Siwoti Sunday: Blodget’s bizarre Goldman apologia

By Felix Salmon
April 18, 2010
Henry Blodget delivered his verdict: both Stewart and her broker, Peter Bacanovic, were not guilty on all counts. But at least he disclosed that he was prejudiced and that he “wouldn't mind seeing the government get egg on its face”:

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After covering the Martha Stewart trial for Slate, Henry Blodget delivered his verdict: both Stewart and her broker, Peter Bacanovic, were not guilty on all counts. But at least he disclosed that he was prejudiced and that he “wouldn’t mind seeing the government get egg on its face”:

My potential biases are so salient that I wouldn’t have made it through the first 10 minutes of jury selection. As a result of my own experiences as a defendant, for example, as well as a decade of working on Wall Street, I have a “rooting bias”: I regard corporate America as my home team and the government as the visitors.

Now Blodget is back at it, rooting for corporate America in the SEC case against Goldman Sachs. But while he at least attempted to play it down the middle in his Slate dispatches, he now seems to have gone simply bonkers: his case for the defense is so weak that one suspects it was written more as a pageview magnet than as a sincere reflection of his own beliefs.

Blodget kicks off with what he calls “some important background to keep in mind”. The problem is that Bloget’s “important background” seems to have been lifted from a fictional planet: it certainly doesn’t reflect reality.

For starters, in BlodgetWorld, this CDO was structured in the wake of numerous failed attempts to bet against the housing market. He talks about the “huge losses” which were suffered by “dozens of other investors who bet against the housing market from 2003-2007”, and goes on to reiterate:

Plenty of firms had been betting on the collapse of the housing market for years, and they’d all been wrong.

In 2007, the housing market had not yet collapsed, and everyone who had bet on it collapsing had lost huge amounts of money, gone bankrupt, and/or otherwise been rendered fools.

I have no idea what Blodget is talking about here, and I don’t think he has much of a clue either, because he names no names and provides no links to back up his assertion. People went bankrupt betting on the collapse of the housing market? Who?

The fact is that for most of recorded history it has been pretty much impossible to short houses. At the end of the housing bubble, Robert Shiller tried to create a market in housing futures, but it failed, plagued by low volumes and illiquidity. And until John Paulson came along, it was pretty much impossible to short mortgages, too.

In general, it’s extremely difficult to short any bonds other than Treasuries. That’s one of the reasons that credit default swaps became so popular so quickly: they allowed people to go short credit instruments in a way that was pretty much impossible before. As the housing bubble grew and the quality of subprime mortgages sank, various fund managers, including Paulson, started asking the likes of Goldman Sachs to sell them credit protection on subprime loans. Eventually, as the market in subprime CDS expanded, the ABX index was created, and entire synthetic CDOs started to be constructed out of these derivatives. But there was no such thing as subprime CDS in 2003, or even in 2005, which means that no one was shorting those bonds back then. Let alone going bankrupt doing so.

But if Blodget is wrong about the people who were short this market, he’s laughably, spectacularly wrong about the institutions which went long.

So much money had been made betting on further appreciation of the housing market, meanwhile, that investors were DESPERATE for vehicles that allowed them to make these bets in a more efficient fashion. That’s why the buyers of Goldman’s CDO bought the CDO: They thought housing prices were headed higher, and they wanted to make a killing on it.

This is one of the silliest things I’ve seen in a very long time. The decision to buy into Abacus was not an attempt “to make a killing” by “betting on further appreciation of the housing market”. To the contrary, it was an attempt to lock in a modest yield pick-up over Treasury bonds, in return for accepting a very high degree of illiquidity. That’s why Abacus was carefully structured to get a triple-A credit rating: the buyers of the instrument wanted no risk at all with regards to their payment stream.

Buying triple-A mortgage-backed securities and collecting coupon payments on them is not making money by betting on house prices going up, any more than buying Treasury bonds and collecting coupon payments is making money by betting on tax revenues going up. The whole reason for the overcollateralization and the waterfall structures and the equity tranche and the built-in diversification and all the other bells and whistles which so impressed the ratings agencies was to try to make it impossible that investors in the triple-A part of the structure could lose money. If the investors wanted housing-market risk, they would have bought the equity tranche. They didn’t, and they didn’t. Instead, they wanted to put their money in a structure where their principal was safe, but where they didn’t need to pay the liquidity premium seen in the Treasury market — since they were long-term investors and had no particular need for a liquid investment.

