Felix Salmon

Schwab’s YieldPlus: The denouement

Felix Salmon
Apr 26, 2010 07:47 UTC

The LAT’s Walter Hamilton makes a good point: with all the brouhaha over Goldman Sachs, how come the Charles Schwab news is considered positive for the company? Schwab’s stock rose by 1% after it said it would pay $200 million to settle a class action suit over its YieldPlus fund, which imploded after the company filled it up with toxic mortgage assets.

Schwab did not admit wrongdoing as part of the settlement, but there was certainly no “big boy” defense here: Schwab’s customers thought they were getting a safe short-duration bond fund, not something which could drop dramatically overnight. It’s hard to see how Schwab’s reputation seems to have been barely damaged as a result of this episode, while a much more recondite disclosure issue has wiped billions off Goldman’s capitalization.

There’s a separate lesson here, too: it’s never too late to sell a falling asset. When I last checked in on YieldPlus, a couple of years ago, it was down 24% year-to-date in 2008, and that was bad enough. But if you decided to hold on and pray, you ended up losing much more: YieldPlus finished the year down 35.4%, and then contrived to lose another 10.5% in 2009. I’m not sure how many bond funds were down by double digits in 2009: that’s really quite an achievement.

This is also depressing for those of us who are worried about the duopoly that Pimco and Blackrock have on bond funds. I don’t think it’s healthy that those two giants are so big while everybody else is so small — but at the same time you can’t argue that they’ve managed to perform well, while smaller bond fund managers can turn in absolutely gruesome performances. If I had a large amount of money to devote to fixed income, I think I’d choose Pimco or Blackrock, too.


Liar Liar pants on fire! Schwab should be testifying in front of congress

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The Goldman wars continue

Felix Salmon
Apr 24, 2010 18:24 UTC

There is no scandal whatsoever associated with Goldman Sachs emails released by Senator Levin today. They show Goldman people going about their line of work, doing what Goldman people do, taking long positions, taking short positions, sometimes even taking big short positions. This is what broker-dealers should do if they have decent risk management.

The most interesting bit about them, for me, is the glimpse they give into the Goldman PR machine. Here’s Lucas van Praag, responding to an upcoming story by Jenny Anderson in the NYT:

GS Gives is not in the story. I have agreed to brief Jenny thoroughly on it tomorrow and expect the news to run either Tues or Wed. I think it would be good if you had a 5 min phone call with her on the subject and I’ll liaise with Russell on timing. We will issue the press release to coincide with the publication of her article…

Which is exactly what happened.

On the subject of simultaneous releases, Goldman has countered Levin’s damp-squib emails with its own 12-page document entitled “Goldman Sachs: Risk Management and the Residential Mortgage Market”. I agree with substantially all of the points it makes, and I’ve consistently defended Goldman against populist charges that simply shorting mortgages, or hedging long mortgage positions, is inherently evil. They write:

Goldman Sachs never created mortgage-related products that were designed to fail. It is critical to remember that the decline in value of mortgage-related securities occurred as a result of the broader collapse of the housing market. It was not because there were any deficiencies in the underlying instruments. The instruments performed as would have been expected in those unexpected circumstances.

I think this is true, narrowly. Pretty much all subprime CDOs imploded, and the Abacus deals would have imploded no matter what subprime securities were put into them. In that sense, the careful choice of securities by John Paulson in the Abacus-AC1 deal in particular didn’t make much if any difference to the final outcome. If Goldman was long subprime and then put on a big short-subprime bet in order to hedge its long position, then the dynamics of correlation trading would end up giving them an unexpected profit in the end, since no one expected correlations to go nearly as high as they did.

So I’m with Kevin Drum: let’s not demonize Goldman Sachs for shorting mortgages, or for making money doing so, especially since it isn’t true: while the Goldman mortgage desk did make $476 million in 2007, it lost $1.686 billion in 2008. That’s less than its competitors lost, but it’s still a lot of money.

Finally on Goldman I should mention that I have a piece in the Washington Post today explaining just how bad the SEC charges are for its reputation. The economic historian Brad DeLong has a learned response, saying that Goldman never really had the reputation that I’m claiming it had:

Felix Salmon thus, I think, mistakes the business of Goldman Sachs. The old House of Morgan was an investment bank interested in building long-term relationships. Goldman Sachs is instead about doing deals and having the knowledge, sophistication, and intelligence so that it can do the deals with greater ease than anybody else–but it won’t protect you from itself, and won’t protect you from yourself.

