Sunday, April 25, 2010

We're All Capitalists

Jonah Goldberg's article for the AEI neatly summarizes the problems with socialism and why we're all capitalists at heart.

If by "capitalist" you mean someone who cares more about his own profit than yours; if you mean someone who cares more about providing for his family than providing for yours; if you mean someone who trusts that he is a better caretaker of his own interests and desires than a bureaucrat he's never met, often in a city he's never been to: then we are all capitalists. Because, by that standard, capitalism isn't some far-off theory about the allocation of capital; it is a commonsense description of what motivates pretty much all human beings everywhere.

And that was one of the reasons why the hard socialism of the Soviet Union failed, and it is why the soft socialism of Western Europe is so anemic. At the end of the day, it is entirely natural for humans to work the system--any system--for their own betterment, whatever kind of system that may be. That's why the black-market economy of the Soviet Union might have in fact been bigger than the official socialist economy. That is why devoted socialists worked the bureaucracy to get the best homes, get their kids into the best schools, and provide their families with the best food, clothes, and amenities they could. Just like people in capitalist countries.

It's why labor unions demanded exemptions and "carve-outs" from Obamacare for their own health-care plans. And why very rich liberals still try their best to minimize their taxes.

The problem with socialism is socialism, because there are no socialists. Socialism is a system based upon an assumption about human nature that simply isn't true. I can design a perfect canine community in which dogs never chase squirrels or groom their nether regions in an indelicate manner. But the moment I take that idea from the drawing board to the real world, I will discover that I cannot get dogs to behave against their nature--at least not without inflicting a terrible amount of punishment. Likewise, it's easy to design a society that rewards each according to his need instead of his ability. The hard part is getting the crooked timber of humanity to yield to your vision.

continue reading the rest of his great article here.

Wednesday, April 21, 2010

Ratings Agencies: The Monsters Congress Created

It should also be noted that ratings are only important for regulatory reasons. Congress created the game, made these private agencies which are just companies issuing opinions on others, into God-like emperors who pronounce if some debt is worthy of inclusion in a pension fund or not.

Even more important is how AAA securities are treated under Basel and Basel II for capital requirements. AAA securities count 100% towards capital requirements while non-AAA securities start off at 50%. Again, Congress created their own boogeyman through bad regulations. It's important to get regulations right or else very unintended consequences can occur.

People should understand that no large investment or financial management company depends upon ratings to determine risk. Everyone from Fidelity to Paulson with his hedge fund has their own analysts and do their own research. No one except for maybe mom and pop (they probably aren't buying CDOs) use S&P, Moodys, or any agency to determine the risk level of default.

Then why are the agencies important? Because Congress made them so. They're part of the regulatory process thanks solely to Congress. And Congress has frozen out all other competitors, even those who have better track records, only a certain select few ratings agencies can issue ratings that "count" towards regulatory requirements.

Thanks to regulations, it was just too tempting for certain greedy institutions to hold AAA securities that count 100% towards capital requirements and pay a good yield over AAA US Treasuries. The very fact that CDO AAA always yielded more than AAA corporate bonds which in turn always yielded more than AAA US Treasuries shows that the market was aware that not all AAA were created equal. But since regulations treated them equally, we have a little discrepancy that ended up fueling (along with a bunch of other factors) the crisis. Now can people understand why regulations have to be very carefully crafted and the urge to just pass any regulation is probably very stupid?

Government Failure: Another Example

Regulations will not work if the regulators refuse to do their jobs. With regards to the massive $8 billion dollar Robert Allen Stanford fraud, the SEC did just that. An internal report released on the same day the Goldman case was filed (of course), revealed that the SEC knew of the fraud as far back as 1997.

The OIG investigation found that the SEC’s Fort Worth office was aware since 1997 that Robert Allen Stanford was likely operating a Ponzi scheme, having come to that conclusion a mere two years after Stanford Group Company (“SGC”), Stanford’s investment adviser, registered with the SEC in 1995. We found that over the next 8 years, the SEC’s Fort Worth Examination group conducted four examinations of Stanford’s operations, finding in each examination that the CDs could not have been “legitimate,” and that it was “highly unlikely” that the returns Stanford claimed to generate could have been achieved with the purported conservative investment approach. Fort Worth examiners dutifully conducted examinations of Stanford in 1997, 1998, 2002 and 2004, concluding in each case that Stanford’s CDs were likely a Ponzi scheme or a similar fraudulent scheme. The only significant difference in the Examination group’s findings over the years was that the potential fraud grew exponentially, from $250 million to $1.5 billion.

