Greed 101 by Abacus

[jade_lee]

Goldman Sachs lawsuit / Wall Street's latest lesson in cynicism
By Dafna Maor


The accusations against Goldman Sachs are an incredible lesson showing that in everything that has to do with profits and money, the incredible is always possible. On Friday, the U.S. Securities and Exchange Commission filed a civil suit against the bank for allegedly selling customers securities it expected would fail, making profits by betting against those securities, and letting a few select customers in on the secret.

Here are some answers for things we've wondered over the past few years, which are being clarified as the accusations come to light.
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How can you sell poison to investors?

You don't need a doctorate in investment theory in order to understand the allegations being raised against Goldman Sachs - you just need to understand a few things about human psychology. Of all the sophisticated investors who bought into Abacus, a complicated portfolio based on synthetic CDOs, how many actually understood the nature of the investment and their chances of profiting? We may guess with a great deal of certainty that aside from top Goldman Sachs officials and the people who created Abacus, only one person knew what he was getting into - John Paulson. He carefully picked the stocks in which Abacus was invested, and betted against them.

Somehow, Goldman Sachs - and many other banks, since no one thinks that Goldman was alone - convinced people to buy a black box, and promised it would turn them profits so long as the housing market increased. Goldman's clients, nearly all of them experienced investors, believed the housing market would continue going up, and that the investment was a good one. The problem is that they didn't really understand what they were getting into.

The truth is that there were several people on Wall Street who knew what was going on. In a rare description of the financial crisis, Michael Lewis described how one analyst, Steve Eisman, knew that the American mortgage market was going to implode, taking the global financial industry with it, and how he happily profited from that knowledge.

And here lies the catch: The people who were aware of the toxicity of it all began poisoning others.

Did Goldman Sachs set a new record for chutzpah?

In the chain of scandals and lawsuits involving Wall Street's biggest banks over the last decade, new records have been set for shamelessness and cynicism. The investment banks paid massive compensation due to accusations of conflicts of interests - their analysts warmly recommended technology stocks, while calling them "trash" in more private forums. The banks gave benefits to analysts for recommending certain stocks. The fine that the big banks paid - $1.4 billion - has been forgotten with time.

The latest financial crisis exposed what bankers are doing as their banks are collapsing on the heads of investors and clients - taking vacations with their workers, and expensively furnishing the offices of their companies while teetering on the brink of bankruptcy.

But no matter how desensitized all this has made us, it's still hard to accept that Goldman Sachs forged a connection with one client, with the goal of creating a Trojan Horse against its other clients. Previous scandals on Wall Street involved lies designed to turn profits. In this case, the lies were designed to cause customers damage - so the bank could profit. Goldman needed customers to buy into Abacus so that it could profit from betting against them.

The future of the 'great vampire squid'

What will happen to Goldman Sachs, the most profitable, efficient and successful investment bank in the history of Wall Street, if it is convicted of the offenses of which the SEC accused it? Will it cause a far-reaching crisis on Wall Street that forces the banks to mend their ways? Will the bank be punished in such a way that prevents it from continuing to make major profits from capital market bets? Will the "great vampire squid," as Matt Taibbi called the bank in the magazine Rolling Stone, find itself grilling on a spit?

The American justice system, which imposes much harsher penalties for second and third offenses, tends to turn a blind eye to the country's big money machines. The American culture is fundamentally one of stockholders. Every American is invested in the financial system, even if he never sees dividends from these holdings.

To judge by past examples, Goldman Sachs will be censured and handed a nasty fine. The bank will be subjected to public anger, and its stock price will fall every time the affair returns to the headlines. Wall Street's champions league will be damaged, but some sanity will be returned to the places that determine the fate of millions of savers.

After Lehman Brothers collapsed, many said that the investment banks' judgment day had come. But now, we're seeing how wrong they were. The banks are still here.

 

[urbandreamer]

Fools and their money.... If investors would just learn how to read a chart they'd have never lost more than 10-20% of their money. Dumb money exists at all levels in the market, and so be it! I've lost money on the market before for only two reasons: greed and stupidity. Since I've curbed my greed and become educated, I haven't lost a penny!