I didn’t really have the pre-war years in mind, of course, but Brad does have a good point, and there were other shops, like Lazard and Rothschilds, which probably had a better reputation in terms of long-term client service than Goldman had in the 1990s. Still, when it came to the big investment banks, Goldman was at the top of the heap: its clients trusted it more than they trusted, say, Bear Stearns or Merrill Lynch. And it’s lost a lot of that reputation now.


Every business makes good and bad decisions, just a matter if they learn and eventually bounces back from it. But what’s important is they move on instead of dwelling and harping on the mistakes.

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The Abacus prospectus

Felix Salmon
Apr 23, 2010 21:44 UTC

I know you’ve been waiting for this one — here you go! Enjoy all 196 pages of it, and let me know what you find: Matthew Goldstein has already found a Goldman conflict of interest on page 71 (page 77 of the PDF) — the “Initial Collateral Security that is a CLO Security” turns out to be another Goldman product. Which is not obvious from the prospectus at all, since it isn’t even named.

ABACUS Offer Document


@mister_x, This whole deal was more than just a bet. Pure and simple, it was a rigged bet from the get-go.
This deck was stacked so the shorts couldn’t lose.

@MichelDelving, Yes, servicers contribute greatly to reference collateral toxicity. Deal makers, traders and servicers are in cahoots. High time investigators get wise to this egregious alliance.

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Goldman’s biggest lie

Felix Salmon
Apr 23, 2010 16:58 UTC

Alea has given us Abacus for Dummies: a very useful quick overview of the structure of the deal. And in doing so, he helps to reveal Goldman’s biggest lie.

Simplifying Alea even further, we have five steps here:

  1. The reference portfolio is put together.
  2. Goldman sells super-senior protection, Paulson buys it.
  3. IKB and ACA sell senior protection, Goldman buys it.
  4. Goldman takes the senior protection that it bought from IKB and ACA, and sells it on to Paulson.
  5. Goldman buys super-senior protection from ACA, through ABN Amro.

From Goldman’s point of view, steps 3 and 4 cancel each other out as a perfect hedge, and it can walk home happily with its fee income. And steps 2 and 5 should do the same thing, but they don’t: in step 2, Goldman sold super-senior protection on the top 50% 55% of the deal, while in step 5 it bought super-senior protection only on the top 45% 50% of the deal. So the hedge was imperfect, Goldman ended up long 5% of the deal, and, in the end, it lost lots of money.

But the fact is that there are two big-picture deals here, not one — and yet they’re very intimately connected.

In the first deal, the super-senior deal, Goldman acts as an intermediary, first selling protection to Paulson, and then buying it from ACA via ABN.

In the second deal, the actual Abacus deal, Goldman creates the Abacus vehicle, which issues securities to IKB and ACA, which are ultimately funded by Paulson taking the other side of the trade.

Now, let’s look at a page from the pitchbook:


The Super Senior tranche here is the one in the first deal; Class A is the notes which were sold to IKB; Classes B, C, and D were sold to ACA; and the First Loss equity tranche at the bottom is the bit of the deal which never existed since, as Alea says, “the deal doesn’t need an equity investor (and doesn’t have one)”. The fact of its nonexistence is conspicuous by its absence: “Not Offered” is by no means the same thing as “Does Not Exist”.

The fact is that the Abacus deal itself didn’t need a super senior investor, either, and didn’t have one. It just needed classes A through D, which were sold to ACA and IKB. The super-senior deal was entirely separate, and had nothing to do with Abacus, although it used the same portfolio of reference securities.

So the question arises: why on earth is the super senior tranche (and the equity tranche, for that matter) even listed in the pitchbook in the first place?

When Goldman refers to ACA as “the overwhelmingly largest investor in the transaction”, it’s clearly referring to the transaction as a whole, including the super-senior deal, rather than just the Abacus part of it. And what’s more, there’s something clean and elegant about the way in which the structure of the deal, as outlined in the pitchbook, goes smoothly all the way from First Loss all the way to 100%.

In theory, as far as I can tell, there’s no reason why the 45-50% tranche — the one that Goldman ended up holding onto and losing $90 million on — should ever have existed either: it, like the equity tranche, could simply never have been offered to anyone. Why didn’t Goldman just move the attachment point for the super senior tranche up from 45% to 50%, so as to match the hedge it bought from ACA via ABN?

