BREAKINGVIEWS – How Goldman Sachs fell out with the SEC
— The author is a Reuters Breakingviews columnist. The opinions expressed are his own —
By Nicholas Dunbar
LONDON, April 20 (Reuters Breakingviews) – In December 2000 I received an email from the Goldman Sachs press office in New York, nominating the firm for Risk magazine’s “Risk Manager of the Year” award. Central to the pitch was how the Wall Street bank had run a boot camp for its supervisors at the U.S. Securities and Exchange Commission, training them in concepts like value-at-risk and derivatives hedging.
It was a win-win move, both sides told me. Goldman ensured its regulator was up to date with financial innovation and earned brownie points for its efforts. By offering a “light-touch” regime for its charges, the SEC hoped to prevent the securities firms under its purview from basing their fast-growing over-the-counter derivatives operations in London.
I was technical editor of Risk at the time and I remember feeling a sense of wonder at the regulator’s willingness to take lessons from one of the firms it policed. But I also accepted that Goldman was motivated by good citizenship. If derivatives were coming to Wall Street, why shouldn’t Wall Street’s best firm join forces with its watchdog to ensure that everything was done properly? The Risk Manager of the Year Award for 2001 went to…Goldman Sachs.
But the SEC did not realise how innovations like the credit default swap would later transform the markets it regulated. Its mission of ensuring market fairness was to collide head-on with new business imperatives driven by the “derivativisation” of the credit market.
Like many, the SEC was anchored in an age-old understanding of markets where securities are originated, bought and sold. Derivatives linked to securities fundamentally changed this cosy universe by creating a synthetic market, a world of securities that imitate and subvert reality.
The business of chopping and bundling U.S. mortgages into bonds, and then into collateralised debt obligations (CDOs), was already a weakly regulated market riddled with conflicts. But it was nevertheless a cash market. The fact that every such bond uniquely connected investors to mortgage borrowers constrained the market’s growth, in turn curbing the potential for damage.
During 2004 and 2005, the industry found a way of expanding the market to cater to growing investor demand — “synthetic” securitisation. It was a critical evolution. Whereas a standard CDO was a package of real mortgage securities that were themselves composed of real mortgages, a synthetic CDO was really just a bet between counterparties.
When synthetic CDOs were first invented, the short position — effectively a form of credit insurance — was typically taken by commercial banks seeking to hedge corporate loan portfolios. Regulators applauded this innovation as making banks safer.
But this was not the case with synthetic subprime CDOs. The short position was not typically taken by investors with an existing long position in subprime mortgages who were seeking to hedge against losses they in fact hoped to avoid. It was taken by speculative investors actively betting on losses materialising.
Goldman, like other banks, operated in all segments of the market — packaging home loans into mortgage-backed securities and putting these into CDOs, as well as trading synthetic CDOs.
It’s not clear that investors on the long side of these synthetic trades really understood what was different about a synthetic subprime CDO. In a cash CDO, investor confidence comes from the knowledge that almost everyone else has skin in the game: the bank arranging the deal, and especially the CDO equity investor who takes the most risk. With a synthetic CDO, it’s a hall of mirrors. Not only are the underlying assets matched with short positions, but each slice of the CDO can also be shorted.
The key issue with Goldman is timing. After first experiencing losses in subprime in December 2006, the bank started hedging its exposure, and by March 2007 (part of the bank’s second quarter), the bank began shutting down its mortgage and cash CDO origination business, at the cost of several billion dollars.
However, Goldman could still make money in subprime by matching investment clients via synthetic CDOs, with the difference being that the driving force was clients seeking to profit from impending meltdown. This is the moment that Fabrice Tourre, a Goldman vice-president, created the now infamous Abacus deal with hedge fund whizz John Paulson. And the timing may help explain why the SEC’s fury is so apparent in the complaint filed last week against Tourre and Goldman.
Goldman’s defence against the SEC suggests that investors like IKB were fully aware of its subtle transformation from cash CDO underwriter to derivative intermediary, and were asking Goldman for new investment opportunities. By trading default swaps to build Abacus, Goldman ended up losing money. But the SEC seems to be arguing that in a world that had moved away from traditional underwriting, arrangers needed to be much sharper about the explanations they gave investors about synthetic CDOs.
The SEC may have other reasons for feeling that Goldman had forgotten what the regulator expected of a firm at the top of the Wall Street hierarchy. When Goldman taught SEC staff about derivatives and risk management almost a decade ago, there was an implicit pledge that it would keep the SEC educated about market developments. But it was not until Bear Stearns bailed out two hedge funds in July 2007 that the regulator really learned about the transformation of the subprime CDO market and the explosion of synthetic structures, according to people familiar with the watchdog.
Goldman may protest that it had no obligation to share tentative risk management insights with its regulator. But the bank shouldn’t be surprised that the SEC is now rubbing the firm’s nose in the mess its bankers thought they were so clever in avoiding.
Nicholas Dunbar’s book, ‘The Devil’s Derivatives’ will be published later this year.
CDS underwriters 20067/07 http://r.reuters.com/tyg48j http://r.reuters.com/vak48j
The case against Goldman Sachs http://graphics.thomsonreuters.com/10/04/US_GSAB0410.gif
(Editing by Chris Hughes and David Evans)