Posts filed under ‘derivatives’
What a scene that 11-hour Senate subcommittee interrogation of Goldman Sachs (GS) executives was on C-Span – I’m still wondering whether a forklift was utilized to hoist in the multi-thousand page binders stuffed with reams of exhibits. With caffeine beverage firmly in hand, I watched as much of the marathon as possible until fatigue set in. Not all was lost though, because I managed to simultaneously conduct new stock research as I was glued to the hearings. After I saw the Goldman executives repeatedly wrestle open the gargantuan-sized binders of smoking-gun emails, I checked the paper futures markets and am now contemplating a purchase of International Paper’s (IP) stock.
Lead trader of the controversial Abacus/John Paulson deal, “Fabulous Fab” Fabrice Tourre, did not disappoint his supporters either, firmly addressing his responses in his French Pepe Le Pew accent. His Goldman trading counterparts (Daniel Sparks, ex-mortgage department head, Joshua Birnbaum, ex-managing director of the department, and Michael Swenson, current managing director of the department), like all Goldman witnesses, did their best at bobbing and weaving the intrusive, pointed questions. On the cozier side of the questioning fence, the Senators did a superb job of raking the Goldman execs over the coals with endless exhibits of emails. Judging by the shiny, sweating mugs of the traders, the Senators were successful in making the testifiers uncomfortable – either that, or the Senators had the thermostat in the room raised to 82 degrees.
Betting Away to Profits
At the heart of the questioning was the key issue of whether Goldman Sachs executives and employees were acting in the best interest of their clients (fiduciary duty), or were they making bets against clients with the benefit of privileged information. Senator Claire McCaskill compared Goldman to a bookie manipulating bets in their own favor without sharing their edge with bettors (investors). In the case of the Abacus deal, Goldman admits to not freely disclosing the involvement of now-famous, mortgage market short seller John Paulson (see the Gutsiest Trade) to the so-called sophisticated institutional investors, ACA Capital Holdings Inc. Was this lack of disclosure illegal? Perhaps unethical, but pundits have already established the high hurdle the SEC (Securities and Exchange Commission) will need to clear in order to prove Goldman’s guilt.
Based on the testimony and facts introduced in the hearings, and as I write in my previous Goldman article (Goldman Cheat?), Goldman’s behavior throughout the housing collapse and participation in the ACA deal reflects more about intelligent opportunism within a loose regulatory framework than it does about criminal behavior. Having managed a $20 billion fund (see my book) I dealt with the conflicts of interest and self dealings of the investment banks first hand. As I entered trade orders reaching into the millions of shares, do I naively believe Goldman and other banks altruistically kept that information in their trading vaults? Or is it possible that information leaked out to other clients or was used for the banks benefit? Suffice it to say, the regulatory structure and conflict of interest frameworks, as they stand today, are not stacked in favor of investors.
Although we wish our regulators and government officials could have been more forward looking, rather than reactive, nonetheless, some reforms need to be instituted to resolve the substantial risks built into our financial system today. Here are a few ideas from the 10,000 foot level:
Volcker Rule: Former Federal Reserve Chairman’s so-called “Volcker Rule” is looking better by the minute. Not a new concept, but as regulators shine the light on the opaque industry of derivatives trading and proprietary trading desks, the need for new reforms becomes even more evident. Derivatives are not evil (see Financial Engineering), but like a gun or knife, if misused these instruments can become extremely dangerous…as we have found out. The Glass-Steagall Act, which separated investment bank functions from commercial bank functions, was repealed almost 70 years after its introduction in 1932. The Volcker Rule would be a “lite” version of Glass-Steagall Act because the thrust of the proposal is aimed at splitting the risk-taking proprietary trading desk activities from the client based activities.
Heightened Capital: If you rented out an exotic car or motorcycle from a store, you would likely be required to commit a deposit or collateral to protect against adverse conditions. The same principle applies to derivatives, which generally raises volatility due to inherent leverage. The riskier the product, the larger the capital requirement should be. The collapse of Bear Stearns, Lehman Brothers, and AIG are painful lessons learned from situations of excessive leverage.
Central Clearing/Transparency: Derivative products such as options, futures, and swaps have existed for decades. The transparency gained by trading these securities on exchanges increases market confidence, thereby increasing liquidity and lowering costs for end-users. Standardization around complex derivatives like CDOs (Collateralized Debt Obligations), CDSs (Credit Default Swaps), and CLOs (Collateralized Loan Obligations) is a must to ensure the fact regulators can actually understand the products they are regulating.