After all, Paulson was not buying credit protection on the reference securities as a whole. But that’s how it looks, in the pitchbook. Here’s the pretty picture of the structure, in the same book:


If you’re ACA, looking at this structure, you know that as the deal is being put together, you’re negotiating to insure the Super Senior Amount which exists in this picture as a semi-fictional entity outside the structure and inside a grey dotted box. In other words, while you know it’s not a formal part of the Abacus structure, you also know that it exists.

And in this picture, the First Loss Amount has the same ontological status as the Super Senior Amount: it exists, but only outside the formal confines of the Abacus deal. Since ACA knew full well that the super-senior tranche existed — after all, it was negotiating to insure it — there’s no reason why it should have doubted that the equity tranche existed as well, just like it did in Magnetar trades with which it was familiar.

Here’s Goldman Sachs, in its letter to the SEC:

The fact that ACA may have perceived Paulson to be an equity investor is of no moment. As a threshold matter, the interests of an equity investor would not necessarily be aligned with those of ACA or other noteholders, and holders of equity may also hold other long or short positions that offset or exceed their equity exposure. Indeed, Laura Schwartz of ACA understood this from her work on a transaction that closed in December 2006 in which Magnetar, a hedge fund that bought equity and took short positions in mezzanine-level debt, participated. (See GS MBS-E-007992234 (“Magnetar-like equity investor”).)

This is, I think, inadvertently damning to Goldman’s case. It’s true that in the Magnetar deals the entity which was long the equity tranche was also short the debt. But at the same time, it’s also true that in the Magnetar deals there was no question that the equity tranche existed. So if ACA’s Schwartz was thinking in terms of the Magnetar deal which closed just before the Abacus deal started being negotiated, then it’s quite understandable that she believed in the existence of an equity tranche in this deal, too. And Goldman never did anything to disabuse her of that belief.

The clear message of the pitchbook is that this synthetic CDO was put together to mimic a cash CDO, which has to have all of its tranches spoken and accounted for. You can’t have a cash CDO without an equity tranche. Remember that if the only point of the Abacus deal was to create the Abacus securities, then there wouldn’t have been a super-senior tranche at all, and ACA would not have been the largest investor in the transaction.

Here, then, is arguably Goldman’s biggest lie of omission: it never told ACA that the equity tranche didn’t exist. If it was being a true and honest broker, it should have done. End of story.


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How important is IKB’s sophistication?

Felix Salmon
Apr 23, 2010 15:24 UTC

John Carney has a defense of Goldman Sachs up at the Daily Beast, based on the not-novel-at-all idea that the investors in the Abacus deal were sophisticated.

A document exclusively obtained by the Daily Beast demonstrates (view them here) that just a few months before it invested in the derivatives at the center of the SEC’s case, the German bank was touting its prowess as a sophisticated investor in those derivatives.

But no one is asserting that IKB, or any other party to this transaction, wasn’t sophisticated. The word never appears in the SEC’s complaint against Goldman, for instance, and I have yet to see a Goldman critic latch onto the idea that IKB was some kind of naive widow or orphan, who was bamboozled by all these CDOs and CDSs and whatnot.

On the other hand, Goldman itself loves hammering home the idea that the investors in the deal were sophisticated. Its first big public statement on the deal uses the word twice, its second uses the word three times, and its two letters to the SEC use the word no fewer than twenty-three times between them.

Here, for example, is a chunk of the first letter:


The problem with all of this banging away about IKB’s sophistication is that it looks very much like protesting far too much. The SEC doesn’t need to show that IKB was unsophisticated, it just needs to show that Goldman didn’t make the disclosures required by the law.

Carney, a lawyer by training, tries to explain why he thinks this is such a big issue, but he’s far from convincing:

The sophistication of IKB will be an important issue in the Goldman case. In general, the securities laws of the United States assume that sophisticated investors can fend for themselves. That’s exactly why hedge funds—which only accept money from so-called “accredited investors”—are largely free from regulation. The focus of our securities laws is the protection of ordinary investors and market integrity.

I’m sure that a class on the history of US securities laws would be fascinated by their treatment “in general” of sophisticated investors, and by their overall focus in terms of investor protection. But the point at question here is whether Goldman failed to make necessary disclosures, simple as that. To be sure, the level of disclosure necessary changes according to the sophistication of the investor in question, and qualified institutional investors in the 144a market are much more sophisticated than ordinary individual investors. But the level of disclosure never goes away entirely, and in fact the statute in question is drawn very broadly:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

There’s nothing there about “any unsophisticated person”: if Goldman’s omission of Paulson’s role in its statements made what it was saying misleading, or if it was deceitful, then that’s it, case closed. IKB may or may not have been a sophisticated investor, but I don’t think that status matters nearly as much as Goldman and Carney think and/or hope that it does.


