PrefBlog

Yet more commentary on Goldman, which has been selected for SEC charges:

The case against Goldman Sachs Group Inc. may turn on the meaning of the word “selected.”

The Securities and Exchange Commission must prove that the most profitable company in Wall Street history defrauded investors by failing to disclose that a hedge-fund firm betting against them played a role in creating what they bought. It must also counter Goldman Sachs’s assertion that an independent asset manager, which the SEC said rejected more than half of the securities initially proposed by Paulson & Co. for a collateralized debt obligation, signed off on the selections.

“The question is whether Paulson’s undisclosed role in portfolio selection was material,” said Larry Ribstein, a law professor at the University of Illinois in Champaign who has written about 140 articles and 10 books on topics including securities law and professional ethics. “There’s no clear and well-defined definition of what you have to disclose in this type of transaction.”

“Selected” means whatever you want it to mean. Anybody who has been selected to receive a special mail-order offer knows that. In this particular case, I’d say that ACA’s role as portfolio manager was quite clear: ACA had full authority and full responsibility, full stop.

Meanwhile, politicians in the native land of Magna Charta displayed a lynch-mob mentality:

Goldman Sachs should be suspended from working for the Government until the outcome of a fraud case brought against the investment bank by US regulators is known, opposition politicians said yesterday.

The demand from the Tories and the Liberal Democrats came as the Financial Services Authority (FSA) began an investigation into the Wall Street giant’s operations in London. Goldman Sachs is on a rota of investment banks that advise the Treasury about debt issuance, which has risen dramatically as the budget deficit has escalated.
…
After Gordon Brown described the US bank as “morally bankrupt” at the weekend, Vince Cable, the Liberal Democrat Treasury spokesman, said yesterday: “The Government should not be paying for the services of a bank that is being investigated on both sides of the Atlantic. The allegations made against Goldman Sachs are extremely serious. Not a penny of taxpayers’ money should be paid while these allegations hang over [the bank].”

The Conservatives also questioned whether Goldman should still be on the roster of approved banks. Mark Hoban, the shadow Financial Secretary to the Treasury, said: “If Gordon Brown believes Goldman Sachs are ‘morally bankrupt’, why is he still using them as advisers? … He is lashing out at the people he was very happy to work with over the last 13 years as both Chancellor and Prime Minister.”

I’d remark on just who in this story has demonstrated moral bankruptcy, but those familiar with the elements of fundamental justice will know that already.

The UK hasn’t yet cut off its nose to spite its face:

“I don’t think you can stop doing business with a firm because an individual is accused of doing something,” [Chancellor of the Exchequer Alistair] Darling said in an interview as he traveled by train to Worcester, central England, today.

Britain’s Financial Services Authority said in a statement today it will formally investigate Goldman Sachs’s London units after the U.S. Securities and Exchange Commission sued the bank for fraud last week over its marketing of a collateralized debt obligation. A Goldman Sachs vice president named in the SEC case, Fabrice Tourre, works at the bank’s London office.

An element of Goldman’s defense has leaked out:

The company failed to disclose that hedge fund Paulson & Co. helped pick the underlying securities in a collateralized debt obligation and then bet against them, the SEC said in a lawsuit filed April 16. After being told in July 2009 that the SEC planned to bring a complaint, New York-based Goldman Sachs argued it had been compelled to keep Paulson’s role secret.

The SEC’s “proposed theory ignores the fact that, as a broker-dealer acting as an intermediary on behalf of a client, Goldman Sachs had a duty to keep information concerning its client’s (Paulson’s) trades, positions and trading strategy confidential,” the company said in a Sept. 10, 2009, document addressed to the agency.

Goldman also points out that such client confidentiality is normal practice. Deal Journal has an expanded version of Friday’s press release.

Beyond politics, there’s another proposed rationale for the SEC’s irrational lawsuit:

SEC Chairman Mary Schapiro, 54, is expanding protection of so-called sophisticated investors such as pension funds, insurance companies and banks after financial companies worldwide lost more than $1.78 trillion since the start of 2007 in the worst economic crisis since World War II.

“The days of ‘buyer beware’ may be changing,” said Todd Henderson, a law professor at the University of Chicago. “In light of the financial crisis and the fact that sophisticated investors aren’t just losing their own money but taxpayers’ money, the interest of regulators is higher.”

God save me from regulatory protection!