While the Fort Worth Examination group made multiple efforts after each examination to convince the Fort Worth Enforcement program (“Enforcement”) to open and conduct an investigation of Stanford, no meaningful effort was made by Enforcement to investigate the potential fraud or to bring an action to attempt to stop it until late 2005. In 1998, Enforcement opened a brief inquiry, but then closed it after only 3 months, when Stanford failed to produce documents evidencing the fraud in response to a voluntary document request from the SEC. In 2002, no investigation was opened even after the examiners specifically identified multiple violations of securities laws by Stanford in an examination report. In 2003, after receiving three separate complaint letters about Stanford’s operations, Enforcement decided not to open an investigation or even an inquiry, and did not follow up to obtain more information about the complaints.

It is any wonder why I am so cynical over government control and fixes for our economy?

The Most Important Lesson of Economics

INCENTIVES MATTER. Why after so many studies and so much evidence this critical factor continues to be ignored is something I can't explain.

There is no perfectly evil or perfectly good person who behaves in a wicked or saintly way regardless of the incentives and disincentives placed in front of them. "Good" people can be lured into doing "bad" acts through incentives. Outcomes can be altered due to mistaken incentives and the old nemesis of unintended consequences can make a well intentioned program into a very very harmful and bad one.

The intent really doesn't matter, what matters is that anytime an activity or outcome is subsidized, you incentivize it and anytime you tax an activity or outcome, you discourage it. At some point, there is danger that, in helping the poor or unemployed, the incentives become so large that behavior is changed and negative factors arise.

Now that's not saying we should end all unemployment or social payments. I just want everyone to take into consideration that INCENTIVES MATTER. I find that the Left's refusal to acknowledge this crucial factor is perhaps the largest reason why conservatives and liberals disagree on the proposed solution to age old problems. Thus the tax cut versus more social payments/subsides, etc.

Notice I'm not saying that giving a penny to the poor will make everyone in the US rush to spend their assets and become poor. The only thing I am saying is that the effects of incentives and disincentives should be considered by everyone. They are simply too important to be ignored, yet they often are as evidenced by the posts above, simply excused away instead of factored into calculations and conclusions.

Friday, April 16, 2010

More Thoughts on SEC vs. Goldman Sachs

Didn't ACA, IKB, and everyone else have the same information on the RMBS in the CDO as Paulson did? That the great Paulson wanted to bet against this CDO was of supreme importance, why? Because he's an omniscient god?

Goldman acted as a broker/middle-man. It's not their responsibility to advise against trades that they don't think will work out well. Imagine if you entered a market buy order for Goldman stock on Monday and it was canceled because your broker thought that would be a stupid move. I'd be furious.

My take is that Paulson thought the subprime real estate market was going to hell and he needed a way to make a bet. So he asked Goldman to find a manager, ACA, that would structure something he could bet against. Paulson could have been wrong, he had no special information on the RMBS he picked along with ACA correct? He was just smarter and better than everyone else who had the same information. The information included credit scores, loan-to-value, etc., Paulson's opinion of the mortgages and of the real estate market isn't relevant. Is he God?

People are looking at this in retrospect with perfect hindsight. I ask you all to come up with a list of 10 stocks that you want included in some sort of "sure to lose money" index. The point is that Paulson had nothing to do with the low yields the buyers were willing to take or the low payments the CDS issuer was willing to accept for writing insurance. The more I understand the situation, the more I think this is totally BS!

SEC vs. Goldman II

I was wrong and Goldman only acted as a middleman/broker in the transactions, they did not directly issue CDS and did not have positions in any of the transactions.

As I read more and more, it seems the SEC is really going to have a hard time proving anything. All Goldman did was find participants, they acted as a market-finder and had no skin in the game. Were they supposed to issue updates on what one of their customers, Paulson, was doing? Or basically say to the CDS issuer, "Hey, don't you know the great Paulson is on the other side of the trade? He's never wrong, and you're going to get taken!".

I think I understand the situation almost completely now. Paulson saw the crisis coming and wanted to bet against housing. But how? There isn't a subprime mortgage index or anything like that so he first had to create a reference index that he could bet against. That was the CDO made up of subprime loans rated Baa2 that he expected would be in trouble. So he asked Goldman to find someone who could act as an asset manager and structure such a CDO so that he could bet against it. Goldman did in ACA. ACA had all the information Paulson did on credit scores and so forth, and subsequent investors would also. After the CDO was structured, Paulson bought CDS on it and he turned out to be correct. Those issuing the CDS had the relevant information, that Paulson wanted to bet against this CDO all along wasn't relevant. It's like if I bought Goldman Sachs tomorrow and I didn't know George Soros was selling me his shares. So what? I'm buying because I see that the SEC has no case, who cares if Soros is selling?