Credit Rating Agency: It’s not entirely clear to me that the rating agencies play a critical role in the market place. In effect, the agencies serve as an outsourced research resource primarily for fixed income investors. If the agencies disappeared today, investors would be forced to do their own homework on each deal – not necessarily a bad idea. If the existing oligopoly structure of agencies ultimately survives, I suggest penalties should be incurred by firms with inaccurate ratings. Conversely, ratings could be structured such that compensation could be tiered (or escrowed) over time with payment incentives tied to the underlying deal performance relative to ratings accuracy.
Too Big To Fail: The massive bailouts and TARP (Troubled Asset Relief Program) money handed out to the financial and auto companies have left a sour taste in taxpayers’ mouths. A systemic risk regulator with the authority to unwind unhealthy institutions makes common sense. An insurance pool financed by self-inflicted industry taxes would assist regulators in achieving the reduction of troubled financial institutions.
Fiduciary Duty: Sidoxia Capital Management is a Registered Investment Advisor (RIA) and must act in the best interests of the client. Unfortunately, much of the industry is structured with a much lower “suitability” threshold, which provides a veil for firms to engage in less than ethical behavior.
Overall, regulatory reform urgency is in the Washington D.C. air and there is no question in my mind that a certain degree of witch hunting and scapegoating is occurring. Nonetheless, Lloyd Blankfein and team Goldman Sachs made it out alive from the Congressional hearing, but not without suffering some negative reputational damage. Former Goldman CEO alum and Treasury Secretary Henry Paulson probably sent roses to Mr. Blankfein thanking him for taking Paulson’s job before the 2008 market collapse. When regulatory reform eventually kicks in, perhaps Lloyd Blankfein and Henry Paulson will take a trip to Las Vegas to celebrate (or commiserate).
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and in a security derived from an AIG subsidiary, but at the time of publishing SCM had no direct positions in GS, IP, AIG, JPM/Bear Stearns, LEH/Barclays or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Really? Am I supposed to be surprised that the SEC (Securities and Exchange Commission) has dug up a CDO (Collateralized Debt Obligation) deal with $1 billion in associated Goldman Sachs (GS) losses? The headline number may sound large, but the billion dollars is not much if you consider banks are expected to lose about $3 trillion dollars (according to an International Monetary Fund report) from toxic assets and bad loans related to the financial crisis. Specifically, Goldman is being charged for defrauding investors for not disclosing the fact that John Paulson (see Gutsiest Trade), a now-famous hedge fund manager who made billions by betting against the subprime mortgage market, personally selected underlying securities to be included in a synthetic CDO (a pool of mortgage derivatives rather than a pool of mortgage securities).
Hurray for the SEC, but surely we can come up with more than this after multiple years? More surprising to me is that it took the SEC this long to come up with any dirt in the middle of a massive financial pigpen. What’s more, the estimated $1 billion in investor losses associated with the Goldman deal represents about 0.036% of the global industry loss estimates. These losses are a drop in the bucket. If there is blood on Goldman’s hand, my guess is there’s enough blood on the hands of Wall Street bankers to paint the White House red (two coats). The Financial Times highlighted a study showing Goldman was a relative small-fry among the other banks doing these type of CDO deals. For 2005-2008, Goldman did a little more than 5% of the total $100+ billion in similar deals, earning them an unimpressive ninth place finish among its peers. As a matter of fact, Paulson also hocked CDO garbage selections to other banks like Deutsche Bank, Bear Stearns, and Credit Suisse. The disclosure made in those deals will no doubt play a role in determining Goldman’s ultimate culpability.
Context, with regard to the fees earned by Goldman, is important too. Goldman earned less than 8/100th of 1% of their $20 billion in pretax profits from the Abacus deal. Not to mention, unless other charges pile up, Goldman’s roughly $850 billion in assets, $170 billion in cash and liquid securities, and $71 billion in equity should buttress them in any future litigation. These particular SEC charges feel more like the government trying to convict Goldman on a technicality – like the government did with Al Capone on tax evasion charges. At the end of the day, the evidence will be presented and the courts will determine if fraud indeed occurred. If so, there will be consequences.
How bad can Goldman really be, especially considering their deep philanthropic roots (the firm donated $500 million for small business assistance), and CEO Lloyd Blankfein was kind enough to let us know he is doing “God’s work,” by providing Goldman’s rich menu of banking services to its clients.