Meanwhile, in Toronto the Precious, using the words “Apartheid” and “Israel” in the same sentence is considered not just objectionable, but a major issue:

But, she said, the city has told them that Toronto Pride had contravened its anti-discrimination policy on the grounds that “those words make certain participants feel uncomfortable.”

Golly, it’s just terrible that some things some people say make other people uncomfortable, isn’t it? This rivals the Barenaked Ladies moronicity for sheer pointlessness. Perhaps I should write my local councillor – but which stamp should I use? The march comes with credible estimates of $125-million into the city, with additional spending by locals of about $89-million; despite the fact that (I’ll bet a nickel) I can find a lot more Torontonians offended by the whole idea of the march than might be made to “feel uncomfortable” at the sight of a few childish political slogans.

Still, at least we’re not as precious as Vancouver!

Another day of startling relative returns in the Canadian Preferred Share market, with PerpetualDiscounts down 20bp and FixedResets losing 55bp to bring yields on the latter class up to 4.14%. One could argue that this type of flattening in the preferred share yield curve is a rational response to today’s BoC announcement, but such an argument has too high a level of rationality to it to be appealing. Volume picked up again and was quite heavy.

There are no winners on the performance highlights table, which is dominated by FixedResets; these issues also dominate the volume highlights (but that’s considerably more usual!).

TD has bought three failed US banks:

Toronto-Dominion added $3.1 billion in deposits to the $117 billion it holds in two other U.S. lenders, according to a company statement. The lender picked up 69 branches in yesterday’s purchases, bringing its total in Florida to 100.
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Toronto-Dominion, which has about 1,000 U.S. branches, has spent more than $15 billion over five years buying Portland, Maine-based TD Banknorth and Cherry Hill, New Jersey-based Commerce Bancorp.

The Toronto-based lender acquired the Florida assets and deposits of Clement-based AmericanFirst Bank, First Federal Bank of North Florida in Palatka and Riverside National Bank of Florida of Fort Pierce.

The FDIC press release states:

As of December 31, 2009, AmericanFirst Bank had total assets of $90.5 million and total deposits of $81.9 million; First Federal Bank of North Florida had total assets of $393.3 million and total deposits of $324.2 million; and Riverside National Bank of Florida had total assets of $3.42 billion and total deposits of $2.76 billion. Besides assuming all the deposits from the three Florida institutions, TD Bank, N.A. will purchase virtually all their assets.

The FDIC and TD Bank, N.A. entered into a loss-share transaction on $2.20 billion of the failed institutions’ assets. Initially, TD Bank, N.A. and the FDIC will share in the losses on assets on a 50% – 50% basis.
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The FDIC estimates that the cost to the Deposit Insurance Fund (DIF) for AmericanFirst Bank will be $10.5 million; for First Federal Bank of North Florida, $6.0 million; and for Riverside National Bank of Florida, 491.8 million.

DBRS comments:

This transaction has limited downside credit risk as there is a loss-sharing agreement in place (FDIC has a share in 50% of the loan losses up to certain thresholds and then 80% in excess of those thresholds). It also has no material impact on earnings and a minimal impact on capital. DBRS notes that TD purchased $3.8 billion in assets, including $2.1 billion in loss-covered loans, and assumed $3.1 billion in deposits.

Stories in Saturday’s Globe by Derek DeCloet and Boyd Erman failed to include any of the Goldman’s four critical points highlighted here on April 16. I guess reporting what the defendant has to say isn’t really exciting news.

Scribd has the marketting material, which shows that Goldman Sachs is the protection buyer; it would be expected in the normal course of events that this would be laid off to clients, rather than retained by the firm. The more I learn about this transaction, the more convinced I am that the SEC charges are a load of hooey. ACA, as the selection agent, can only buy what others want to sell. If there was any malfeasance, it has to be because ACA did not exercise due diligence in its purchases; not because they bought stuff from Goldman’s menu of available instruments without knowing who wrote the menu. ACA, by the way, did not have a meaningful track-record as PMs for this type of deal.

I mean, hey! If I’m running the Very Big Preferred Share Fund and I need to buy 100,000 PerpetualDiscounts to get my allocations where I want them, and I call Friendly Brokers Inc. to find some for me, and they do and it’s executed as a cross …. does it really matter to me who the client on the other side of the cross was? If the shares’ issuer goes bankrupt tomorrow, is the broker really liable because the seller was the Very Smart Preferred Share Fund and they didn’t tell me that because it was none of my business? Really?

Basically, what the SEC is saying in this lawsuit is that “Me too!” constitutes due diligence and safe harbour for Portfolio Managers.