Blodget then continues:

As Goldman has observed, with CDOs like the one in question, there is ALWAYS a short side and a long side: The buyers of the CDO knew that someone was going to be betting against them.

This is true, but also misleading, because the central point of the SEC’s suit is that Paulson was represented to ACA as ACA’s friend and coinvestor in the deal, while in fact they were ACA’s enemy, taking the opposite side of the trade.

But let’s back up a bit and look at the Abacus structure from the point of view of ACA and IKB. Simplifying a little, there were basically three parts to it: equity, bonds, and super-seniors. The bonds were the product of the magic of securitization: triple-A-rated instruments which were inherently safe themselves even if they were made up of risky bits and pieces. The investors buying the credit protection on the underlying securities might get paid out here or there, but never in sufficient quantities to endanger the senior cashflows.

Then there was the equity part of the deal: that was the bit where speculation might be going on. An aggressive hedge fund like Paulson would take the long side, betting that it could make a killing as the underlying mortgages avoided default. (Remember that ACA thought Paulson was long the equity tranche.) Some other hedge fund, or perhaps somebody who was already long housing and wanted to hedge that position, would take the opposite side of the trade, protecting themselves against housing defaults or maybe even making a speculative bet that those defaults would be quite numerous.

In any event, the CDO was designed, in the eyes of ACA and IKB, to confine speculative activity to the equity tranche. Equity investors can lose money — or make a lot. And if they lose, then some unknown short will have gained. The bond investors, by contrast, were the boring ones, clipping coupons and sleeping well at night because they didn’t need to worry about losing their principal.

Finally, there was the super-senior tranche, also known in some circles as the “quadruple-A” tranche. This tranche was so safe, and so low-yielding, that it was never even sold: it was, in the parlance of structured finance, “unfunded”. The risk there was entirely theoretical, and was often laid off onto an insurance company which took in a very low premium in order to make sure all the books balanced.

In reality, however, something very different was going on. It’s a little unclear, but it looks very much as though the equity tranche here was unfunded: Paulson certainly didn’t want it, and Goldman never even tried to find someone so bullish on the subprime housing sector that they would buy it. That’s what Blodget is referring to when he says that “Goldman retained an ownership stake in the CDO and lost money on it”. While Goldman was leading ACA to believe that Paulson was speculating on house prices going up, in fact Paulson was betting that they would go down so much that the entire CDO would be wiped out — not just the equity tranche but also the safe triple-A bits. Even the super-safe unfunded super-senior tranches were at risk.

Goldman knew full well what Paulson was seeing, and deliberately kept its client ACA in the dark as to what Paulson’s motivations were, and what the risks were in the structure. While Goldman was trying to persuade the ratings agencies that the bond part of the structure was perfectly safe, it was also listening to Paulson explain why in fact the structure could blow up spectacularly. Neither ACA nor the ratings agencies ever suspected the true reason for the structure’s existence — because Goldman never told them what it was.

Which brings us to the meat of Blodget’s argument:

If Paulson had had control over which securities were selected for the CDO, this would OBVIOUSLY be fraud: Paulson wanted BAD bonds in the CDO, not good ones. The buyers of the CDO, meanwhile, wanted GOOD bonds. That would be a direct conflict of interest that should obviously have been disclosed.

But…

Paulson did NOT have control over which securities were selected for the CDO.

This seems to me to be tantamount to an admission of defeat. If Paulson controlled which securities were selected for the CDO, says Blodget, then that’s not only fraud but it’s OBVIOUSLY fraud.

Blodget then goes on to explain why he thinks that Paulson did not have such control, but he’s pathetically unconvincing.

The firm that DID have control over which securities were selected, ACA, was a highly sophisticated firm that analyzed securities like this for a living. It had FULL CONTROL over which securities were included in the CDO. We know this because, of the 123 bonds that Paulson proposed for the CDO, ACA only included 55 of them. In other words, ACA dinged more than half of the bonds Paulson wanted in the CDO, presumably because they did not meet ACA’s quality hurdle.

Let’s remember here that in the end there were 90 securities in the CDO. Of those 90, it seems that 55 were chosen by Paulson. In other words, more than 60% of the securities in the CDO were picked, essentially, out of a stacked deck. It didn’t matter which securities ACA chose; Paulson had come up with his longlist of 123 securities precisely because all of them were particularly toxic. That’s a material fact which, if ACA had known it, would surely have sufficed to get them to exit the deal entirely.

