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.

PART 1

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.”

then

47.
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.

61.
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.
62.
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.
63.
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.

41.
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.

Fundamental Causes of the Financial Crisis

As I've learned recently, capital requirements (as in Tier I capital, etc.) are the only limit to lending by banks. But the use of SIVs and off balance sheet subsidiaries allowed banks to escape the capital requirements imposed on them. Even without the SIVs, a "well-capitalized" bank only needs a tier 1 ratio of around 8%!

The capital requirement for Fannie, and other GSEs were even lower at around 3%. Back in 2002-4 when Fannie had an accounting scandal, Congress had a chance to reform and limit the outrageous size of the GSEs, but of course this was defeated. Meanwhile Bush pushed for lower down payment requirements and government subsidies to make housing "affordable for all".

The crisis is almost totally due to bad loans, or loans that are underwater. Had the standard 20% down payment been in place, it would have been hard for the majority of the populace to engage in the bubble. Bubbles can only happen when the mainstream populace participates. The 20% equity would have also cushioned the banks from the majority of losses in my opinion as the peak would have been lower to begin with.

Interestingly enough, we're not the only ones with a housing induced crisis. Australia and Spain are only some of the many other nations that similarly experienced a housing bubble. This leads me to the belief that there is a systematic problem within the global financial network. The problem is that bank lending is not constrained adequately. Furthermore, the low interest rate environment does NOT translate into commodity or consumer good inflation thanks to what the modern financial system has developed into, which is a credit based system.

In this new system, firms or agents first identify an investment opportunity (it can be to build a factory or buy an income producing asset that will generate a greater return than the cost of the loan). Banks then lend to the firm or agent. Notice that the identification of the investment opportunity is step number one, not the lending. With a low interest rate environment, the hurdle to clear for a profitable investment is much lower. Borrowers then borrow to acquire assets. I believe this is why we saw asset and commodity inflation but no inflation in goods and services tracked by the CPI. Firms and agents aren't borrowing to consume, they are borrowing to acquire income assets or building a factory (or store) that produces consumer goods and services to sell at a profit. The new production that comes online keeps prices for consumer goods and services down, but the means of production get bid up. The lower the interest rate, the lower the threshold yield needed for a firm or agent to borrow to acquire or build.

I don't think people understand this new system of finance. This is why people are constantly looking for inflation (as measured by CPI) but finding none except in asset prices (which aren't included in CPI) and can't see the connection between the FED's loose monetary policy and the various bubbles (all asset bubbles) that have popped up. In sum, I identify lax leverage limits and the low interest rate environment established by the various central banks as the underlying causes of the crisis.

2009 Year End Real Estate Charts

Here are some useful charts as we end the year.

Los Angeles Real Estate Prices Based on Traffic Flow

As we end 2009, it seems the worst for residential real estate is over. During this year, I picked up three properties in the Oakland area and all of them seem to have gone up looking at recent sales data. With properties generating huge cash flows even with a worsening rental market, I doubt that we'll see a new low being made in Oakland. As for the rest of the nation? Who knows. In LA where I live, I see single family homes continuing to trend lower in price, the homes in various non-Westside areas like Riverside, La Puente, Silverlake and so forth need to return to their pre-bubble prices of around $250,000-$450,000 depending on their proximity to Downtown LA.

In LA, it's all about traffic. Traffic is horrible going west in the mornings and east in the afternoons, north and south are horrible all day long. Downtown is the center of the freeway system where all traffic merges into a few lanes ill suited to today's traffic flow. Downtown is also where a lot of high paying jobs are, generally the easier traffic is to and from Downtown, the more valuable the real estate will be. Those who bought homes 30-60 miles away East of Downtown have 2 hour drives each way at least, to and from work. These are the homes that have more to fall, no one wants to spend 4 hours a day in the car, and with prices getting cheaper elsewhere, hitting the magic price point of $400,000-$600,000, the starter home price in LA, real estate in Riverside will have to return to $200,000 to attract takers. Because north/south traffic is especially bad, homes that are oriented on the 5/101/110/405 interstates that seem closer to Downtown than homes to the east oriented on the 10/60 will be just as cheap. That is moving 5 miles north or south is like moving 10 miles east valuewise. The further east and north/south, the lower property values. Homes located west of Downtown are able to escape the bad traffic flow and so reflect that convenience in their prices. West Los Angeles where I live saw prices drop by only 5.5% in 2009 according to Zillow, and the average home is still at a very high $798,900 (Oct 2009 sales).

My general thoughts are that LA has more to fall. It's a rich city, but having to spend $800,000 just to live in a decent area without facing horrendous traffic to and from work is just too much. Surprisingly, it will be these areas that hold up the best as everyone considers traffic congestion to be one of the major factors when deciding where to purchase. Consider this article as a very general overview of the LA market, I was thinking about more specific predictions and so forth but that's a lot harder and more time consuming than I thought it would be. This was supposed to be just a quick 5 minute blurb, but it's been well over 45 minutes now as I have to check facts and so forth. Maybe the lesson from this post is that real estate is very location specific and generalizations are all but useless. No wonder my real estate instructor drilled into us that location, location, location are the three most important factors in real estate. Now that I have 7 properties in LA and Oakland, I fully understand why.