 

[jade_lee]

When the fraud puts the economic life of most citizens in jeopardy it goes beyond a wrist slapping/buyers beware scenario and I would think the average Joe recognizes this. Certainly our children who will have to pay for the bailouts, out of their future earnings, will. The corruption is wide and deep but the stage has been set, the public is now starved for truth about the corruption of the 1% in our society and I say let the games begin.
Did our Canadian banks have exposure to these bundles? Did our government backstop for loses with taxpayer cash without accountability or public discussions?

 

[E.B.]

Fools and their money.... If investors would just learn how to read a chart they'd have never lost more than 10-20% of their money. Dumb money exists at all levels in the market, and so be it! I've lost money on the market before for only two reasons: greed and stupidity. Since I've curbed my greed and become educated, I haven't lost a penny!

This has nothing to do with fools and their money.

The Securities and Exchange Commission alleges Goldman failed to disclose that one of its clients (John Paulsen) created — and then bet against — subprime mortgage securities that Goldman sold to investors. If the allegations are true, they intentionally deceived the investors to make money for themselves and the client. John Paulsen made one billion dollars on this scam, and the investors lost one billion dollars. The investors were institutions that invested pension money that belonged to the average person. (It's been reported that $800 million british pension funds and $200 million German pension funds)

The way it played out according to the SEC complaint is that Goldman, working with Paulson, created this mutual fund of housing bonds and Paulson picked the worst stuff they could find to go into the mutual fund. This included mortgages from Florida, Arizona, Nevada, and California. They wanted mortgages that were taken out by people with the worst credit ratings. They want mortgages that were largely adjustable rate, which meant that sooner or later when interest rates went up, those people would be less likely to pay. So what the SEC is alleging is that they built this thing to fail and Paulson and Co. went and bet against it. And Goldman Sachs went wrong because they didn't tell the investors that the other side of this trade Mr. Paulson had built the product to fail and it was betting against it.

In 2008, Goldman had shorted (bet against) other mortgage securities and made a bundle.

It is strongly believed that other investment banks have done the same thing.

This is a stacked deck. It's fraud.

 

[urbandreamer]

^Yes I understand what's going on. However, that's quite simply how the stock market has worked for decades! Intentional deception! Other than GS, the portfolio managers at these pension funds are the ones that ought to be tossed in jail--for sheer stupidity and recklessness. If gold goes to $5000 an ounce, would you buy it at $5000? It's not a stacked deck--it's called hedging your bets.

The real story is the wall st bailout.

 

[E.B.]

Are you kidding me, Intentional deception is illegal, that's why we have agencies to intervene. I understand that firms have done business this way; and the regulators, rating agencies etc., have turned a blind eye. This time, however,Goldman and other firms almost brought down the economy, at enormous cost to all of us. And now that the public is aware that we've been screwed, they want something done.

Regarding the fund managers, they were negligent. They accepted the AAA rating that the rating agencies gave this fund. The ratings agencies are paid by the investment banks (goldman etc.).This has been criticized as a conflict of interest, and they are now being scrutinized more carefully. However, there's lots of blame to go around.

When you boil right down to it, the investment banks are the central figures in this mess. They lobbied congress with huge amounts of money to get regulations changed. They paid real estate firms to get as many mortgages as possible, regardless of quality. They paid the rating agencies to give triple A ratings for garbage mortgage securities. They advised clients to purchase these funds, stating that they were triple A, therefore, very safe investments.

In this specific case, Goldman set up a third party firm to be an independent advisor, responsible for reviewing the assets in the fund. But they weren't independent, as they took instructions from Goldman and John Paulsen.

I agree with you on the bailouts. But at the time, governments around the world had to do something or we would have been in deep trouble.

By the way, the Treasury Secretary and the Bank of New York gave bailout money to AIG, and AIG passed $10 billion on to Goldman (covered 100%). Other firms got paid as well. AIG had issued credit default swaps (insurance),for premiums from the investment banks and hedge funds. AIG didn't have the money to cover the insurance, and went bankrupt. The Treasury and Bank of New York advised Goldman and others to keep this information from the public and Congress.

Goldman should pay the consequences for their actions.

