Sunday, April 18, 2010

Channeling Interfluidity

Over at the bottom of the links list on the right is the only finance/economics/market link Guambat provides. Steve Waldman writes that one. Guambat is so envious. After getting all the preceding posts off Guambat's puny chest, he wandered over to see what Steve had to say. Steve's take on this Goldman Sachs thing is thoughtful, personal, provocative, prosaically expressed. As you'd expect. Steve is even more wordy that Guambat, but it is worthy because of his prose. There are extracts following, but to get the full flavor, argument and understanding of his message, you should go read the whole piece. Take your time, it's worth it.
Goldman-plated excuses
My first reaction, upon reading about the SEC’s complaint against Goldman Sachs was to shrug. If that’s the worst the SEC could dig up, I thought, there’s way too much that’s legal.

Had you asked me, early Friday afternoon, what would happen, I would have pointed to the “global settlement” seven years ago. Then as now, investment banks were caught fibbing to keep the deal flow going (then via equity analysts who hyped stocks they privately did not admire). The settlement got a lot of press, the banks were slapped with fines that sounded big but didn’t matter, promises were made about “chinese walls” and stuff, nothing much changed.

The SEC threw Goldman a huge softball by focusing almost entirely on the fibs of a guy who calls himself “the fabulous Fab” and makes bizarre apocalyptic boasts. Given the apparent facts of this case, phrases like “bad apple” and “regret” and “large organization” and “improved controls” would have been apropos. It’s almost poignant: The smart thing for Goldman would be to hang this fab Fab out to dry, but whether out of loyalty or arrogance the firm is standing by its man.

But Goldman’s attempts to justify what occurred, rather than dispute the facts or apologize, could be the firm’s death warrant. The brilliant can be so blind.

The core issues are simple. Goldman arranged the construction of a security, a “synthetic CDO”, which it then marketed to investors. No problem there, that’s part of what Goldman does. Further, the deal wasn’t Goldman’s idea. The firm was working to serve a client, John Paulson, who had a bearish view of the housing market and was looking for a vehicle by which he could invest in that view. Again, no problem.

I’d argue even argue that, had Goldman done its job well, it would have done a public service by finding ways to get bearish views into a market that was structurally difficult to short and prone to overpricing.

Goldman could, quite ethically, have acted as a broker. Goldman could have tailored a security or derivative contract to Paulson’s specifications and found a counterparty willing to take the other side of the bet in full knowledge of the disagreement.

Investors get to disagree. But it did need to ensure that all parties to an arrangement that it midwifed understood the nature of the disagreement, the substance of the bet each side was taking. And it did need to ensure that the parties knew there was a disagreement.

Goldman argues that the nature of the security was such that “sophisticated investors” would know that they were taking one of two opposing positions in a disagreement:
"These investors also understood that a synthetic CDO transaction necessarily included both a long and short side."
That line is so absurd, brazen, and misleading that I snorted when I encountered it.

Of course it is true, in a formal sense. Every financial contract — every security or derivative or insurance policy — includes both long and short positions.

So why did Goldman put that line in their deeply misguided press release? One word: derivatives. The financially interested community, like any other group of humans, has its unexamined clichés.

One of those is that derivatives are zero sum contests between ‘long’ investors and ’short’ investors whose interests are diametrically opposed and who transact only because they disagree. By making CDOs, synthetic CDOs sound like derivatives, Goldman is trying to imply that investors must have known they were playing against an opponent, taking one side of a zero-sum gamble that they happened to lose.

Of course that’s bullshit. Synthetic CDOs are constructed, in part, from derivatives. (They are built by mixing ultrasafe “collateral securities” like Treasury bonds with credit default swap positions, and credit default swaps are derivatives.) But investments in synthetic CDOs are not derivatives, they are securities.

While the constituent credit default swaps “necessarily” include both a long and a short position, the synthetic CDOs include both a long and a short position only in the same way that IBM shares include both a long and a short position.

Synthetic CDOs were composed of CDS positions backed by many unrelated counterparties, not one speculative seller. Goldman’s claim that “market makers do not disclose the identities of a buyer to a seller” is laughable and disingenuous.

