Goldman Sachs Hate Week

April 28, 2010

by Chidem Kurdas

George Orwell’s classic novel, Nineteen Eighty-Four, describes a political ceremony called the Two Minute Hate, featuring Public Enemy Number One, a reprobate named Goldstein. People attend official rituals to work up a frenzy of hatred against Goldstein and love for their protector, Big Brother, or B-B.

To quote Orwell, at the climax of the Two Minute Hate, “the entire group of people broke into a deep, slow, rhythmical chant of “B-B! … B-B! …B-B!” – over and over again…” This daily rite is supplemented with elaborately prepared Hate Weeks.

In the past week there has been a similar fury in the media against Goldman Sachs, with herds of pundits all expressing their horror of the derivatives deal that is at the center of the Securities and Exchange Commission’s fraud case against the investment bank. This campaign starts with chants of “Social Benefit! Social Benefit! Social Benefit!” and climaxes with “Regulation! Regulation! Regulation!” Thus a mythical regulator stands in for B-B.

To pick one example out of many, George Soros writes that “Whether or not Goldman is guilty, the transaction in question clearly had no social benefit.” Mr. Soros is wise to hedge his bet about Goldman’s guilt—the SEC complaint contains holes the size of the real estate bubble. But was the mortgage-based collateralized debt obligation really devoid of social value?

“This synthetic collateralized debt obligation did not finance the ownership of any additional homes or allocate capital more efficiently; it merely swelled the volume of mortgage-backed securities that lost value when the housing bubble burst,” Mr. Soros charges.

As a synthetic debt obligation, the investment vehicle did not buy mortgages but rather a kind of insurance, credit default swaps, for a reference portfolio of mortgage-backed bonds. So the question really is about credit default swaps. Do these derivative instruments have social value? Once you look at it that way, it is obvious that they do. Like any financial instrument, they act as signals.

In this instance, CDS signaled that the property bubble was deflating. The hedge fund, Paulson & Co., whose role in the deal the SEC accuses Goldman of  concealing, used CDS to bet against subprime mortgage-backed securities. So Paulson & Co. played the role that short sellers of over-priced shares played in the 1999 stock bubble.

Short selling is a market mechanism for limiting bubbles. To argue that the Goldman deal had no social use is in effect to argue that the bubble should have continued, become bigger and done more damage.

The real issue about CDS is not whether they are useful but how to make them more transparent and reduce the risk that writers of swaps might default. Because swaps are private contracts, information about them is hard to get, though CDS indexes developed in recent years act as indicators.  Central clearinghouses are the solution to the problem.

Moving credit default swaps to centralized clearinghouses has already begun and exchanges have been working on it for some time. Regulatory bills now in Congress mandate this and the further step of exchange trading of CDS. To some extent it will happen regardless of regulation because the historic trend is to standardize financial instruments and trade them.  In any event, none of these issues justify the virulent condemnations.

In the Orwellian dystopia, Goldstein was hated and despised by everybody yet remained a huge threat—according to official propaganda. He was essential as an easy target for channeling popular rage that otherwise might turn against the ghastly regime itself.

In our predicament, the coordinated attack on Goldman is used  to push Republicans into a corner politically and get support for more aggressive financial regulation. But it may also have a broader aim—perhaps to take folks’ minds off matters like the role of public institutions such as Fannie Mae in creating the housing bubble and the current gigantic expansion of government in all directions.

65 Responses to “Goldman Sachs Hate Week”

  1. Daniel Kuehn Says:

    Really? I’ve been impressed with the extent to which commentators are pointing out the shakiness of the Goldman charges.

    You don’t have an Orwellian dystopia simply because charges that can’t be held up in court are brought against someone. That sort of thing happens. Overzealous prosecutors are part of life. You have an Orwellian dystopia when there is no dissent, and when everyone chimes in to the chorus, and when the dissenters get ostracized. That’s clearly not happening here – not even close. You have an overzealous prosecution effort that is getting some people worked up and some other people poking holes in the case… and everyone is actually sitting down and discussing it.

    I know you guys would love to recast Obama as Big Brother and conflate every difference of opinion into propaganda, but I think you need to reread 1984 if you think it has anything to do with this.

  2. Tom Dougherty Says:

    “People attend official rituals to work up a frenzy of hatred against Goldstein and love for their protector, Big Brother, or B-B.”

    http://blogs.reuters.com/mediafile/2010/04/28/anyway-you-look-at-it-its-still-shitty/

    Oh, and Fannie Mae? That went down the memory hole.

  3. Pete Canning Says:

    CDS and Synthetic CDOs are not the same thing. It would be hard to argue they act as insurance.

    Beyond that, as I mentioned in a previous post,

    “Ultimately, had there been MORE synthetic CDOs the crisis could have been much more muted. The issuance of synthetic CDOs allowed smart money to express a negative view on an over-valued asset. Buyers of the synthetic CDOs were able to get exposure to the market there rather than buying non-synthetic securities.