Certainly, if Goldman broke securities laws, then there should be hell to pay and heads should roll. But if Goldman was really trying to defraud investors in this particular structured deal (called Abacus 2007-ACI), then why would they invest alongside the investors (Goldman claims to have lost $90 milllion in this particular deal)? I suppose the case could be made that Goldman only invested for superficial reasons because the fees garnered from structuring the deals perhaps outweighed any potential losses incurred by investing the firm’s own capital in these deals. Seems like a stretch if you contemplate the $90 million in losses overwhelmed the $15 million in fees earned by Goldman to structure the deal.
Maybe this will be the beginning of the debauchery flood gates opening in the banking industry, but let’s not fully jump on the Goldman Scarlet Letter bandwagon just quite yet. Politics may be playing a role too. The Volcker rule was conveniently introduced right after Senator Scott Brown’s Senate victory in Massachusetts, and political coincidence has reared its head again in light of the financial regulatory reform fury swelling up in Washington.
Waiting for More teeth
There is a difference between intelligent opportunism and blatant cheating. There is also a difference between immorally playing a game within the rules versus immorally breaking laws. Those participants breaking the law should be adequately punished, but before jumping to conclusions, let’s make sure we first gather all the facts. While the relatively minute Abacus deal may be very surprising to some, given the trillions in global losses caused by toxic assets, I am not. Surely the SEC can dig up something with more teeth, but until then I will be more surprised by Jesse Jame’s cheating on Sandra Bullock (with Michelle “Bombshell” McGee) than by Goldman Sachs’s alleged cheating in CDO disclosure.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in GS, DB, Bear Stearns (JPM), and CSGN.VX/CS.N or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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Bill Lockyer, California’s State Treasurer, is in charge of driving “The Golden State’s” budget, but as he maneuvers the finances, he is hearing some strange knocks and pings as it relates to the pricing of Credit Default Swaps (CDS) on California debt obligations. CDSs, like virtually all derivatives, can either be used to speculate or hedge (see also, Einhorn CDS and Financial Engineering articles), so the existence of strange noises does not necessarily indicate foul play or problems that cannot be fixed.
Checking Under the Banks’ Hoods
At the heart of the CDS markets lie the major investment banks, so that is where Lockyer is looking under the hood and requesting information on the role the banks are playing in the municipal bond CDS market. Specifically, Lockyer has sent letters requesting information from Bank of America – Merrill Lynch (BAC), Barclays, Citigroup (C), Goldman Sachs (GS), JP Morgan (JPM),and Morgan Stanley (MS). California pays the banks millions of dollars every year to market bonds on behalf of the state. The I-banks operate in some way like a car dealership – the state produces the cars (bonds) and the banks buy the bonds and resell them to buyers/investors.
The financial transaction doesn’t necessarily stop there, because the banks can further pad their profits by selling and making markets in credit default swaps. After the state issues bonds, speculators can then pay the banks to place bets on whether the cars (bonds) fail (default), or investors can also buy insurance from the banks in the form of swaps. As you can probably surmise, there is the potential for conflicts of interest between the state and the banks, which partly explains why Lockyer is conducting his due diligence.
California…the Next Greece or Kazakhstan?
As the housing market came crashing down, credit default swaps were at the center of financial institution collapses and the billions made by John Paulson (see also the Gutsiest Trade Ever). More recently, CDSs were cited as negative contributors to the Greek financial crisis. Lockyer tries to deflect California comparisons with Greece by stating the European country’s budget deficit is 13 times larger than California’s (as % of GDP) and the foreign country’s accumulated debt is 25 times larger on GDP basis as well (read California’s Debt Hole story).
Beyond making sure the profit rules of the game are not stacked against California, Lockyer wants to understand what he perceives as a mispricing in the default risk of California debt obligations. He is worried that the state’s borrowing costs on future bond issues could be artificially escalated because he says the credit default swaps “wrongly brand our bonds as a greater risk than those issued by such nations as Kazakhstan, Croatia, Bulgaria and Thailand.”
Clarity on these issues is important because the state is exploring the expansion into taxable municipal bonds. The government has been subsidizing taxable munis, termed Build America Bonds (BABs), to stimulate the economy and bring down borrowing costs for municipalities. According to Thomson Reuters, BABS accounted for approximately 26% of overall muni bond issuance ($25.8 billion) in the first quarter.