Getting in on a deal with Goldman-Sachs is like sitting at a poker table:

If you can’t spot the obvious patsy within the first 5 minutes then YOU ARE THE PATSY!

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USAA’s anti-finreg campaign

Felix Salmon
Apr 23, 2010 06:08 UTC

The Euro-style bancassurance business model has never really taken off in the U.S., but there’s one big exception: USAA, the financial services company for military families. It’s an insurer which owns an excellent bank, and that structure — which is unusual if not unique in this country — puts it into conflict with the Volcker rule. Insurers, by their nature, invest in diversified portfolios of stocks and bonds, which is an activity which looks very much like prop trading if you’re a bank. Since the Volcker rule would ban prop trading at banks, USAA is worried that it will fall foul of it.

But I’m not a fan of USAA’s reaction to this legislative threat. The CEO has sent out an alarmist message to all of USAA’s members, which is very light on specifics and which doesn’t even mention the word “insurance”.  I doubt that one member in 100 understands what he’s talking about when he writes that “the current Senate bill would disproportionally impact USAA because we are a unique and fully integrated association”. A follow-up blog entry isn’t much clearer.

The result is predictable, and can be seen in the comments at USAA.com:

It looks as though the government is taking control of all of us. Our freedom is going down the drain quickly.

I am for less government control. It is not good and nothing good will become of it. Let’s pray for deliverance from this evil.

The fact is that this entire issue could probably be addressed pretty easily by tweaking USAA’s corporate structure and making the insurer a different company to the bank. They could still cross-sell each others’ products, they just wouldn’t be liable for each others’ losses. It’s the sort of thing which makes quite a bit of sense even without the Volcker rule.

But instead of being constructive and helpful, USAA is being opaque and obstructive. I would have hoped for better from them.


Institutions – you seem to have animosity towards USAA and its CEO and AIF. Why so, what is your agenda? I appreciate the lower premiums, dividends, and excellent customer service. I’m concerned about reforms that are necessary due to others bad deeds now impacting a company that had nothing to do with it, and its customers who haven’t either. Prior to being in USAA, I had higher insurance premiums and higher costs to conduct banking transactions less conveniently. USAA has very much helped with my family finances and is greatly appreciated. And I believe people are getting very sensitive about the CEO asking for member help in pointing out our concerns about one provision in this bill and how it impacts the membership. It is not reactionary or political, we are simply stating our concern about proposed legislation and its impacts and hope that this would be addressed in a manner that addresses the necessary reform without the negative impacts of one provision.

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Felix Salmon
Apr 22, 2010 19:04 UTC

Obama’s speech as delivered — White House

TIME was writing about “banksters” in 1933 — Time

The change in composition of US exports to China over the past 10 years — CFR

Holy crap, Greek 2-yr yields over 10% — FT

“Ben Stein is not a BusinessWeek or Bloomberg employee. This was a one-time editorial contribution.” — Ritholtz

If we want diversity on the Supreme Court, maybe Obama should nominate someone who knows what a text message is — Lawyers USA

Fabrice Tourre To Testify To Senate On April 27 — TBI

Pretty color chart of US income taxes over time — Weathersealed

The new $100 bill has its own twitter account! @uscurrency, if you want to follow. Or watch the hilarious video — New Money

Yikes is right. But also, weirdly compelling — Yike Bike

“No longer can Goldman win mandates simply because it is Goldman. In fact, it may lose many for that very reason.” — TED

Simon van Norden has a good upsum of the SEC OIG report on Allen Stanford — Worthwhile Canadian Initiative


Will Fabrice Tourre demand to be addressed as the “fabulous Fab”? – No One Serious

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Has the SEC changed the culture of Wall Street?

Felix Salmon
Apr 22, 2010 17:06 UTC

Michael Lewis addresses the fixed-income group at Goldman Sachs:

The masses will be curious to know, for instance, how you became blinded to the very simple difference between right and wrong. The more moralistic among them will ask the question mainly to fuel their own outrage; the more tactical will ask the question because they sense that the financial system doesn’t function unless you have the incentive to think in these terms — and you clearly do not.

He concludes:

There was a time when a Wall Street bond trader could work with a short seller to create a bond to fail, trick and bribe the ratings companies into blessing the bond, then sell the bond to a slow-witted German without having to worry if anyone would ever know, or care, what he’d just done.

That just changed.