But it’s actually worse than that: the fact is that Paulson not only proposed 55 of the 90 securities, but also had veto power over the other 35, and signed off on all of them. The timeline is complicated, and stretches from January 9 to February 26 of 2007, with quite a lot of back-and-forth between ACA, Goldman, and Paulson. And in fact it’s not entirely clear that exactly 55 of the final 90 securities were on the initial Paulson longlist. But what is clear is that whenever ACA proposed adding any new securities, Paulson could and did exclude those it didn’t like from the final structure: on February 5, for instance, it deleted eight of ACA’s names from consideration. And in the end it declared itself happy with every single name in the structure.

Given all that, it makes no sense to say that ACA had full control over which securities were included. Really, it was Paulson which had that control: ACA was confined to tinkering at the margins, and only to the degree that Paulson was OK with their alterations. If and when ACA tried to include securities Paulson didn’t like, Paulson simply removed those securities from the deal. So no, ACA did not have full control over anything.

Blodget tries to paint Paulson as merely “influencing” the contents of the CDO structure, in much the same way that PR flacks, the media, or stock screeners might influence decisions. But none of those influences had veto power over the outcome, or were proactively involved in putting the deal together, or, for that matter, paid Goldman Sachs $15 million in order to get exactly what they wanted from the structure. (It’s worth noting here that Alan Dershowitz has said that Paulson “could easily have been charged with conspiracy to defraud” in this matter.)

At this point, Blodget starts just making stuff up.

ACA, furthermore, did not just pick the securities. It BOUGHT THE CDO. ACA’s parent invested more than $900 million in the CDO.

Er, no. ACA’s parent did not “invest” money in the CDO: it did not take $900 million in cash, and give it to Goldman Sachs in return for securities. The parent that Blodget is referring to here is ACA Capital, the insurance company which insured the super-senior tranche of the CDO. From the complaint:

On or about May 31, 2007, ACA Capital sold protection or “wrapped” the $909 million super senior tranche of ABACUS 2007-AC1, meaning that it assumed the credit risk associated with that portion of the capital structure via a CDS in exchange for premium payments of approximately 50 basis points per year.

ACA Capital no more “invested” $900 million in the CDO than an insurance company is investing $1 million if it starts accepting insurance premiums on a $1 million house. Yet Blodget says that ACA “bet almost $1 billion”. He’s wrong. ACA certainly made a very bad decision when it agreed to write this particular policy. But it never took the best part of a billion dollars and wagered it. Maybe it should have done: the discipline of seeing $909 million disappear out the door would certainly have stopped ACA from writing this policy.

Blodget then says something very interesting:

Goldman argues that the Abacus process was the same process used to construct all of these securities, not just at Goldman–in other words, it was a standard industry practice. A transaction sponsor (in this case Paulson), paid for the CDO to be created, the bank created it and sold it, someone went long and someone went short, and everyone knew all of that.

Has Blodget been talking to Goldman? Because there’s nothing in the official Goldman statement along these lines. Probably because it isn’t true. The fact is that standard industry practice was for the transaction sponsor to take the equity tranche, precisely because that helped to align the interests of the sponsor with those of the CDO manager. In fact, I challenge Blodget to come up with a single other CDO where the sponsor was not an equity investor. This was not a standard deal, by any stretch of the imagination.

Blodget concludes with a conditional statement: “the SEC may criminalize this lack of disclosure in hindsight,” he writes, “but if it was a standard industry practice at the time, Goldman likely has a solid defense.” That’s a very big if. And it’s going to be very hard indeed for Goldman to make the case that it was standard industry practice for a speculative short to be given veto power over a CDO manager’s picks, without the CDO manager knowing of the speculator’s position or motives. Henry might be rooting for his Goldman Sachs home team here, but if this is their best defense, it’s looking decidedly rocky.

Comments
21 comments so far

Wow, that was quite the smackdown there.

“In fact, I challenge Blodget to come up with a single other CDO where the sponsor was not an equity investor.”

Are you saying this was the ONLY deal done this way? How do you know this?

