Macaskill on markets: Goldman suit amplifies threat to derivatives-based trading revenues
The SEC fraud suit against Goldman Sachs has shone a spotlight on the exploitation of the useful idiots at the heart of the credit crisis.
Goldman must now hope for similar suits against rival dealers so that it can try to exercise the Murder on the Orient Express defence – the argument that they all did it. But whether or not Goldman is joined in the dock by some of its peers, the industry now faces the most serious threat yet to its derivatives-based trading revenues and a business model of adopting multiple roles in the modern capital markets.
The rating agencies correctly attracted criticism for their role in offering a spurious security to investors in leveraged credit instruments. Their internal models were deeply flawed and agency officials proved easily manipulated by the investment bankers who structured trades.
The SEC suit over one of Goldman’s Abacus synthetic CDO trades shifted the focus to the external credit portfolio managers who were also played by bankers and some of their hedge fund clients, especially as the credit boom moved into its final stages.
The details of the SEC suit underline the sheer gullibility of many of the participants in the credit boom. Clear signs of problems in the US mortgage market by late 2006 led some credit investors to demand use of supposedly independent collateral managers in any new portfolio deals.
Goldman addressed this issue for the Abacus 2007-AC1 deal by lining up insurer ACA as both collateral manager and investor for a deal that also targeted IKB of Germany as a subscriber to its top-rated tranches.
The SEC suit and Goldman’s subsequent response focus on whether the bank misled ACA and IKB about the role of hedge fund Paulson in selecting mortgage reference assets for a deal it intended to short as part of its now-famous bearish housing bet.
The SEC’s case is far from cut and dried. Its initial complaint was light on clear evidence that Goldman misled its investors about Paulson’s role as asset selector or as a potential investor in the riskiest equity tranche of the deal.
But Goldman’s own marketing materials for the deal paint a damning picture of how easy it was for investment banks to exploit players such as ACA and IKB.
More than half of a 66-page presentation created by Goldman as one of the early marketing documents for the deal was devoted to extolling the virtues of ACA as a portfolio manager. A description of ACA’s supposedly rigorous investment criteria and business mix took 28 pages. Biographical details of key staff at the firm were spread across six pages. An organizational chart of 37 names seemed to attest to the depth of the bench at ACA.
In reality ACA was effectively leveraged over 100 times and was run by a CEO – Alan Roseman – whose main background was as a lawyer. It would fail less than a year after the Abacus deal closed.
An example of the Alice in Wonderland nature of structured credit at the time was included in the Goldman marketing material’s description of ACA’s approach to business.
“Philosophy is to maintain insurance company capital at close to AA margin of safety while pursuing an A-rated business strategy,” ran the bullet point.
In fact ACA, like much of the structured credit market, was effectively pursuing the opposite approach, by assuming as much risk as possible within specific rating parameters, in order to maximize returns.
There were red flags that should have demonstrated Goldman’s own view of the Abacus transaction, away from its disputed responsibility to disclose to IKB the extent to which Paulson decided which mortgage reference obligations to include.
One was Goldman’s unwillingness to act as counterparty on the key credit default swap behind the deal. ACA Capital was lined up to wrap or sell protection on the $909 million super-senior tranche of the deal for a premium of 50bp a year. Instead of acting as protection buyer on this trade, Goldman lined up ABN Amro as a swap intermediary for a fee of 17bp a year. ABN Amro would enjoy this income for less than a year before ACA became unable to meet all its obligations. Eventually RBS – which bought ABN Amro at the end of 2007 – was forced to unwind the swap by paying $841 million to Goldman, most of which was passed on to Paulson.
Goldman ended up assuming some of the risk on part of the super-senior tranche and paying out on swaps to Paulson, for a net loss on the deal that has become part of its defence against the SEC charges. But it clearly intended to take a fee of $15 million or more without assuming any net exposure to either side of the synthetic mortgage bet.
The SEC suit against Goldman will embolden potential litigants against other banks over a host of different structured credit market practices that were widely, if tacitly, acknowledged as standard at the time, but that now look like abuses.
One was the practice of combining a long position in the equity tranche of a synthetic CDO with a much more substantial short in a better-rated tranche. This left either a dealer or investor such as a hedge fund with nominal skin in a deal, but an effective net short exposure that was not always disclosed to other buyers.
Another practice was to source the riskiest possible assets for any given rating band in order to boost the yield on a deal, whether it was based on mortgage exposure or corporate credit.
As cases increase in frequency, banks are likely to have to boost their provisions for litigation losses. That exposure may look manageable in an environment where Goldman can generate $7.39 billion of fixed income trading revenue in a single quarter. But the eventual Enron and WorldCom litigation settlements demonstrate how legal costs swell like construction projects over time.
And the bigger threat for the industry from the SEC case against Goldman is that it could prove a tipping point for radical reform of investment banking practices. The immediate threat is that aggressive derivatives reform will hit revenues. JPMorgan CEO Jamie Dimon recently guessed that derivatives reform could shave revenue by between $700 million and a couple of billion dollars for the bank – an estimate made just before the SEC suit against Goldman raised the political temperature.
JPMorgan has the single biggest derivatives book in the world – around a dozen other dealers generate significant income from swaps and options, so the bill for reform could easily top $10 billion of revenue a year and reach towards $20 billion. That is a range based on lower trading margins and other costs of disclosure. Aggressive reform that limits rules-based arbitrage and the performance of multiple functions within broad-based investment banks could prove far more costly for the industry.