have arms of its business that function as RIAs (Goldman Sachs Asset Mgmt, which manages mutual funds, for example) the investment bank and broker/dealer elements responsible for building and selling CDOs do not operate under those registrations and their institutional clients absolutely, positively know that.

Posted by fixedincome | Report as abusive

“It’s also critical to differentiate between a broker/dealer (the arm of an i-bank responsible for distributing securities) and a registered investment advisor. The former, in fact, owes no fiduciary duty to its clients (though for retail purposes this is a hotly contested issue in the industry), while the latter decidedly does.

And while GS does have arms of its business that function as RIAs (Goldman Sachs Asset Mgmt, which manages mutual funds, for example) the investment bank and broker/dealer elements responsible for building and selling CDOs do not operate under those registrations and their institutional clients absolutely, positively know that.”

I think many of our comments above recognize this point. However, it still isn’t exculpatory for Goldman Sachs.

When I go to the car dealer, I know that the car dealer has no fiduciary duty and that his goal is, of course, to sell me a car. However, if the car dealer sells me junk, I certainly have recourse against him through lemon laws and warranties. As I mentioned above, caveat emptor is not quite as strong a concept in law as people believe it to be.

Posted by jaherman | Report as abusive

“When I go to the car dealer, I know that the car dealer has no fiduciary duty and that his goal is, of course, to sell me a car. However, if the car dealer sells me junk, I certainly have recourse against him through lemon laws and warranties.”

I think this analogy demonstrates the problem, fixedincome’s point is that the relationship between Goldman and the purchasers of these synthetic CDO’s is not like that of a store and consumer. The better analogy is that of a car company and a mechanic. If you wanted to use legal terminology the relationship would be “between merchants”.

If Goldman willfully hid information, is Goldman dissembled, if Goldman outright lied, then yes they would be both morally and legally wrong. But if the evidence here is correct and Goldman let the mechanic knock around the car as much as they wanted, then an institutional purchaser assumes the liability.

JMS

Posted by JMS | Report as abusive

Let’s be clear here:
Goldman was not merely some dealer or reseller.

Goldman created these financial products. They put their brand on this toxic waste. There is no question that buyers, and especially those overseas bought these things in large part because they were buying a Goldman Sachs branded product.

Did folks trust the *new* (investment) vehicle they purchased *from the manufacturer* and not look too much under the hood because of the Goldman brand? Of course.

Posted by DanHess | Report as abusive

They should be prosecuted for fraud

Posted by Anonymous | Report as abusive

Financial firms that securitize or underwrite securities often take positions opposite to the security to protect themselves from adverse market movements during the selling period.

Firms that create and sell a security are looking to make their profits from the commission or markup on the security and not from investment gains. During the selling or underwriting period, it is not unusual for a firm to be holding the security in inventory for future sale. While the firm is holding the security, it is at risk for adverse market changes and price movements. Firms will hedge the security they are holding by taking an opposite position. Some customers will already have purchased the security, so the firm has a position opposite to its customers.

If the firm is frequently selling the same type of security, the firm may put on a more permanent, longer-term hedge to save costs. To someone who does not see the holding of the opposite position to customers as a hedge against inventory risk, will think it looks like a bet against the customers.

Posted by MiltonRecht | Report as abusive

Many people here are knowledgeably and eloquently making the same point.

Buyer beware? We weren’t there when the salespeople were doing their job, so we don’t know (but can suspect) that perhaps someone was being snowed. Just look to the Procter & Gamble and Gibson Greeting Cards’ suits against Bankers Trust to see how it can happen.

This kind of behaviour is why Glass-Steagall was established in the first place. It is exactly why GS — among others — lobbied so hard over the years for deregulation, then chose to go public when it did.

In the U.S. GS and others like them need to see the re-establishment of dividing lines between the businesses.

However abhorrent their behaviour, GS has always excelled at establishing very long-term plans, and ensuring and/or taking advantage of their presence, obvious or not, within governments around the world. It would be very difficult for anyone to clip their wings at this point, but you can be assured they have many contingency plans in place to respond to change of any kind.

Posted by nktrumpsall | Report as abusive

“Financial firms that securitize or underwrite securities often take positions opposite to the security to protect themselves from adverse market movements during the selling period.”

True enough, everyone hedges, and so they should. Synthetic MB CDOs, however, are extremely complex instruments. When valuation, pricing, and forecasts of future performance are based solely on sophisticated computer models developed by the seller, the customer is at a distinct disadvantage.

In theory, free markets work based on some degree of transparency and a fair availability of information. There were more established, transparent ways to hedge bets on the real-estate market boom. No-one should have been allowed to create synthetic MB CDOs, among other “instruments” in the first place.

Posted by nktrumpsall | Report as abusive

If you create a financial instrument that is based on fraudulent mortgages, how can that be a legitimate financial instrument? Incomes, assets claims, appraisals and many other things all constituted fraudulent false statements. These were the basis for the products in question.

The crises would never have been as severe if fraud hadn’t been repackaged and sold, allowing new fraudulent mortagages to be originated.

Did Goldman know that the loans were fraudulent? They were called Liar Loans for goodness sake! Everybody knew!

Posted by DanHess | Report as abusive
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