Posted by mister_x | Report as abusive

well done,

fact is that of the securities in the portfolio, 99% of them were downgraded by the rating agencies within 10 months of the deal closing. of the choices given by Paulson, ACA had no chance of selecting the ones that were good. they were all garbage — every single one.

goldman sachs was once a highly regarded company — the management at Goldman Sachs let the company and this country down. its all very disgusting.

that Blodget sees it a different way? well, great Henry — he was at ground zero of yet another round of ‘chase bad business in pursuit of $10 million 1-year compensation Wall Street bulls—’ just take your money and go drinking with Fabrice and talk about how screwed you got making millions amid a sleazy business of products that were total crap.

Posted by FrankC123 | Report as abusive

I’m saying I don’t know of any other deal done this way, and I don’t think that Henry does, either. So I don’t think it can be considered “standard industry practice”.

Here’s the $64 question: With Goldman Sachs defending the propriety of the ABACUS deal in the face of the facts cited by the SEC, who in their right mind would ever do a deal with them again?

Posted by MattF | Report as abusive

Blodget has a point. In 2005 and 2006, hedge funds lost billions betting too early against the housing market. I don’t know about bankruptcies, but, by late 2006, it was known throughout the industry that betting against the housing industry was food for the folly

Posted by Storyburncom_is | Report as abusive

Felix, right on with this rebuttal – Blodget is a stooge. You may be frequently wrong, but at least your blog isn’t laughable.

Story, if you’re going to try to respond, please provide one example. I don’t know of any major hedge fund that lost significant money shorting housing, for the reasons Felix described. If you look at http://hf-implode.com/ hedge fund failures kick off with Dillon Read and Bear Stearns due to leveraged long housing market exposure. The short list of pre-2007 failures are almost all due to the obvious sort of fraud (stealing investors funds to buy Bentleys). Felix doesn’t know any counter-examples. Blodget doesn’t point to any examples. You don’t point to any examples. Seems like Felix is probably right.

What I wonder about is the claim that GS lost money on the deal. I find it hard to believe. They knew Paulson was selecting crap. They knew how important it was to distribute the AAA and super-senior risk to idiots. Why would they keep $90m of almost certainly worthless equity when they were only pulling in $15m of fees? By 2007 I’m pretty sure GS knew that the worst mezz subprime was highly likely to exceed 1.5% losses and would be extremely hard to sell. If Fab is so smart, why is he putting $90m at high risk to pull in $15m? It seems more likely to me that GS hedged the $90m or actually took more than $15m in fees. I wouldn’t be surprised if they get egg on their face and have to pull back from that statement.

Posted by najdorf | Report as abusive

Felix, you write:

“It’s a little unclear, but it looks very much as though the equity tranche here was unfunded….”

What?!!!

Are you saying that, unlike Magnetar, Paulson & Company did NOT even put up money to fund the equity tranche (which eventually became worthless)?

How can that be true? How can a CDO be born without an equity investor?

Please explain.

Posted by dedalus | Report as abusive

“ACA was confined to tinkering at the margins, and only to the degree that Paulson was OK with their alterations. If and when ACA tried to include securities Paulson didn’t like, Paulson simply removed those securities from the deal. So no, ACA did not have full control over anything.”

Oh please. ACA was forced to go along with this scam in exactly the same way that the getaway car driver is forced to wait outside the bank with the motor running. They went along with it for the money.

Posted by rootless | Report as abusive

BTW: Martha Stewart was shafted. While Bush’s SEC was wasting time going after her and Mark Cuban and others for borderline nonsense, they did not have time to investigate Madoff or worry about Repo 105 and other slightly more significant things.

Posted by rootless | Report as abusive

http://online.wsj.com/article/SB10001424 052748703574604574499740849179448.html

“They met with bankers at Bear Stearns, Deutsche Bank, Goldman Sachs, and other firms to ask if they would create securities—packages of mortgages called collateralized debt obligations, or CDOs—that Paulson & Co. could wager against.

The investment banks would sell the CDOs to clients who believed the value of the mortgages would hold up. Mr. Paulson would buy CDS insurance on the CDO mortgage investments—a bet that they would fall in value. This way, Mr. Paulson could wager against $1 billion or so of mortgage debt in one fell swoop. “

Posted by rootless | Report as abusive

dedalus, yes, that’s exactly what I’m saying. It seems as though Goldman kept the equity risk in the deal without even bothering to turn it into securities. But it would be nice to see the prospectus.