If there is a culprit here, it is Paulson, not Goldman who only acted as broker. Still it is a stretch, Paulson didn't have any information that wasn't available to everyone else. He was just smarter and better.

Analysis of SEC's Case Against Goldman Sachs

Those who want to read the actual complaint made by the SEC should go here. After reading the complaint, the SEC's case can be split into two parts.


Goldman mislead ACA, the third party picked to head selection of securities, that Paulson, a person also involved in the selection of securities to be included, would have skin in the game of the final CDO.

On January 10, 2007, Tourre sent an email to ACA with the subject line, “Transaction Summary.” The text of Tourre’s email began, “we wanted to summarize ACA’s proposed role as ‘Portfolio Selection Agent’ for the transaction that would be sponsored by Paulson (the ‘Transaction Sponsor’).” The email continued in relevant part, “[s]tarting portfolio would be ideally what the Transaction Sponsor shared, but there is flexibility aroundthe names.”


On January 10, 2007, Tourre emailed ACA a “Transaction Summary” that included a description of Paulson as the “Transaction Sponsor” and referenced a “Contemplated Capital Structure” with a “[0]% - [9]%: pre-committed first loss” as part of the Paulson deal structure. The description of this [0]% - [9]% tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche. In fact, GS&Co never intended to market to anyone a “[0]% - [9]%” first loss equity tranche in this transaction

Considering that what Goldman described was a CONTEMPLATED capital structure, I think this alleged deception will be very hard for the SEC to prove. It's up to ACA to do due diligence as they were hired to do just that, act as a neutral third party analyst for the selection of securities to be included in the CDO.

Later on, ACA's parent company would write insurance on the CDO. The SEC claims that ACA wouldn't have done so if they knew that Paulson had gone short (bet against the CDO since he helped pick the underlying securities. However I think that's a very weak argument as ACA also helped pick and had ultimate say in that they could have refused to put their name on a CDO they didn't like.

ACA’s parent company, ACA Capital Holdings, Inc. (“ACA Capital”), provided financial guaranty insurance on a variety of structured finance products including RMBS CDOs, through its wholly-owned subsidiary, ACA Financial Guaranty Corporation. On or about May 31, 2007, ACA Capital sold protection or “wrapped” the $909 million super senior tranche of ABACUS 2007-AC1, meaning that it assumed the credit risk associated with that portion of the capital structure via a CDS in exchange for premium payments of approximately 50 basis points per year.
ACA Capital was unaware of Paulson’s short position in the transaction. It is unlikely that ACA Capital would have written protection on the super senior tranche if it had known that Paulson, which played an influential role in selecting the reference portfolio, had taken a significant short position instead of a long equity stake in ABACUS 2007-AC1.
The super senior transaction with ACA Capital was intermediated by ABN AMRO Bank N.V. (“ABN”), which was one of the largest banks in Europe during the relevant period. This meant that, through a series of CDS between ABN and Goldman and between ABN and ACA that netted ABN premium payments of approximately 17 basis points per year, ABN assumed the credit risk associated with the super senior portion of ABACUS 2007AC1’s capital structure in the event ACA Capital was unable to pay.

Part 2

Goldman did not disclose to investors that the selection process involved Paulson who had a short position against some of the underlying securities or similar securities.

On or about April 26, 2007, GS&Co finalized a 178-page offering memorandum for ABACUS 2007-AC1. The cover page of the offering memorandum included a description of ACA as “Portfolio Selection Agent.” The Transaction Overview, Summary and Portfolio Selection Agent sections of the memorandum all represented that the reference portfolio of RMBS had been selected by ACA. This document contained no mention of Paulson, its economic interests in the transaction, or its role in selecting the reference portfolio.

I think this is the only place where the SEC might have a case. But did Goldman have to disclose Paulson's role? After all, Paulson is just another client of the firm and so does it have to keep track of what each and every client is doing? What if Paulson had entered into short positions with another firm instead of Goldman, clearly then Goldman would not have known (but he didn't). It was known that the underlying securities would be based on subprime mortgages rated Baa2, does Goldman have to reveal that Paulson, who played a part in the selection of the particular mortgages, had a negative view of the mortgage market and bet against those securities?