If California were a car, I’m not sure how much cash they would get for their clunker ($16 billion budget deficit), but I tip my hat to State Treasurer Lockyer for holding the investment banks’ feet to the fire. All investors and financial product consumers stand to benefit by looking under the hood of their financial institution and asking tough questions.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in BAC, C, GS, JPM, and MS or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Although the pain and suffering of the 2008-09 financial crisis has been well documented and new books are continually coming out in droves, less covered are the winners who made a bonanza by predicting the collapse of the real estate and credit markets. Prizewinning Wall Street Journal reporter Gregory Zuckerman decided to record the fortunes made by hedge fund manager John Paulson in his book The Greatest Trade Ever (The Behind-the-Scenes story of How John Paulson Defied Wall Street and Made Financial History).
Paulson’s Cartoonish Cut
Zuckerman puts Paulson’s massive gains into perspective:
“Paulson’s winnings were so enormous they seemed unreal, even cartoonish. His firm, Paulson & Co., made $15 billion in 2007, a figure that topped the gross domestic products of Bolivia, Honduras, and Paraguay…Paulson’s personal cut was nearly $4 billion…more than the earnings of J.K. Rowling, Oprah Winfrey, and Tiger Woods put together.”
As impressive as those gains were, Paulson added another $5 billion into his firm’s coffers and $2 billion into his personal wallet over 2008 and early 2009.
There are many ways to skin a cat, and there are countless strategies used by the thousands of hedge fund managers looking to hit the jackpot like Paulson. John Paulson primarily made his multi-billion fortune thanks to his CDS positions (Credit Default Swaps), the same product that led to massive multi-billion bailouts and government support for various financial institutions.
Bigger Gamble than Perception
One surprising aspect I discovered from reading the book was the uncertainty surrounding Paulson’s negative real estate trade. Here’s how Zuckerman described the conviction level of John Paulson and Paolo Pelligrini (colleague) as it related to their CDS positions on subprime CDO (Collateralized Debt Obligation) debt:
“In truth, Paulson and Pellegrini still were unsure if their growing trade would ever pan out. They thought the CDOs and other risky mortgage debt would become worthless, Paulson says. ‘But we still didn’t know.’”
Often the trades that cause you to sweat the most tend to be the most profitable, and in this case, apparently the same principle held.
Disingenuous Dramatic License
Before Paulson made his billions, Zuckerman uses a little dramatic license in the book to characterize Paulson as a small fry manager, “Paulson now managed $1.5 billion, a figure that sounded like a lot to friends outside the business. But the firm was dwarfed by its many rivals.” Zuckerman goes on to call Paulson’s hedge fund “small potatoes.” I don’t have the industry statistics at my fingertips, but I’ll go out on a limb and make an educated guess that a $1.5 billion hedge fund has significantly more assets than the vast majority of hedge fund peers. Under the 2 and 20 model, I’m guessing the management fee alone of $30 million could cover Paulson’s food and shelter expenses. Before he struck the payload, the book also references the $100 million of his personal wealth he invested with the firm. I think John Paulson was doing just fine before he executed the “greatest trade.”
What Drove the Greatest Trade
Hind sight is always 20/20, but looking back, there was ample evidence of the real estate bubble forming. Fortunately for Paulson, he got the timing generally right too. Here are some of the factors leading to the great trade:
- CDO Leverage in Subprime: By the end of 2006, the subprime loan market was relatively large at around $1.2 trillion (representing around 10% of the overall mortgage market). But thanks to the introduction of CDOs, there were more than $5 trillion of risky investments created from all the risky subprime loans.
- Liars & Ninjas: “Liar Loans” loans based on stated income (using the honor system) and “ninja loans” (no income, no job, no assets) gained popularity and prevalence, which just led to more defaults and foreclosures in the mid-2000s.
- No Down Payments: What’s more, by 2005, 24% of all mortgages were completed with no down payment, up from approximately 3% in 2001. The percentage of first-time home buyers with no down payment was even higher at 43%.
Overall, I give kudos to Gregory Zuckerman, who spent more than 50 hours with John Paulson, for bringing something so abstract and homogenous (a skeptical real estate trade) to life. Zuckerman does a superb job of adding spice to the Paulson story by introducing other narratives and characters, even if the story lines don’t blend together perfectly. After reading The Greatest Trade Ever I came away with a new found respect for Paulson’s multi-billion dollar gutsy trade. Now, Paulson has reloaded his gun and is targeting the U.S. dollar. If Paulson’s short dollar and long gold position works out, I’ll keep an eye out for his next book…The Greatest Trad-er Ever.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including VNQ), but at time of publishing had no direct positions in companies mentioned. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.