This, it would seem, is the power of the SEC: by filing its complaint in public rather than seeking to settle in private, it might have significantly changed the culture of Wall Street in a way that Barney Frank and Chris Dodd and Paul Volcker and of course Barack Obama have been trying and failing to do ever since they took office.

Certainly the SEC seems to have changed the attitude of Michael Lewis towards these instruments: there was no hint of “tricks and bribes” in his book on this subject. I wonder whether he’ll add some kind of afterword for the paperback edition.


Everyone forgets capitalism is about rewarding the greedy. It should not come as a surprise this sometimes produces crooks. Democracy is based upon such people existing and testing the limits. Through time and memorial there has always been a lag before a Democratic movement puts those Crooks away. Many a time, the crooks are long gone before the broom comes in. Its the capitalist way.

We are in the process of seeing some Crooks put away but DO NOT BE FOOLED. Crooks will continue to exist. You just won’t notice until the next crisis.

Wall Street/Finance is and always will be the home of crooks because that’s where the money is and ALWAYS WILL BE.

The people only have themselves to blame for the crooks. Every crook out there knows they just have to wait things out before the public loses interest in this.

If people were really serious they would be talking about dismantling Wall Street rather than reforming it.

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Paulson’s letter appears, but not in the press

Felix Salmon
Apr 22, 2010 16:04 UTC

When the WSJ and FT wrote articles about Paulson’s letter to investors yesterday, I was cross: I wanted to see it, and they neither posted it nor linked to it.* Since then, it has appeared on both Zero Hedge and the Big Picture; it can be downloaded directly here.

The weird thing is that since the letter was made public, I haven’t been able to find a single mainstream media outlet which has linked to it. (Do let me know if you find any, I’ll happily name them here.) The WSJ even put up a blog entry with the headline “Read John Paulson’s Take on the Goldman CDO Case”; the timestamp I have on that is 10:25am Eastern time, which is a good three hours after the 7:33am timestamp on the Zero Hedge posting. Yet there’s still not a single link in that post, even today.

Yesterday, I emailed the WSJ’s Greg Zuckerman, who literally wrote the book on Paulson and who was bylined on that paper’s story. Hypothetically speaking, I asked, if you obtained a letter from a fund manager on the condition that it not be posted online, would agreeing to that condition prevent you from posting the letter if you got it from other sources? He never replied.

It would be pretty bad, I think, if fund managers could prevent their letters from appearing in places like the WSJ by the simple expedient of sending those outlets their letters. It’s all well and good giving someone exclusive access to something you want them to see, but it’s another thing entirely giving them access in order to prevent them from letting anybody else see it.

But this case seems to be worse than that. For one thing, any agreement made by the WSJ reporter who first obtained the letter seems to have bound not only that reporter, but the entire newsroom. And more gruesomely, the agreement seems to have gone well past the question of whether the WSJ can post the letter: it seems to include the question of whether the WSJ can even link to a copy of the letter posted elsewhere. And judging by the lack of links at the NYT and the FT, similar agreements would seem to have been entered into there. Otherwise, why wouldn’t they link to a letter which constitutes a key development in the SEC/Goldman case?

Now it’s possible, I suppose, that all the hundreds of journalists at these outlets have been so busy reporting the story that they simply didn’t have time to notice that the letter had actually appeared in public. But I doubt it: the blogs which published it get a lot of traffic. It’s also possible that they’re not being censored by an agreement they made with Paulson, but that they’re simply self-censoring, in the knowledge that if they link to the letter, Paulson will be much less likely to talk to them in future.

In any case, it’s pretty obvious that if you want to stay on top of all the developments in this case, you’re going to have to start reading blogs: the big financial newspapers won’t give you the whole story.

Oh, and one question about the letter itself: what do you suppose Paulson means when he writes this?

After ABACUS AC-1 was structured, tranched, rated, and issued, Paulson purchased CDS protection on the “AAA” tranches from Goldman Sachs, our counterparty.

The triple-A tranches of the Abacus deal added up to only $150 million or so; Paulson’s profit on it, meanwhile, was the best part of $1 billion. And in any case, wasn’t Paulson buying CDS protection on the underlying reference securities, rather than on Abacus itself or its tranches? Very odd.

*Update: FT Alphaville did post the contents of the letter yesterday. Good for them. Apologies for missing it. But after they did so, the WSJ can’t possibly still have felt bound by any agreements. Can they?


Then again, the WSJ just truncated its blogs RSS feeds. Maybe it just has zero interest in being part of the online conversation.

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