    This increased supply of mortgage market exposure would serve to decrease the value of those securities. This would have decreased the incentive to create non-synthetic mortgage securities and ultimately reduce the ability of mortgage brokers to push crappy mortgages onto the market.”

    As to Dan’s point, the government is a criminal organization that engages in mass theft and murder. Chidem was being charitable.

  4. Gene Callahan Says:

    “So Paulson & Co. played the role that short sellers of over-priced shares played in the 1999 stock bubble.”

    Well, except that Paulson was also packaging and selling the CDOs they were insuring. So they were in the position of a company deliberately selling passengers tickets on planes they knew were rickety, and then taking out life insurance on those passengers.

    And the salespeople at Goldman knew they were unloading crap to their customers.

  5. Gene Callahan Says:

    “In any event, none of these issues justify the virulent condemnations.”

    No, I’ve been around people like these sales people off and on for 15 years. They are scum who will sell a pension fund for firemen or teachers making 1/20 of their salary absolutely anything they think they can get away with selling them.

  6. Richard Shannon Says:

    While it is probably true that complex financial products such as these can have “social value”, if by that you mean they can play a role in making markets more efficient. But you miss the point of the whole case against Goldman Sachs. They are not being maligned for selling the products themselves, but for purposefully allowing one client to stack the portfolio in his favor, while peddling the opposite side of the trade to their very own clients! Now, please explain to me the “social value” in that.

  7. Pete Canning Says:

    Gene, the packager, ACA was the largest long player in the transaction and lost the most money. Paulson was thought to be ignorant and inexperienced in the mortgage market. For there to be a long there must be a short. Thus, it makes sense that they should both have input on the securities despite their opposing views.

    These products were ultimately sold to experienced professional investors. While you might find sales people to be “scum,” there was a demand for mortgages in the market. These people served the demand. These synthetic instruments, certainly not “designed” to fail in this case unless the packager, ACA wished to lose hundreds of millions, filled that demand. If a pension fund manager could not determine these were “crap” they are the one to blame (they make plenty too).

    Your characterization of what Paulson, Goldman, and ACA’s role in this transaction is flat out wrong. You don’t understand even the agreed upon facts of the case.

  8. Tom Dougherty Says:

    Gene writes, “Well, except that Paulson was also packaging and selling the CDOs they were insuring. So they were in the position of a company deliberately selling passengers tickets on planes they knew were rickety, and then taking out life insurance on those passengers.”

    You might want to read this from Sebastian Mallaby, “Next, the SEC complains that Paulson had a hand in designing the securities, maximizing the chances that they would blow up. He did the equivalent of building a timber house with a large fireplace and a blocked chimney, then buying fire insurance on the structure. Shocking though this may sound, it is another non-scandal. An investor who wants to bet against a bundle of mortgages is entitled to suggest what should go into the bundle. The buyer is equally entitled to make counter-suggestions. As the SEC’s complaint states clearly, the lead buyer in this deal, a boutique called ACA that specialized in mortgage securities, did precisely that.”

    Gene writes, “And the salespeople at Goldman knew they were unloading crap to their customers.”

    And this from Richard Epstein, “Indeed paragraph 30 of the SEC complaint states that ACA rejected some of the subprime reference positions that Paulson had proposed for inclusion in the mortgage reference pool and substituted others in its place. As such, the SEC claim’s of Goldman deception looks utterly groundless given ACA’s active role.”

    And this, “If Goldman committed fraud, then so did Paulson, who was mysteriously not charged. Even more notably, the SEC complaint makes no mention that Goldman actually took the same side of the deal as ACA, which puts it in the unique position of defrauding itself.”

    http://www.washingtonpost.com/wp-dyn/content/article/2010/04/20/AR2010042003528.html?wpisrc=nl_pmopinions

    http://www.forbes.com/2010/04/26/goldman-sachs-sec-regulation-opinions-columnists-richard-a-epstein.html


  9. “And the salespeople at Goldman knew they were unloading crap to their customers.”

    The customers knew what they were getting (some securities were tossed out of the package as inferior) and didn’t think it was crap. This is the nature of securities trading, no? For every buyer there’s a seller.


  10. “They are not being maligned for selling the products themselves, but for purposefully allowing one client to stack the portfolio in his favor, while peddling the opposite side of the trade to their very own clients! Now, please explain to me the “social value” in that.”

    The were peddling what they were asked to peddle to sophisticated parties who knew what they were buying and disagreed with their counterparties’ estimate of the future. Why does that not produce social value?

  11. Gene Callahan Says:

    “The were peddling what they were asked to peddle to sophisticated parties who knew what they were buying and disagreed with their counterparties’ estimate of the future.”

    A) Goldman deliberately hid Paulson’s involvement; if they hadn’t, no one would have bought this junk; and
    2) The buyers were almost NEVER sophisticated investors who knew what they were buying; the modus operandi is to sell these things to people like “Iowa hog truckers pension fund” manager, and bedazzle him with high powered suits with incomprehensible models and really expensive presentations, combined with assurances that “our modellers have assured us you are protected here.” (In this case, even while they knew the person who had packaged the securities was so sure they would collapse that he took out a billion dollars of insurance betting they would do so!)


