Saturday, April 17, 2010

Goldman Sachs: Enron On The Hudson (first of a series)

The infamous Vampire Squid may finally have met its
Calamari moment.

In a stunning blow to its image as the all-powerful,
unquestioned ruler of Wall Street, The SEC has formally
charged Goldman Sachs with fraud concerning a major
"synthetic CDO" deal.

This transaction, labeled ABACUS 2007-AC1, was conceived
by Goldman Sachs and its hidden "partner", famous hedge
fund operator John Paulson, as a means of "shorting" the
subprime residential mortgage market during the heady
days of 2007.

Now, there's nothing really wrong with "shorting" a market,
a security, or an expected future financial event. For every
Bull, there has to be a Bear - and the proper expression of
both positive and negative market sentiment is necessary
for financial markets to function properly.

But ABACUS 2007-AC1 wasn't set up as a vehicle for investors
to take short positions in the residential mortgage market.
Rather, it was a scam set up secretly by Goldman and Paulson
that required the participation of unwitting "long" investors
to succeed.

And the story reads like something out of a crime novel.

First of all, a little explanation of what a "CDO" like ABACUS
actually is. A "CDO" is a special purpose entity ( a shell
corporation), that purchases securities, arranges
them in slices ("tranches") according to credit, interest rate,
and maturity risk, and then issues notes to the investors,
who can pick and choose among the various tranches
according to their appetites for risk and return.

Properly structured, CDO's assist in providing liquidity
to the fixed-income marketplace, while offering sophisticated
institutional investors a greater range of choices than would
otherwise be available. And, to further assure the
integrity of the offering, several parties, each independent
of one another, work to put the deal together.

The securities to be purchased by the CDO are selected by an
independent adviser in accordance with the goals set forth in
the offering documents. The CDO is managed by another
party, independent of the others, to receive payments
of principal and interest from the bonds and make payments
to the investors. Each bond or bond pool purchased by the CDO
is rated for credit and other risk by an independent ratings
agency - either Moodys, Fitch, Standard and Poors, or all three.
Finally, the CDO sponsor, in this case Paulson, puts up a small
amount of equity to serve as a loss buffer in case of defaults
in the bond portfolio. Normally, when the CDO is dissolved
(usually in 3-5 years), this equity is recovered, plus a profit,
from the onward sale of the remaining portfolio.

So far, so good - except in this case, as Goldman and Paulson
had intended for this CDO deal to go bad, none of these
protections really applied. The selection adviser (a little-known
company called ACA), was brought to the deal by Paulson.
In an "efficiency" move, Goldman elected to act as CDO
manager itself - removing a critical level of protection
for the investors - as it had already created some nineteen
other similar "deals" in the ABACUS series and thus had
more "experience" in this type of transaction. And, when
it came to rating the bonds in the CDO - which can only
be charitably described as "toxic waste" - Goldman put
immense pressure on the ratings agencies to give them
"investment grade" ratings (AAA through BBB-).

A more truthful rating for the whole deal would be
one word - junk.

With the deal in place, then, all Goldman had to do
was find some willing "marks" or patsies to fund it.
And for this it turned to a 27-year old Managing Director
in its London office - Fabrice Tourre - who had helped put
many of the ABACUS deals together.

This enterprising Sorbonne and Stanford-educated
Frenchman had a Rolodex full of European institutions
eager to get in on the never-ending bull market in U.S.
residential real estate. And, using the exalted reputations
of Goldman and Paulson as parties "already in" on the deal,
he found two players - ABN Amro, a Dutch bank,
and a mid-size German bank, IKB, to take major positions.

Just one thing was omitted by M. Tourre - that Goldman
and Paulson were in on the deal all right - but on the
short side, betting that it would fail.

And once ABN Amro and IKB ponied up, it was time to
sting the marks. Goldman and Paulson loaded up
on collateralized debt swaps ("CDS's") to insure their
payoffs. Only these CDS's had one unique feature -
unlike most CDS's which would pay off only on a
default, these would pay off on a mere rating agency
downgrade. Among the insurers on this deal were
ACA Capital, Ambac and AIG - all of whom would
ultimately collapse in the wake of this and other
frauds perpetrated by Goldman and the other
"major players" on Wall Street. So eager was
Goldman to start collecting on the scam that it even
advanced Paulson the money for its "equity"
portion, in exchange for a fee.

And just as Goldman and Paulson intended, no sooner
did the deal close than it started to go south.
Within three months, all of the ABACUS tranches below
AAA had been downgraded - triggering the payouts to
the perpetrators. Within six months, half of the tranches
were in default. And within ten months, the entire CDO
was bankrupt.

And the outcome?

ABN Amro was seized by Dutch regulators
as a result of this and other deals and sold off
to Royal Bank of Scotland. IKB was partially
nationalized and restructured by the German
government. Many of the clients and shareholders
of both these institutions lost their shirts.

Bernie Madoff couldn't have done it better.

And at this point in time, Goldman wasn't
alone in creating these types of toxic scams -
it faced brutally intense competition from JP Morgan,
Merrill Lynch, Bear Stearns, Lehman Bros. and Citicorp
for this dubious type of "business". In its defense, Goldman
will no doubt make much of the fact that "everyone was
doing it", and that had it passed on this particular deal,
Paulson would have just gone elsewhere.

And from where I sit, that's just bulls**t - just because everyone
else in your industry is doing frauds and crimes doesn't mean
you have to. Besides, if you're Goldman, you've got an edge
the others don't have - you've got all the politicians and
regulators in your pocket, if not in fact on your payroll.

And now all that seems likely to go away. The investigation
of almost every deal Goldman has done in the last ten years
will now get under way. Goldman's "business practices"
in other areas of finance are now going to get intense
regulatory and enforcement scrutiny. The lawsuits are
already starting, and criminal indictments may shortly follow.
Goldman's friends and protectors in high places are already
running for cover.

Let's see - off-balance-sheet "special vehicles", hidden
"inside partners", manipulation of ratings, balance sheets,
income statements, assets and liabilities - hmmm ... we've
seen this movie before, folks.

Remember the "Energy Company that became a Hedge Fund"
down in Houston called Enron? Well, we now have Enron II,
with Lloyd Blankfein playing the part of Kenny Lay, with
Gary Cohn as Jeffrey Skilling and David Viniar as Andy

Yes, It's Calamari Time for The Squid - and I like mine
fried and breaded, with plenty of Marinara on the side.

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