A CDO, synthetic or otherwise, is a newly formed investment company. Typically there is no identifiable “seller”. The investment company takes positions with an intermediary, which then hedges its exposure in transactions with a variety of counterparties.

The fact that there was a “seller” in this case, and his role in “sponsoring” the deal, are precisely what ought to have been disclosed. Investors would have been surprised by the information, and shocked to learn that this speculative short had helped determine the composition of the structure’s assets. That information would not only have been material, it would have been fatal to the deal, because the CDO’s investors did not view themselves as speculators.

I have little sympathy for CDO investors.

Wait, scratch that. I have a great deal of sympathy for the beneficial investors in CDOs, for the workers whose pensions won’t be there or the students at colleges strapped for resources after their endowments were hit.

But I have no sympathy for their agents and delegates, the well-paid “professionals” who placed funds entrusted them in a foolish, overhyped fad. But what investment managers believed about their hula-hoop is not what Goldman now hints that they believed.

Investors in synthetic CDOs did not view themselves as taking one side of a speculative gamble against a “short” holding opposite views. They had a theory about their investments that involved no disagreement whatsoever, no conflict between longs and shorts. It went like this:
There is a great deal of demand for safe assets in the world right now, and insufficient supply at reasonable yields. So, investors are synthesizing safe assets by purchasing riskier debt (like residential mortgage-backed securities) and buying credit default swaps to protect themselves. All that hedging is driving up the price of CDS protection to attractive levels, given the relative safety of the bonds.

We might be interested in capturing those cash flows, but we also want safe debt. So, we propose to diversify across a large portfolio of overpriced CDS and divide the cash flows from the diversified portfolio into tranches. If we do this, those with “first claims” on the money should be able to earn decent yields with very little risk.
I don’t want to say anything nice about that story. The idea that an investor should earn perfectly safe, above-risk-free yields via blind diversification, with little analysis of the real economic basis for their investment, is offensive to me and, events have shown, was false.

But this was the story that justified the entire synthetic CDO business, and it involved no disagreement among investors. According to the story, the people buying the overpriced CDS protection, the “shorts” were not hoping or expressing a view that their bonds would fail. They were hedging, protecting themselves against the possibility of failure.

The RMBS investors may have believed that they were overpaying for protection, just as CDO buyers did, just as we all knowingly and happily overpay for insurance on our homes. Shedding great risk is worth accepting a small negative expected return.

That derivatives are a zero-sum game may be a cliché, but it is false. Derivatives are zero-sum games in a financial sense, but they can be positive sum games in an economic sense, because hedgers are made better off when they shed risk, even when they overpay speculators in expected value terms to do so. (If there are “natural” hedgers on both sides of the market, no one need overpay and the potential economic benefits of derivatives are even stronger. But there are few natural protection sellers in the CDS market.)

Perhaps the bankers thought Paulson was a patsy, that his bearish bets were idiotic and they were doing investors no harm by hiding his futile meddling. Perhaps, as Felix Salmon suggests, the employees doing the deal had little reason to care about whether the part of the structure Goldman retained performed, as long as they could book a fee. But all of that is irrelevant, assuming the SEC has the facts right.

Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO.

They no more thought they were trading “against” short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio.

Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors. That’s inexcusable.

Was it illegal? I don’t know, and I don’t care. Given the amount of CYA boilerplate in Goldman’s presentation of the deal, maybe they immunized themselves.

But the firm’s behavior was certainly unethical. If Goldman cannot acknowledge that, I can’t see how investors going forward could place any sort of trust in the firm.

As mentioned, Interfluidity can be provocative, and this post certain generated a lot of 2-way dialogue. If you want to try to think your way through the GS imbroglio, you could start with his post and the comments. He's also continuing to publicly think his way through the issues, so keep up with his posts. If you want to soundbite your way through the GS "story", you can read most of the press. In either case, Guambat highly recommends his own take, suggested in the various posts on this subject over the least coupla days.

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