  12. Chidem,

    Interestingly, there is at least one place on earth where a true “2 minutes hate” type ceremony takes place once a year– North Korea

    I also wrote a review of a recent independent documentary film, The Red Chapel, which has a scene in which the film’s producers and two stars inadvertently end up participating in this annual hate fest and even march in the hate parade, which is captured on NoKo state television! It’s hilarious and tragic, all at the same time.

    My review is here: http://www.economicpolicyjournal.com/2010/04/red-chapel-meeting-of-absurd.html


  13. “Goldman deliberately hid Paulson’s involvement; if they hadn’t, no one would have bought this junk;”

    The second half of this is by no means self-evident. What’s the basis for the claim?

    ACA and IKB were naifs?

  14. Tom Dougherty Says:

    Gene writes, “The buyers were almost NEVER sophisticated investors who knew what they were buying….”

    Gene you should really read the links I provided above. Mallaby: “It was their [the buyer's] job to evaluate the Goldman offer and make up their own minds. One of the big losers in the deal was IKB, a German bank with a big business in mortgages. We’re not talking mom and pop.” So much for the buyers not being sophisticated investors.

    Gene writes, “Goldman deliberately hid Paulson’s involvement; if they hadn’t, no one would have bought this junk….”

    Mallaby, “What the complaint does show is that ACA believed Paulson was a buyer, not a seller; and the really intriguing mystery is how ACA could have been so dumb. As the deal was taking shape, ACA and Paulson met repeatedly. If ACA had any doubt as to Paulson’s intentions, surely it could have asked him a straight question rather than relying on alleged hints from Goldman. Throughout the negotiations, Paulson kept proposing notoriously low-quality mortgages for the bundle and vetoing high-quality ones. It should have been obvious to ACA that he meant to bet that they would go down.”

  15. chidemkurdas Says:

    The comments here are so good that I don’t know if I can add much.

    But I’ll address Daniel’s objection above. He wrote: “You don’t have an Orwellian dystopia simply because charges that can’t be held up in court are brought against someone. That sort of thing happens.” It’s not just the SEC complaint that I was referring to in the Orwellian metaphor but rather the vast panoply of condemnation all around. Notice that Soros (whom I quoted) starts by saying that whether or not Goldman is guilty this is reprehensible–so the legal issue is an opening but the attacks are mostly about the “morality” of the deal. And Soros is genteel compared to hundreds of others making similar points.


  16. The question I would ask is not what, but why?

    Why Goldman and why now?

    Goldman employees gave more money to Obama than any other firm. The Obama administration is filled with ex-Goldman employees.

  17. chidemkurdas Says:

    Taylor, thanks for pointing out North Korea’s “2 minutes hate” ceremony. It is frightful. I had not heard about it before but of course it fits everything else we know about that regime.

  18. Gene Callahan Says:

    Tom writes: ‘“It was their [the buyer's] job to evaluate the Goldman offer and make up their own minds. One of the big losers in the deal was IKB, a German bank with a big business in mortgages. We’re not talking mom and pop.” So much for the buyers not being sophisticated investors.’

    Ah, so big and involved in a market equals sophisticated, hey? Fortunately, I worked in the finance industry for a number of years and still have many contacts in it, so on seeing this post I called one up, to actually find out if IKB is sophisticated in MBS market, prepared to eat crow if I was wrong. What I asked my contact was, “Compared to Goldman, is IKB a sophisticated buyer in this market — would they have people at the table capable of understanding Goldman’s models?”

    His reply: “No way.”

    So much for that sophisticated buyer.

  19. chidemkurdas Says:

    Great question,Jerry. I don’t know the full answer, of course, but one thing stands out about Goldman: it has been a very successful investment bank. After all this, it might be less successful.

    Or maybe somebody decided that Goldman is the best target for attacks because its name starts with, well, “Gold”.

  20. Joe Says:

    Awe, those poor, poor, multi-millionaire executives of Goldman Sachs. Maybe they are afraid they are going to get the Enron treatment? As to the ” current gigantic expansion of government in all directions.”, where were you when Bush took that $246 Billion surplus and turned it into a $2 trillion deficit?


  21. Has IKB sued? If not, why not? Does it regard itself as a victim of fraud?

  22. chidemkurdas Says:

    Gene, you raise a major issue. There are several aspects to it. For one thing, almost no buyer understands how exactly something is produced. I do not understand how microchips work but I’ve done reasonably well buying computers for myself. Buyers of financial instruments are in the same situation I am with respect to computers. They are supposed to pay attention to what they’re doing, even if they don’t understand all the details. Moreover, the German bank was capable of hiring expert help if it wanted to learn more about CDOs.

  23. chidemkurdas Says:

    Sheldon, my impression is that IKB was not doing anything about this & had written off its loss. The impetus for the SEC action certainly did not come from IKB, notwithstanding the pretense that the SEC is trying to protect investors. Given the legal & PR circus, IKB may go to court in the future to piggyback on the SEC case.