 

[cacruden]

^Yes I understand what's going on. However, that's quite simply how the stock market has worked for decades! Intentional deception! Other than GS, the portfolio managers at these pension funds are the ones that ought to be tossed in jail--for sheer stupidity and recklessness. If gold goes to $5000 an ounce, would you buy it at $5000? It's not a stacked deck--it's called hedging your bets.

The real story is the wall st bailout.

I have to agree with EB, intentional deception is called Fraud, Fraud is illegal. Financial firms are required to disclose all relevant information to their customers. If proven, Goldman Sacks is in for a lot of hurt since there would be a lot of customers seeking redress in the courts.

BTW, hedging has to do with offsetting your risk..... they sold the risk to their customers without proper disclosure - the only risk they would have to offset is the risk of the customers suing them into the ground

 

[cacruden]

If I were building a condo building, and after finishing it I sold it to investors and then took out an bet that the building would crumble into dust..... (and I did not tell the buyers) and it did.... don't you think that would be sufficient proof for a civil case if not a criminal fraud case?

 

[urbandreamer]

^That's precisely what happened on 911!

 

[E.B.]

article by steve randy waldman

Goldman-plated excuses

My first reaction, upon reading about the SEC’s complaint against Goldman Sachs was to shrug. Basically, the SEC claims that Goldman failed to disclose a conflict of interest in a deal the firm arranged, that perhaps Goldman even misdirected and misimplied and failed to correct impressions that were untrue but helpful in getting the deal done. 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.

But Goldman’s PR people have once again proved themselves to be masters of ineptitude. Haven’t those guys ever heard, “it’s not the crime, but the cover up� 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 CDOâ€, 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. Had there been some existing security that Paulson wished to sell short, the firm might have borrowed that security on Paulson’s behalf and sold it to a willing buyer without making any representations whatsoever about the nature of the security or the identity of its seller. Apparently, however, the menu of available securities was insufficient to express Paulson’s view. Fine. 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. Goldman needn’t (and shouldn’t) proffer an opinion on the substantive economic issue (was the subprime RMBS market going to implode or not?). 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. On this, Goldman is simply full of it:

Extensive Disclosure Was Provided. IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities. The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side. [bold original, italics mine]

The line I’ve italicized is the sole inspiration for this rambling jeremiad. 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. Financial contracts are promises to pay. There is always a payer and a payee, and the payee is “long†certain states of the world while the payer is short. When you buy a share of IBM, you are long IBM and the firm itself has a short position. Does that mean, when you purchase IBM, you are taking sides in a disagreement with IBM, with IBM betting that it will collapse and never pay a dividend while you bet it will succeed and be forced to pay? No, of course not. There are many, many occasions when the interests of long investors and the interests of short investors are fully aligned. When IBM issues new shares, all of its stakeholders — preexisting shareholders, managers, employees — hope that IBM will succeed, and may have no disagreement whatsoever on its prospects. Old stakeholders commit to pay dividends to new shareholders because managers believe the cash they receive up front will enable business activity worth more than the extra cost. New shareholders buy the shares because they agree with old stakeholders’ optimism. The existence of a long side and a short side need imply no disagreement whatsoever.

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. Speculative short interest in whole CDOs was rare, much less common than for shares of IBM. Investors might have understood, in theory, that a short-seller could buy protection on a diversified portfolio of credit default swaps that mimicked the CDO “reference portfolioâ€, or could even buy protection on tranches of the CDO itself to express a bearish view on the structure. But CDO investors would not expect that anyone was actually doing this. It would seem like a dumb idea, since CDO portfolios were supposed to be chosen and diversified to reduce the risk of loss relative to holding any particular one of its constituents, and senior tranches were protected by overcollateralization and priority. Most of a CDO’s structure was AAA debt, generally viewed as a means of earning low-risk yield, not as a vehicle for speculation. 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 “sellerâ€. 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. There needn’t have been any disagreement about price. 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.)

Goldman claims to have lost money on the CDO it created for Paulson. 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. It is likely that even if Paulson had had nothing to do with the deal, the CDO would still have failed, given how catastrophically idiotic RMBS-backed CDOs were soon revealed to be.

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. Whatever does or does not happen in Washington D.C., Goldman Sachs needs to reform or die.

 

[jade_lee]

Speaking of the Canadian consequences now.........................

http://www.globalresearch.ca/index.php?context=va&aid=12007

This article is worth wading through.