In the end, a stupid German commercial bank, IKB, decided to purchase $150 million of the CDO in two tranches. They lost just about all of the $150 million while Paulson, who had purchased credit default swaps on the underlying securities, profited. The CDS was purchased through Goldman, which means that Goldman "lost" money as they had to pay out on the CDS. That will add complications to the SEC case, but the SEC claims that the money IKB lost went to Paulson which isn't directly true. IKB lost money through purchasing a CDO offered by Goldman. Paulson made a bet on securities that the CDO was based upon or similar securities and collected his insurance money from Goldman. Goldman "won" with IKB and "lost" with Paulson, it doesn't follow that IKB's money went to Paulson. We'll have to see what happens, but this is by no means an open and shut case.

SEC Has Weak Case Against Goldman

Today, the SEC filed civil charges against Goldman, a short summary from the NY Times reads,

Goldman Sachs, which emerged relatively unscathed from the financial crisis, was accused of securities fraud in a civil suit filed Friday by the Securities and Exchange Commission, which claims the bank created and sold a mortgage investment that was secretly devised to fail.

After reading more details of this transaction, I'm not sure if the SEC has a case or not. ACA knew that Paulson was involved with picking the securities, they exchanged e-mails with him and both negotiated over which securities would be included in the CDO.

On January 22, 2007, ACA sent an email to Tourre and others at GS&Co with the subject line, “Paulson Portfolio 1-22-10.xls.” The text of the email began, “Attached please find a worksheet with 86 sub-prime mortgage positions that we would recommend taking exposure to synthetically. Of the 123 names that were originally submitted to us for review, we have included only 55.”

It seems the whole SEC case hinges on the fact that Goldman did not disclose Paulson had purchased Credit Default Swaps (CDS) on some of the underlying securities from Goldman, and was involved with ACA in the initial selection process. However someone else on Felix Salmon's blog raised a really good issue,

“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.”

In other words Paulson bought insurance for the underlying portfolio from Goldman.

If the underlying portfolio fails–or if it were to fail–Goldman will have to post collateral.

If Goldman knew that these are bad securities (implying that at some point it has to post collateral to Paulson & Co.) then why would GS structure them in a way that Paulson wants?

Even if for some strange reason GS did structure it the way Paulson wanted and got a fee in return, how can GS be held culpable, given the fact it is long on the underlying insurance?"

This will be a very hard case and is not a clear case of wrongdoing. Goldman was not an underwriter, they were just the broker in the deal. There's no guarantee that anything a broker sells has to be a "good" security in the eyes of the broker or the seller. It's like a yard sale, the buyer knows that the stuff there is junk in the eyes of the seller, but one man's junk is another's treasure. In the financial world, no one is omniscient, Paulson turned out to be right, but ACA had the opportunity to review the proposed list of securities, made revisions, and agreed to the final list. They could have rejected any of the securities on the list, and in fact did reject 21 out of the initial list as well as pick the replacement securities. It was a negotiation and ACA is a big boy who should have done better analysis (actually it's really the willingness of subsequent investors to accept risk for such a low yield). The fact that these were to be based on subprime mortgages at the Baa2 credit level underscores that this wasn't going to be as safe as a government bond.

This occurred on February 2, 2007: “Later the same day, ACA emailed Paulson, Tourre, and others at GS&Co a list of 82 RMBS on which Paulson and ACA concurred, plus a list of 21 “replacement” RMBS. ACA sought Paulson’s approval of the revised list, asking, “Let me know if these work for you at the Baa2 level.”

The only fault I can see is that Goldman didn't correct ACA's false assumptions that Paulson was long in the fund.

On January 10, 2007, Tourre emailed ACA a “Transaction Summary” that included a description of Paulson as the “Transaction Sponsor” and referenced a “Contemplated Capital Structure” with a “[0]% – [9]%: pre-committed first loss” as part of the Paulson deal structure. The description of this [0]% – [9]% tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche. In fact, GS&Co never intended to market to anyone a “[0]% – [9]%” first loss equity tranche in this transaction…

On February 12, 2007, ACA’s Commitments Committee approved the firm’s participation in ABACUS as portfolio selection agent. The written approval memorandum described Paulson’s role as follows: “the hedge fund equity investor wanted to invest in the 0- 9% tranche of a static mezzanine ABS CDO backed 100% by subprime residential mortgage securities.”

All the instant analysis on the mainstream news sites don't do justice to the complexity of the issue. It's a good thing there are blogs out there that will provide real analysis from people who understand the business, but that's bad for the SEC as the deeper you look into the case, the worse it appears for the SEC.