  24. Roger Koppl Says:

    Jerry asks the real question. Perhaps Goldman has buyer’s remorse. It does seem that the case against them is weak, however, so you start to wonder if it’s just political theater. The coming “reforms” are sure to bolster existing moneyed interests, so it’s likely gonna be good for Goldman Sachs. (The discretionary regulation we’re likely to get favors the politically powerful.) I don’t know how paranoid to be, but it does help the bootleggers when Baptists blast demon rum.


  25. Epstein suggests that perhaps the SEC wants us to forget how it failed to go after Madoff even when the entire case was dropped in its lap. Maybe it was looking for some flashy fraudy looking thing to make a big deal over.

  26. Efinancial Says:

    Koppl’s answer to O’Driscoll’s question is right on the money. This is political theater at its best (worst?). The SEC case has nothing to do with what caused the financial crisis and everything to do with passage of the “reform” legislation. Legislation which couldn’t be more favorable to Goldman and crony capitalists unless it was written by Hank Paulsen.

  27. Pete Canning Says:

    “A) Goldman deliberately hid Paulson’s involvement; if they hadn’t, no one would have bought this junk;”

    Paulson sat down with ACA multiple times. They were in the business of doing nothing but these type of deals. If they could not figure it out, then they were morons and got what they deserved. The largest long investor, ACA had final say in all the securities. ACA LOST THE MOST, they were the ones who picked the securities. Goldman was also long, and lost money.

    Gene, you simply have no idea what happened, and no idea what your are talking about.

  28. John Says:

    I agree, and during the hearings no one would dare say what everyone was already thinking… hey, you morons on the investigative committee are the ones that deregulated virtually all oversite in this market in 2000. I wanted Levin to admit ethics violations and admit blame!! Dong!!

  29. Phoebe Says:

    Chidem Kurdas shows himself quite willing to take on a propaganda-spewing mode. OMG, people are making accusations I don’t agree with – ‘1984’ IS HERE!! This undermines his position.

  30. chidemkurdas Says:

    Phoebe, why would you assume that I’m a “he”?!

  31. Gene Callahan Says:

    Pete, Michael Lewis notes in Bloomberg that goldman’s contention that they lost money on the deal is almost certainly a lie. I think you simply have no idea what you are talking about!

    Lewis also notes the idea of “morality” operating at Goldman was, if it’s not strictly illegal, and it makes money, it’s meritorious, a “morality” you yourself have expressed above (if they’re too dumb to detect you’re lying to them, they DESERVE to lose money). You wouldn’t happen to sell securities for a large Wall Street firm yourself, would you, Pete?

  32. chidemkurdas Says:

    Gene– They could not sell all the notes on the deal and ended up holding the stuff. That’s almost certainly correct. The structured transaction did not have an equity tranche to take the first loss; without the equity the debt is very exposed and hard to sell. By then — 2007 — nobody would buy the equity because real estate was already sliding. Not being able to unload left the loss on Goldman. That’s the particular deal. What happened elsewhere is another question.

  33. chidemkurdas Says:

    Now, about the “morality”, I’m not sure what you mean. Here is this big German bank, it wants to get returns on US mortgages without actually buying any. That’s what this deal does. As best I understand, Goldman is not their investment adviser but the broker of the deal. At that time there are still plenty of people who expect such investments to do well, even as others bet on a collapse. Every trade always has two parties with opposite views. Why is a broker not supposed to sell in such a situation?

  34. Pete Canning Says:

    Gene, it is not relevant if Goldman lost money or not. It would have been just fine if they had made billions. What is relevant is that you completely misunderstood the terms of the deal. Goldman put together a buyer and a seller. If one is going long, and the other short it makes sense that they should both decide what securities are in the Synthetic. Ultimately, that is what happened.

    The problem is that people bought over valued assets. If they were ignorant they should have hired better advisors. Goldman was not acting in a fiduciary capacity. It is a GOOD THING that people shorted the mortgage market, it was overvalued. More shorts might have prevented the problem, and possibly less money would have been lost by unskilled investors.

    As to my profession, yes, I work for “Wall Street” firm as a financial advisor. I have every incentive for my clients to do well because they pay me for advice. In most cases I am acting as a fiduciary, and I always act as such. I care a great deal about making money for my clients and ultimately my livelihood depends on it.

    However, when I enter an order to sell an option for my personal account, I DO INTEND, for the buyer to LOSE THEIR ENTIRE INVESTMENT. Yes, Gene in my personal account, I sell derivative contracts that I personally believe will “fail” by expiring worthless. Sometimes, these securities have never been traded before I sell them. I simply post an offer and lay in wait for someone to buy. Is this immoral? Is it immoral for the etrade customer to enter a sell order on a company they believe will go bankrupt? Should they call the buyer and warn them? Should they ride it down to zero because it would be unfair to sell something you know will go to zero to another? I simply do not think so.

    If you don’t understand how going short is valuable, you simply do not understand economics. If you do not like Goldman’s business practices, do not do business with them. If you think Goldman was too smart for ACA and IKB then they should have not been involved in a deal with Goldman and should have consulted outside advisors who were more competent. However, I cannot feel sorry for professional investors who made mistakes because of “scum” salesmen.

