Marco Onado

1
Marco Onado

• 8196 Comparative Financial Systems
• April 28, 2010
• Goldman and its sisters
• The new world of investment banking

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Agenda

• The Sec action against Goldman Sachs
• The Senate investigations
• The possible regulatory consequences
• The investment banking is dead. Long live the
  investment banking

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The SEC complaint

• The Commission brings this securities fraud
  action against Goldman, Sachs Co and a GSC
  employee, Fabrice Tourre , for making materially
  misleading statements and omissions in connection
  with a synthetic collateralized debt obligation
  ("CDO") GSCo structured and marketed to
  investors.
• This synthetic CDO, ABACUS 2007ACI, was tied to
  the performance of subprime residential
  mortgage-backed securities and was structured and
  marketed by GSCo in early 2007 when the United
  States housing market and related securities were
  beginning to show signs of distress. Synthetic
  CDOs like ABACUS 2007-ACI contributed to the
  recent financial crisis by magnifying losses
  associated with the downturn in the United States
  housing market.

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The SEC complaint

• GSCo marketing materials for ABACUS 2007-ACI-
  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, 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., with economic interests
  directly adverse to investors in the ABACUS
  2007-ACI CDO, played a significant role in the
  portfolio selection process.,

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The SEC complaint

• 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 GSCo to
  buy protection on specific layers ofthe ABACUS
  2007-ACI 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 GSCo 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.

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The Sec complaint

• In sum, GSCo 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 process
  or its adverse economic interests.

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The Sec complaint

• Tourre was principally responsible for ABACUS
  2007-ACI. Tourre devised the transaction,
  prepared the marketing materials and communicated
  directly with investors. Tourre knew of Paulson's
  undisclosed short interest and its role in the
  collateral selection process. Tourre also misled
  ACA into believing that Paulson invested
  approximately 200 million in the equity of
  ABACUS 2007-ACI (a long position) and,
  accordingly, that Paulson's interests in the
  collateral section process were aligned with
  ACA's when in reality Paulson's interests were
  sharply conflicting.

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The Sec complaint

• The deal closed on April 26, 2007. Paulson paid
  GSCo approximately 15 million for structuring
  and marketing ABACUS 2007-ACl. By October
  24,2007,83 of the RMBS in the ABACUS 2007-AC1
  portfolio had been downgraded and 17 were on
  negative watch. By January 29,2008,99 of the
  portfolio had been downgraded. As a result,
  investors in the ABACUS 2007-AC1 CDO lost over 1
  billion. Paulson's opposite CDS positions yielded
  a profit of approximately 1 billion for Paulson.

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The hot issue

• The crux of the suit is that the ultimate long
  investors were not informed about Paulsons role
  in selecting the reference portfolio.
• And it appears, according to the SECs complaint,
  that Paulson did indeed suggest securities to
  include, and that Paulsons role in this was not
  disclosed to IKB

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The parties involved
Goldman Sachs

• Investors
• IKB
• Abn Amro

Paulsons hedge fund
ACA Cap Mgmt
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The structure of the trade
Notional equity ca. 20 of total
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The layers

• Notional equity 20 360 mn (synthetic CDO a
  pure convention between the two parties)
• Next layer 440 Credit Linked Notes (IKB and ACA)
• Super Senior Layer 90 mn (Goldman Sachs)
• Super Senior Tranche 910 mn

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The CDS part of the deal

• In turn, because of the size of the credit
  exposure that this implied for the central
  counterparty, Goldman, ACA entered into a Credit
  Default Swap that served to substitute ABN Amro
  risk (later Royal Bank of Scotland) for that of
  ACA (see next slide).

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The rationale of the Cds

• GS was the central counterparty, facing off
  against both the long and the short side, and
  protecting against credit risk of its
  counterparties with a combination of CDS and
  collateral posting.
• A key reason to have a broker/ dealer at the
  center of the structure is to allow the buyer and
  seller in a transaction to maintain their
  identities private another is to allow each to
  have exposure to an institution known to them
  rather than maintaining a direct exposure to a
  counterparty or counterparties it is less
  familiar with, or whose credit it does not want
  to take

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Senator Carl Levin, Apr 27 2010

• Goldman Sachs and other investment banks, when
  acting properly, play an important role in our
  economy. They help channel the nations wealth
  into productive activities that create jobs and
  make economic growth possible, bringing together
  investors and businesses and helping Americans
  save for retirement or a childs education.
• Why does this matter? Surely there is no law,
  ethical guideline or moral injunction against
  profit. But Goldman Sachs didnt just make money.
  It profited by taking advantage of its clients
  reasonable expectation that it would not sell
  products that it didnt want to succeed, and that
  there was no conflict of economic interest
  between the firm and the customers it had pledged
  to serve. Goldmans actions demonstrate that it
  often saw its clients not as valuable customers,
  but as objects for its own profit

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Senate Permanent Subcommittee on Investigations
findings on Goldman Sachs

• Securitizing high risk mortgages
• Magnifying risk
• Shorting the mortgage market
• Conflict between client and proprietart trading
• Abacus transaction
• Using naked Credit Default Swaps

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Securitising high risk mortgages

