Banking with piranhas

By Julian Delasantellis

From before anyone in town could remember any differently, the local used car dealership was there; it operated its business with such probity and circumspection that people thought it would be there forever. One day, a man, a man who had played high-school football and was now the town's local volunteer fire chief, came in to buy a good, safe car for his 16-year-old daughter, the apple of his eye, and the joy of his life.

When the deal was done, after the now standard surfeit of hugs and tears between the two American men, the auto dealer asked for the phone number of his insurance broker.

"I want to get some action on that kid. Any second now that kid's going to drive that posh car off the lot, have it explode on her; I want to see if anybody will write me a policy that's gonna pay off for me when it explodes."

The auto dealer's aide was rather perturbed at this, but then the



phone rang. "It's one of your competitors; he's pretty peeved at what you just did."

"What's his problem? It's all part of business."

"He objects to you not spreading the word around sooner. He wanted to bring a bag of marshmallows."

And so, there it is. Over 200 years ago, Adam Smith noted that "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interests."

Today, it is not the screams of the aforementioned butchers, brewers or bakers being broken upon Goldman's wheel, it's more like the howls of torture by these said same Goldmanites as they listen for the breakage of the bones of their business in this bizarre new free-enterprise experiment.

In many ways, what happened last week on Wall Street was the classical Chronicle of a Death Foretold, after the 1981 novella by Gabriel Garcia Marquez. For years, all the glossy investophile (or, in reality, money porn) has featured the now standard idolatrous coverage of one John Paulson (no relation to former US Treasury secretary Hank Paulson) and the rapid rise to power and fortune for his hedge fund. Either he had managed the equivalent of cold fusion - making good long-term money with US subprime mortgage securities, or his books were - and for the longest time, had been - finely fricasseed into classic fool's gold.

Guess which it was?

As traders prepared to cut out on Wall Street early on Friday afternoon to commence slopping down the poopdecks on their US$10 million Long Island Sound sloops, a curious tidbit moved on the financial wires. From the SEC news release:
The Securities and Exchange Commission today charged Goldman, Sachs & Co and one of its vice presidents for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the US housing market was beginning to falter. ... The SEC alleges that one of the world's largest hedge funds, Paulson & Co, paid Goldman Sachs to structure a transaction in which Paulson & Co could take short positions against mortgage securities chosen by Paulson & Co based on a belief that the securities would experience credit events. According to the SEC's complaint, filed in the US District Court for the Southern District of New York, the marketing materials for the CDO [collateralized debt obligation] known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS [residential mortgage-backed securities] portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. The SEC alleges that undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.
You can advance your career as a prospective champion American baseball player by better knowing what pitch the pitcher is about to throw at you. Among these ways, cheating usually works best. By now, most people on the world know that the global financial catastrophe has something to do with mortgages on subprime mortgage bonds; even on such cultural avatars as the Jerry Springer Show, you can watch tomatoes being lobbed at the heads of subprime mortgage brokers in between advertising offers to sue subprime mortgage brokers.

The basic mechanism of misery would be to have a bank or mortgage company put down $1million of mortgages on properties that, at their best, might be worth only $750,000. Eventually, the game would be up, and the system would be $250,000 poorer - times the incalculable number of times this happened.

That's all well and good, but what if you're such a muscled up misanthrope that not only do you want to see others suffer, but you want to make some good scratch on it too? Then, this disaster, like most, could only mean smooth personal sailing for you ahead; it's like watching the Hindenburg crash knowing you've shorted Deutsche Zeppelin Reederei.