  35. King Mob Says:

    “You wouldn’t happen to sell securities for a large Wall Street firm yourself, would you, Pete?”

    You wouldn’t happy to be a seedy academic, would you, Gene?

    If you want to sling personal attacks, I’m your huckleberry.

  36. chidemkurdas Says:

    Going back to North Korea’s annual hate fest, we might note that there are no securities brokers or collateralized debt obligations in that country. Not much food, either, but hey, they can enjoy hate parades.

  37. Gene Callahan Says:

    “In this case the manager was ACA Management, but there were other CDO managers at least as pliable as ACA. The SEC suit charges you with using ACA as a shill: the end investors in your CDO assumed that it was ACA’s job to figure out whether the bonds inside the CDO were intelligent investments.
    “But ACA quite clearly had no idea what it was doing — and you quite clearly understood that.” — Michael Lewis

    Pete, you clearly have no idea what went on in this deal!

  38. Gene Callahan Says:

    “If you want to sling personal attacks, I’m your huckleberry.”

    Interesting, King Mob — so you believe simply asking someone if they work on Wall Street is a personal attack? Wow, you’re view of the financial industry is far more negative than mine!

  39. Bill Stepp Says:

    Gene Callahan writes:

    2) The buyers were almost NEVER sophisticated investors who knew what they were buying; the modus operandi is to sell these things to people like “Iowa hog truckers pension fund” manager, and bedazzle him with high powered suits with incomprehensible models and really expensive presentations, combined with assurances that “our modellers have assured us you are protected here.” (In this case, even while they knew the person who had packaged the securities was so sure they would collapse that he took out a billion dollars of insurance betting they would do so!)

    The buyers were institutional investors, not retail investors. Goldman only does businssess with institutional investors, and accredited individual investors. Indeed, the anyone in the latter group typically has to have at least $10 million in assets to be a Goldman client.
    Of course, institutions and accredited individuals sometimes make bad investments. That is irrelevant to the case though.

    When Paulson was making his bearish bet on housing in 2007, Goldman thought he was wrong. See today’s Wall Street Journal.

  40. Gene Callahan Says:

    “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.” — Michael Lewis

  41. chidemkurdas Says:

    Gene, are you suggesting that Michael Lewis is the ultimate authority here? To be sure, he’s an engaging writer with a lively style, fun to read. But he might not always have the best judgment. My memory is that in Liar’s Poker his hero was John Meriwether–who subsequently founded & presided over the destruction of the hedge fund, Long-Term Capital Management. And then in The New New Thing, Lewis lionized a computer entrepreneur at the peak of the DotCom bubble, with nary an idea that it was a bubble. Does not mean that he’s always wrong, of course. But does not inspire confidence in his ability to analyze a situation. His forte is to conjure up the prevailing mood.

  42. Pete Canning Says:

    “Pete, you clearly have no idea what went on in this deal!”

    Gene, ACA put money into this deal. They might have been idiots, but they were trying to make money. Most of the money Paulson gained was an ACA loss. As to your not understanding the deal, here is my evidence: “In this case, even while they knew the person who had packaged the securities was so sure they would collapse that he took out a billion dollars of insurance betting they would do so!”

    Gene, Paulson didn’t take out insurance, and he didn’t package the deal. They were the short. In a synthetic, there is a short and a long. This is very similar to a futures contract. Paulson sold it, ACA, Goldman, IKB bought it. No one took out insurance. I know derivatives are complicated, and no one in congress seemed to get it, but the very act of selling (Paulson) is what made him short. Money could only go one way or the other. If one goes long June Gasoline and one goes short the profits of the long are paid by the short. Again, I sell options contracts all the time that I think will become worthless. For every dollar I profit, the buyer loses, and if the buyer profits, it is through my losses. You are over your head on this, or blinded by some odd hatred of success or salespeople.

  43. chidemkurdas Says:

    Pete, so you’re saying that Paulson wrote the swaps. I have no problem with your argument but can see why Gene talks about insurance. Credit default swaps are often described as a kind of insurance.

    How one thinks of the synthetic CDO is obviously relevant to the case. Here is what the SEC says in the complaint:
    “In a synthetic CDO, the SPV does not actually own a portfolio of fixed income assets, but rather enters into CDSs that reference the performance of a portfolio.” The SPV is the special purpose vehicle set up to issue the notes. The SEC says that credit default swaps (CDS) were used to get the return on the reference portfolio of mortgage securities.

    From the ACA people sitting around in the Paulson office, one infers that Paulson was the other side of the trade and ACA knew that as they picked the securities for the portfolio. It follows that Paulson must have written the swaps.