• GS contributed to securitize loans for bad
  lenders such as Washingon Mutual
• WaMu, Long Beach, and Goldman Sachs collaborated
  on at least 14 billion in loan sales and
  securitizations, even though Long Beach
  originated some of the worst performing subprime
  mortgages in the country.
• In 2005, Long Beach saw a surge of early payment
  defaults and had to repurchase over 875 million
  of nonperforming loans from investors, as well as
  book a 107 million loss. Internal audits of Long
  Beach and examinations by the Office of Thrift
  Supervision repeatedly identified lax lending
  standards, poor controls over loan officers. Long
  Beach securitizations had among the worst credit
  losses in the industry from 1999-2003, and in
  2005 and 2006 Long Beach securities were among
  the worst performing in the market

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Securitising high risk mortgages

• Nevertheless, in May 2006 Goldman Sachs acted as
  co-lead underwriter with WaMu to securitize about
  532 million in subprime second lien, fixed rate
  mortgages originated by Long Beach issued about
  495 million in RMBS securities backed by the
  Long Beach high risk mortgages.
• The top three tranches, representing 66 percent
  of the principal loan balance, received AAA
  ratings from SP, even though the pool contained
  high risk, subprime second lien mortgagesloans
  for which there was little prospect of recovering
  collateral in the event of a housing
  downturnissued by one of the nations worst
  mortgage lenders

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Securitising high risk mortgages

• Goldman Sachs then sold the Long Beach securities
  to investors.
• In less than a year, the Long Beach loans started
  to become delinquent. By May 2007, the cumulative
  net loss on the underlying mortgage pool jumped
  to over 12 percent, wiping out a significant
  amount of the deals loss protection and causing
  SP to downgrade 6 out of 7 of the mezzanine
  tranches of the securitization. The Long Beach
  securities plummeted in value.

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• Goldman Sachs owned some of the mezzanine
  securities, but had also placed a bet against
  them by purchasing a credit default swap that
  paid off if the securities incurred loss. One
  Goldman employee, upon learning of the Long Beach
  losses, wrote in an email to management bad
  news the loss wipes out the m6s and makes a
  wipeout of the m5 imminent costs us about
  2.5million dollars good news we own
  10million dollars protection at the m6 we make
  5million. Ultimately, in this transaction,
  Goldman Sachs profited from the decline of the
  very security it had earlier sold to clients. By
  May 2008only two years latereven the AAA
  securities in LBMLT 2006-A had been downgraded to
  default status. By March 2010, the securities
  recorded a cumulative net loss of over 66
  percent.

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Goldman Sachs shorting the mortgage market

• Goldman Sachs senior management closely monitored
  the holdings and the profit and loss performance
  of its mortgage department.
• In late 2006, when high risk mortgages began
  showing record delinquency rates, and the value
  of RMBS and CDO securities began falling
  generally, Goldman Sachs Chief Financial Officer
• David Viniar convened a meeting on December 14,
  2006, to examine the data and consider how to
  respond.

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Goldman Sachs shorting the mortgage market

• Beginning in early 2007, Goldman Sachs initiated
  an intensive effort to not only reduce its
  mortgage risk exposure, but profit from high risk
  RMBS and CDO securities incurring losses.
• A presentation to the Goldman Sachs Board of
  Directors identified a number of actions taken
  during the year, including Shorted synthetics
  and Shorted CDOs and RMBS

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Senator Levins position

• But Goldman Sachs did more than earn fees from
  the synthetic instruments it created. Goldman
  also bet against the mortgage market, and earned
  billions when that market crashed. In December
  2006, Goldman decided to move away from its
  long positions in the mortgage market in what
  began as prudent hedging against the firms large
  exposure to that market, exposure that sparked
  concern on the part of the firms senior
  executives. The edict from top management after a
  Dec. 14, 2006 meeting was get closer to home,
  meaning get to a more neutral risk position. But
  by early 2007, the company blew right past a
  neutral position on the mortgage market and began
  betting heavily on its decline, often using
  complex financial instruments, including
  synthetic collateralized debt obligations, or
  CDOs.

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Senator Levins position

• Goldman took large net short positions throughout
  2007. This chart, which is based upon data
  supplied to the Subcommittee by Goldman Sachs,
  tracks the firms ongoing huge net short
  positions throughout the year. These short
  positions at one point represented approximately
  53 of the firms risk as measured by the most
  relied upon risk measure, Value at Risk or
  VaR. And these short positions did more than
  just avoid big losses for Goldman. They generated
  a large profit for the firm in 2007.

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Possible regulatory actions

• Tighter capital requirements
• Separation (Volcker rule)
• From Otc to regulated markets
• Stricter fiduciary duties

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The strengths and weaknesses of the investment
banks businesse model

• Two drivers of profitability
• Leverage
• Rotation (earnings per volume of assets)
• Leverage can mean fragility
• Rotation can mean
• Aggressive search for fees
• Insufficient liquidity support for positions

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The 4 lives of investment banking according to a
research from Natixis. Returns
Before 2007 2007/2008 2009 2010/2012
High returns. No differentiation between banks. Activities delivering big losses, especially banks carrying structured products and credit derivatives refinanced in the short term on interbank markets. Historically high margins on flow activities. Toxic asset positions still taking a heavy toll on the accounts of some banks (decoupling). Margins lower but still high, especially compared with other banking activities. Banks with global franchises in flow activities and with high distribution capacity will be at an advantage
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