But up until recently, there was no robust and deep way to short, to profit from the fall, of mortgage-backed securities such as subprime. The opening of the market in credit default swaps, as described by Michael Lewis in his new book, The Big Short (see review by Chan Akya, Lewis comes up short, Asia Times Online, April 17, 2010) opened up this strategy. Now all was needed was a sniperscope to precisely target the new weapon

To understand the strategy one must, at the most basic level, understand just what is a "collateralized mortgage debt obligation". Investopedia provides a workable, but bloodless, definition of it is a "A type of mortgage-backed security that creates separate pools of pass-through rates for different classes of bondholders with varying maturities, called tranches. The repayments from the pool of pass-through securities are used to retire the bonds in the order specified by the bonds' prospectus."

What these are are pools of individual mortgages, perhaps up to or more than 1,000 mortgages, bundled up and tied together to present a generalized payment profile for the whole security.

The entire security structure is supposed to be transparent. Thus, if you see that mortgage 555 in the pack represents a house that is supposed to be worth $800,000, and it in fact is worth that, you know that an attempt is being made to treat prospective investors fairly.

But what if this is not the case? What if the bond prospectus says that the buyers of mortgage 555 had a combined credit score of 700, but in reality the only thing they had that was rated that high were beer cans stacked in their front yard to be taken back for their nickel deposit? What if the mortgage application says that the couple owns two working late model cars that are used to commute to work, but the only thing visible from the street are the two Studebakers left up on blocks while the homeowners take the bus for their daily fix to the methadone lab?

In these circumstances, what you sure don't want is these people being obligated to make regular mortgage payments to you - they won't. In that case, credit default swaps related to whatever commercial mortgage desk containing the Party Gang's debt will skyrocket; wouldn't it be great to know beforehand which mortgage securities are heavy with both disreputable borrowers and credit default swaps ?

And what would be the most desirable situation of all? It would be if Goldman deliberately followed upon Paulson's research and lead, only issuing securities with the magic formula. From the SEC charging document:
The Commission brings this securities fraud action against Goldman, Sachs & Co. ("GS&Co") and a GS&Co employee, Fabrice Tourre ("Tourre"), for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation ("CDO") GS&Co structured and marketed to investors. This synthetic CDO, ABACUS 2007ญAC1, was tied to the performance of subprime residential mortgage-backed securities ("RMBS") and was structured and marketed by GS&Co in early 2007 when the United States housing market and related securities were beginning to show signs of distress. Synthetic CDOs like ABACUS 2007-AC1 contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.

2. GS&Co marketing materials for ABACUS 2007-AC1 - including the term sheet, flip book and offering memorandum for the CDO - all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management LLC ("ACA"), a third-party with experience analyzing credit risk in RMBS. Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co Inc ("Paulson"), with economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO, played a significant role in the portfolio selection process. After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps ("CDS") with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure. Given its financial short interest, Paulson had an economic incentive to choose RMBS that it expected to experience credit events in the near future. GS&Co did not disclose Paulson's adverse economic interests or its role in the portfolio selection process in the term sheet, flip book, offering memorandum or other marketing materials provided to investors.

3. In sum, GS&Co arranged a transaction at Paulson's request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson's role in the portfolio selection.
It's almost as if Paulson searched the junkyards of Europe to try to find the most wrecked, broken-down versions of the old Yugo automobile, sold them to General Motors, who slapped GM nameplates on the junk, but never told anyone the wiser.

Rolling Stone's Matt Taibbi, noted for his rant on Goldman last year referring to the giant bloodsucking squid on the face of humanity, says he heard rumors of the Goldman/Paulson plan while researching his article, but even he didn't believe them at the time (see Goldman good but not that bad, July 09, '09). (It is interesting that, on Friday afternoon, after the Goldman charges were released, oil markets sold off sharply, the fear there being that, at last, Goldman might be unable to do that voodoo trick that it does so well to support prices.)

Gretchen Morgansern, of the New York Times, is also said to have gotten a lot of this story right in December. Perhaps the real reason this story was so hard to comprehend even after it fell apart was that no one really ever believed that big houses like Goldman would actually treat their smaller customers like so many guppies to be eaten alive by so many piranhas.

With toasted marshmallows for all for dessert.

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at