  44. Pete Canning Says:

    Chidem, Paulson was the short. One could say he “wrote” the synthetic but I do not think that is the correct term, and it does not make the situation more clear. Paulson was the short, (you could say he was the seller of the CDO). In a synthetic for someone to be long, others must be short. This was not insurance anymore than an S&P futures sale is insurance. Paulson did not build a bad product and take out insurance. Paulson sold short over valued securities at somewhere near market prices. The only difference here is that it is done through derivatives. If Paulson had owned all these securities and was trying to sell them and Goldman found Paulson a buyer in IKB no one would be discussing this. IKB would still have lost a lot of money. No one would have felt Goldman had any obligation to tell IKB who the seller was. IKB would still have lost a lot of money. Paulson would have avoided a loss rather than made a profit.

    Paulson wanted to profit from the mortgage market doing poorly. Banks, and many others wanted yield and had a positive view of the mortgage market. A reference portfolio of existing mortgage securities was put together. To me, it seems obvious that Paulson the short, and ACA the largest long should both have input in the reference portfolio. Paulson would not want to short things he thought would go up, and ACA would want to know what they were investing in the performance of.

    What so many don’t understand is that whenever one of these securities is created someone will lose money on it. This isn’t a bad thing. It is similar to the options and futures market in this regard. Often times people attempt to hedge away this risk. Other times they do not.

    To say Paulson hoped the security would be full of mortgages that were of terrible quality is absolutely correct. To say Paulson bought insurance on the portfolio after he structured it to fail misses the boat entirely. No one could have bought this synthetic CDO if Paulson (or someone else) had not been short. The fact that the reference portfolio securities had value in the market place proves that many disagreed with Paulson’s negative view of these securities. Paulson’s activity here is no more sinister than any short selling transaction.

  45. chidemkurdas Says:

    Pete, that is a good way of explaining it. It has become common to describe swaps as taking out a kind of insurance but it may be misleading in transactions like this.

    From ACA’s email, it is clear that ACA picked what it wanted. An email from ACA with the subject line “Paulson Portfolio 1-22-10.xls” says: “Of the 123 names that were originally submitted to us for review, we have included only 55.”

  46. chidemkurdas Says:

    “This was not insurance anymore than an S&P futures sale is insurance.” On second thought; you can use a futures contract to lock in a price & thus protect yourself. This is what the commercial players — or hedgers — in futures markets do for commodities they produce or need. In that sense, futures are used as insurance. This may be a quibble in the current context. I agree that Paulson did not take out insurance in the sense of buying an insurance contract on a product. He made a bet.

    We get back to the argument that all this is so complicated that it’s bound to result in asymmetrical information and Wall Street having an unfair advantage. That’s what Gene is saying. But is it any different when you simply buy a stock? There is almost always some asymmetry to how well two sides to a trade understand a security. And here we’re talking about clients that are big financial institutions with resources to get any expert advice they want.

  47. Bill Stepp Says:

    We get back to the argument that all this is so complicated that it’s bound to result in asymmetrical information and Wall Street having an unfair advantage. That’s what Gene is saying. But is it any different when you simply buy a stock? There is almost always some asymmetry to how well two sides to a trade understand a security. And here we’re talking about clients that are big financial institutions with resources to get any expert advice they want.

    When you say “Wall Street,” who are you talking about–the institutional (i.e., Wall Street) buyers, or the institutional sellers?
    Both buyers and sellers of these instruments were institutions, i.e. (supposedly) sophisticated investors, who had been around the block more than a few times. Mom and Pop were not in the market for these things. I see nothing unfair about these transactions, which were sold after many pages of documents about these instruments were sent to all the parties involved.
    If anyone didn’t understand them and still got involved and lost money, well, that’s their fault.
    Regarding information asymetry, information is in the eye of the beholder. As they say, that’s what makes markets.
    The cash flows thrown off by these things was always uncertain, and the discount rates used to present value them were also subjective and not written in stone. The same thing is true for stocks or any other investments. And caveat emptor always applies.

    As for “expert advice” on Wall Street, having been a stock purveyor early in my career, I know full well that that is an oxymoron, at least in some instances.

    The government (read: SEC) is looking for a scalp, or scalps, having failed to nab some real crooks (Madoff, et al.). It should crawl back into its cave and stay there, while the market sorts out the wheat from the chaff.

  48. Bill Stepp Says:

    “were always” for “was always”

  49. Pete Canning Says:

    I used S&P futures because they are not commodities. No one produces all the stocks in the S&P. If there is a problem with securities being too complex, people should stop buying them. The system works.


  50. The case demonstrates the pitiful state of business reporting and commentary. I heard one talking head (Chris Matthews, I believe) say that GS took advantage of widows and orphans. How often has Paulson’s action been analogized to knowingly selling someone a car with bad brakes and then taking out an insurance policy on the buyer’s life? Sound bites favor demagogues.

  51. chidemkurdas Says:

    Sheldon, true, the coverage has been badly skewed. Those “widows and orphans” images are both easy and of immediate emotional appeal, so they tend to crop up even though there is no relevance to these types of deals.

    Mind you, it doesn’t really matter. Plenty of people lost their shirts buying houses at the height of the bubble–with encouragement from members of Congress who are now harrumphing about the bubble. You do not need CDOs to lose money.