I wonder if the GS case will go the way of Martha Stewart. She wasn’t found guilty of the original charge but was found guilty of obstruction. If GS remains as arrogant as they are this is just the sort of thing they’ll trip up on – burning papers, deleting e-mails, etc.
An issue for GS in such an investigation is convincing clients that things won’t leak even when there are investigators trouping in and out of the building, sealing rooms, and taking away documents…

Posted by nicfulton | Report as abusive

I know that if I consume certain drugs I risk addiction and other health issues. If I choose to consume them anyway, I am a sophisticated market participant and should be left alone. Right?

Posted by silliness | Report as abusive

Najdorf, you wrote:
It seems more likely to me that GS hedged the $90m or actually took more than $15m in fees
Another possibility is that the people at GS who put this together were benefitting somehow from Paulson directly and that they snowed GS as well.

Posted by JamesPerly | Report as abusive

From the complaint:

“On January 9, 2007, ACA performed an “overlap analysis” and determined that it previously had purchased 62 of the 123 RMBS on Paulson’s list at the same or lower ratings.”

So how was ACA in the dark here, if sourcing assets was not only part of their business, but they had also been invested in half of Paulson’s original selections?

Posted by Mega | Report as abusive

Felix Salmon you wrote:
But it would be nice to see the prospectus.

I think that is an interesting notion. How can anyone “speculate” on who was doing what without reading the freaking prospectus? By just reading the complaint, pitchbook or journalist accounts we are missing a big part of the story.

Posted by wmaustin5 | Report as abusive

Not for nothing, but while working as outside counsel, from about 2000-2007, I frequently observed that Barclays, Credit Suisse and Lehman bankers, often in conjunction with credit risk management and the trading desks, would PACK CDOs and MBS with their own ‘toxic waste’ regularly and sell them off to investors chasing a minor increase of the Treasury yield as Felix described above, with a AAA-rating, in a feeble attempt to keep their balance sheets light.

Posted by Ex-Lehman | Report as abusive

Agree with MattF, re the $64 question: if Goldman defends this, who will do business with them again?

While the church’s problem with molesting children is far, far more serious than defrauding investors could ever be, the problems facing the pope and goldman appear similar in a way:

The pope can defend the church, and make everyone skeptical about joining it. Or it can say, “We did wrong,” and clean out the guilty parties, and restore its reputation, confessing that it lacked oversight and control, and made errors in judgement.

Goldman can do the same, save the legal fees, and be humbled and restore its once sterling reputation.

There’s a downside to either approach goldman takes – defense or admission of guilt, but the stakes are high: the reputation of the institution.

In short, does the church/goldman want to protect the children/investors, or itself?

Again: I don’t mean to be inflammatory, and again, what goldman did can NEVER be compared as nearly as bad as what happened to the children, but the shape of the problem appears the same.

Posted by YoungMC | Report as abusive

“So no, ACA did not have full control over anything.”

Couldn’t ACA simply walked away from the deal? Doesn’t even the SEC complaint say that ACA was selected as manager because they were being more aggressive in the market than other managers?

You are wrong. ACA was in full control and could have decided not to manage the deal.

Posted by TinyOne | Report as abusive

Tinyone, greed makes it easy for the wool to be pulled, so true, which is why regulation is necessary. Clear laws, clear business practice, and clear penalties are needed to curb those who place profit above ethical practice.

Being able to use unethical past practice as a defence at all is rather dubious, don’t you think? Most of us not on Wall Street feel that way. The little guy who loses his pension will agree as well.

Risk of criminal law charges would have kept this from happening in the first place. It’s a house of cards and it is getting shakey. Words like trust, investment, money management and confidence have lost their original meaning and more then one firm is going to lose credibility.

ACA being aggressive doesn’t mean they should be duped by anything or anyone underhanded, and THAT has to be the prime focus. Saying that unethical practice is OK because that’s how it is done at that level and ACA should have known, shouldn’t be an excuse or a defence.

Perhaps there were greedy individuals making kickback in the scheme … who knows? Was the investigation thorough or will there be a lot of missing paper trail? There is so much more to this story that we need to know and hopefully will hear about as regulations tighten and the rats start scattering over other unethical/toxic traders.

Posted by hsvkitty | Report as abusive

I wish the story itself had a “Report as abusive” option and not just the comments because you gave Blodget quite the beat-down!

Posted by gerJohnimo | Report as abusive
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