  52. Gene Callahan Says:

    Pete Canning: “The system works.”

    Yes, Pete, and fortunately, most people have now caught a glimpse of just how “The system works.” and just who it “works” for.

  53. Gene Callahan Says:

    Pete: “Gene, Paulson didn’t take out insurance, and he didn’t package the deal. They were the short. In a synthetic, there is a short and a long. This is very similar to a futures contract. Paulson sold it, ACA, Goldman, IKB bought it. No one took out insurance.”

    Well, Pete, once again, ready to eat crow, I went to someone deep inside this industry and asked if I was wrong and you are right, and he said, “No, CDS is certainly a form of insurance, and not equivalent to going short a transaction, because going short you have unlimited upside risk.”

    So every time I take your comments seriously, and then go and ask someone who is not just some retail broker out in Connecticut but is actually deep inside this market, they tell me that I am right and you are wrong.

    So, sorry, dude, you have no idea what you are talking about.

  54. Pete Canning Says:

    Gene, when did I say he had unlimited upside risk? (even if it was exactly like a future, what static portfolio of debt securities has unlimited upside?) It is similar to a futures contract in that one cannot create it without a long and a short. If you want to describe Paulson’s actions as taking out insurance, fine. I disagree with characterization. Obviously some use it, but I think it is misleading. But if Paulson was taking out insurance why shouldn’t he pick what he is buying it on?

    “Well, except that Paulson was also packaging and selling the CDOs they were insuring. So they were in the position of a company deliberately selling passengers tickets on planes they knew were rickety, and then taking out life insurance on those passengers.”

    Being the short in a synthetic CDO is the “insurance” you are talking about. A better analogy is that Paulson saw some rickety planes flying, the reference portfolio, and found ACA, IKB, and Goldman to insure them. This is an incredibly different story. Although, I don’t think any of these analogies are helpful.

    ACA and IKB knew what was in the reference portfolio. They also knew if the reference portfolio did poorly someone would profit from their loss as that is the nature of a synthetic. The portfolio didn’t own the underlying securities.

  55. von Pepe Says:

    Debate Flares on Goldman’s Role as Market Maker
    May 4, 2010, 6:14 pm
    Goldman Sachs insists that it did nothing wrong and was just acting as a middleman when it sold billions of dollars of securities that are at the center of the Securities and Exchange Commission’s fraud case against the firm. But John C. Coffee Jr., a professor of securities law at Columbia University, told a Senate hearing on Tuesday that Goldman was much more than a middleman and that it therefore had a duty to its clients that went beyond just filling orders.

    “Goldman was not a neutral dealer, but a soliciting placement agent,” Mr. Coffee told a Senate Judiciary subcommittee. “Acting as a placement agent for a securities offering that one has itself designed is very different from a dealer simply quoting a two-sided spread.”

    Goldman has argued that it was a market maker in credit derivatives business and that it was just helping firms that wanted to buy a synthetic collateralized debt obligation meet up with those that wanted to bet against it.

    Goldman’s chief executive, Lloyd C. Blankfein, was almost apoplectic in trying to explain the firm’s role in the matter to Charlie Rose in a rare interview last week. When asked if the firm ever took the opposite side of a trade that it had advised its clients to take, Mr. Blankfein seemed dumbfounded.

    “As a market maker, we are making buying and selling a thousand times a minute, probably,” Mr. Blankfein responded. “Advising is where people are coming to us for advice — people are asking us our opinion, where we have an obligation and duty,” he continued, attempting to illustrate the differences between the firm’s market-making activities and its advising business.

    When acting as a market maker, Mr. Blankfein said Goldman’s clients “are not asking us for our opinion, we are not providing, we are simultaneously sell, buy, sell, buy.”

    Therefore, by just bringing sellers and buyers together, Goldman insists that it did not have any duty, moral or legal, to disclose to its clients that a portfolio of synthetic C.D.O.s, had been built, at least in part, by another Goldman client, the hedge fund manager John A. Paulson, who the S.E.C. said was on the other side of the trade.

    Mr. Coffee took issue with Goldman’s explanation, calling it a “straw man argument.” He argued that the firm was much more than a market maker in this case. By actively marketing the portfolio, Goldman owed its clients taking the long side of a synthetic C.D.O. the same level of care that they would get if they were buying a real C.D.O. made up of actual mortgages.

    “Put simply, this is why they came to Goldman: for its expertise and skill,” Mr. Coffee said, referring to the clients that went long on the portfolio. “That the C.D.O. was instead a synthetic one and thus inherently involved a short side, and a credit default swap, changes nothing; the investor in the synthetic C.D.O. should continue to be able to expect that Goldman is seeking attractive securities, not dogs, to place in its portfolio.”

    Goldman maintains that it lost about $100 million in the transaction at the center of the S.E.C.’s fraud case, showing that it did not have an incentive for the portfolio to fail.

    Mr. Coffee rejected that argument. “The fact that Goldman lost money on the deal was because it could not sell out its offering,” he said. “And so like an unsuccessful underwriter, it had to absorb the weak securities that it could not sell.”

    As an underwriter, Goldman would therefore have an obligation to disclose all pertinent information about the offering to its clients.

    “Goldman should not have permitted one client to bias the deal in its own favor,” Mr. Coffee said. “Nor should it have represented that a neutral and objective portfolio manager was selecting the portfolio if it knew that the short side was heavily influencing the selection of the securities in the portfolio.”

    http://dealbook.blogs.nytimes.com/2010/05/04/debate-flares-on-goldmans-role-as-market-maker/#more-220721

  56. Pete Canning Says:

    Mr. Coffee is the first person who actually understood what happened to make a reasoned argument against Goldman. However, I don’t see how his argument holds up given ACA was the main long and had the final say in the portfolio’s content. From what is represented they had every incentive to “bias” the portfolio in their own favor.

    Further, I don’t know why IKB came to Goldman, and I don’t know how Coffee can know that. Unless one can prove that ACA stood to profit from the reference portfolio falling, I do not see how Paulson’s involvement is an issue.

  57. chidemkurdas Says:

    Didn’t the deal itself came with a disclaimer? The fine print in almost all such documents states that not all information is disclosed. There has been some legal debate about how much protection such disclaimers offer to the entity doing the disclaiming.

    In practice, people tend not to read the fine print.


  58. Re Mr. Coffee: Do the purported victims feel victimized? Have they filed complaints? If not, does that tell us anything?

  59. chidemkurdas Says:

    Here one of Warren Buffett’s comments:
    “Mr. Buffett said that the case against Goldman seemed to be based only on hindsight.
    “It’s very strange to say, at the end of the transaction, that if the other guy is smarter than you, that you have been defrauded,” he said. “It seems to me that that’s what they are saying.”
    From http://www.nytimes.com/2010/05/04/business/04sorkin.html?partner=rssnyt&emc=rss
    That’s what the SEC is saying. Re Sheldon’s point, best we know ACA and IKB had not filed complaints.

  60. Gene Callahan Says:

    Pete says: “Mr. Coffee is the first person who actually understood what happened to make a reasoned argument against Goldman.”

    Very amusing, Pete, because I don’t see anything in Coffee’s statement that contradicts anything I said — but Coffee understood what was going on and I had no idea!

  61. Pete Canning Says:

    Gene, the departure between you and Coffee that I see is related your feeling that the CDO was “created to fail.” Coffee clearly understands that every time a synthetic CDO is created on party stands to gain from the reference portfolio going to zero. I haven’t seen that you understand this. I also haven’t seen that you understand that Paulson didn’t create the underlying securities, but rather picked already existing securities that he felt were over valued. He had no control of their creation. Maybe you do understand this, but it is not apparent.

    Coffee’s quibble is that Goldman has a duty to CDO buyers in assuring that the CDO has a high quality portfolio. I fail to see why Goldman has a duty to the buyer but not to the seller. If Paulson was trying to unload a block of bonds, having Goldman call everyone it new to sell them wouldn’t require that they believe the portfolio was fantastic.

    If Paulson is to be seen as “Buying insurance” wouldn’t that imply that Goldman had a duty to assure that Paulson didn’t over pay? If insurance was sold ACA and IKB sold it. If a CDO was purchased Paulson was the seller, and ACA and IKB were the buyers. There are two ways of viewing the transaction.

    Further, the main buyer ACA, absolutely did have a greater hand in selecting the securities than Paulson. The reason, as I see it, that IKB would go along with such a transaction was that the selection agent, seen as a specialist, was going long. That was the assurance given to IKB that the portfolio was sound. ACA is no longer, so obviously they were not good at what they do.

    The only issue I can see here if ACA wanted the reference portfolio to go down and misrepresented themselves as being long, and having the final say. I am not sure why it would be even material if participant who was not the selection agent was going long or short and making suggestions. Ultimately, IKB got exposure to the reference portfolio, and knew the portfolio contents before buying. It is just as difficult to pick a portfolio of securities that will go down as it is to pick a portfolio that will go up.

    So is your problem with Goldman’s activity that they have a duty, as a “soliciting agent” to pick good securities? If that is the case, the securities law may be on your side (Mr. Coffee claims to be an expert). However, from the stand point of “free market” perspective I am not sure why it matters. In all cases the parties involved will have different views of the value of the reference portfolio. If not, the transaction has little reason to happen.

  62. Mario Rizzo Says:

    Is Goldman a fiduiciary or a market-maker? If only the latter (legally), what are we all talking about? Ethics? First, there is no clear ethics here (In fact, Thomas Aquinas says that a vendor does not have to disclose info regarding market conditions of his product.) Second, it the SEC wants the law to be changed, it should simply say so. And then make the case with Congress.

  63. Pete Canning Says:

    I think it is a very hard ethical case to say that GS was a fiduciary on this transaction. If securities law says otherwise, Goldman was/is unaware of that. If IKB wanted Goldman’s advice, they should have opened up an account with the asset management division.


  64. So who is the victom here??
    Btw great info it made my research for my blog content super easy! Keep up the great work.


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