But it’s all just politics:

“We must pass Wall Street reform to bring practices like these into the light of day and protect our economy,” Senate Banking Committee Chairman Christopher Dodd, the Connecticut Democrat who wrote the bill, said in a statement.

Senate Majority Leader Harry Reid, a Nevada Democrat, said the Goldman Sachs case reinforces the need to “pass strong Wall Street reform this year,” and urged Republicans to “stop obstructing our efforts to hold Wall Street accountable.”

and:

President Barack Obama’s political advisers are trying to harness the government’s case against Goldman Sachs Group Inc. to build support for a financial- markets overhaul pending in Congress.

A Google Inc. search of “Goldman Sachs SEC” yields an advertisement entitled “Help Change Wall Street” that is sponsored by Organizing for America, Obama’s official political arm outside the White House.

“Help Pres. Obama Reform Wall Street and Create Jobs,” the ad says. “Families First!”

and:

The U.S. Securities and Exchange Commission split 3-2 along party lines to approve an enforcement case against Goldman Sachs Group Inc., according to two people with knowledge of the vote.

SEC Chairman Mary Schapiro sided with Democrats Luis Aguilar and Elisse Walter to approve the case, said the people, who declined to be identified because the vote wasn’t public. Republican commissioners Kathleen Casey and Troy Paredes voted against suing, the person said.

You know what I figure? I figure it’s the whole David Berry thing all over again. They spent untold hours, untold millions of dollars trying to nail the firm – and the best they could come up with is THAT? The guys at Goldman must be saints.

One commenter has suggested:

To make matters worse, Goldman Sachs is circling the wagons around Fabrice Tourre which I believe is a big mistake. The company should have simply issued a press release saying:

Goldman Sachs does not comment on any current litigation and will address any issues in court proceedings.

In addition, Goldman Sachs could have said that:

The company takes any allegations of impropriety seriously and is placing Fabrice Tourre on leave pending the outcome of the SEC litigation.

In any company, especially a company that is the size of Goldman Sachs, there are always some employees who bend the rules or break the law and end up getting a company in legal trouble. By circling the wagons around Fabrice Tourre, Goldman Sachs raised the ante from a single employee issue involving a certain corporate transaction to a corporate wide issue involving the entire company. A very dumb move!

In other words, that Mr. Tourre should be assumed guilty and thrown to the wolves; that management should not stand up for their staff in times of trouble. Let’s just say that I’m glad I don’t work for that blogger!

But the smarminess is spreading:

Prime Minister Gordon Brown today called for the Financial Services Authority to start an investigation, saying he was “shocked” at the “moral bankruptcy” indicated in the suit. Germany’s financial regulator, Bafin, asked the SEC for details on the suit, a spokesman for Chancellor Angela Merkel said.

Goldman has other problems: the EU wants to scapegoat them for Greece:

providing swaps to the Greek government to help reduce its budget deficit will be “profound and thorough,” EU Monetary Affairs Commissioner Olli Rehn said.

The investigation relates to “our relationship with Goldman Sachs,” Rehn said at a press conference in Madrid today after a meeting of EU finance chiefs and central bankers. “I have asked the Ecofin and Eurostat to conduct a profound and thorough investigation in which the Greek authorities are very well cooperating.”

As discussed on March 1, Eurostat explicitly endorsed the type of transaction Goldman facilitated (note the word “facilitated”, and note that they owed no duty to either Eurostat or the EU) at the time.

There was a bit of a switch in the preferred share market today, with PerpetualDiscounts losing 5bp, while FixedResets lost 19bp to take the median weighted average yield on the latter index up above 4%, territory last traversed in November 2009. Volume was down a bit from the peaks, but remains elevated (FixedResets dominating), while price volatility remains muted.

The SEC has charged Goldman Sachs with fraud:

According to the SEC’s complaint, filed in U.S. District Court for the Southern District of New York, the marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. The SEC alleges that undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.

The SEC’s complaint alleges that after participating in the portfolio selection, Paulson & Co. effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure. Given that financial short interest, Paulson & Co. had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson & Co.’s short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors.

Bloomberg quoted a smiley-boy:

“I wouldn’t want to own Goldman stock right now,” said Keith Goddard, president of Capital Advisors, which oversees $810 million in Tulsa, Oklahoma. “If this turns out to be remotely true, do you want to be doing business with someone who doesn’t have your best interests in mind? That’s the accusation here.”

Institutional PMs routinely do business with those who don’t have their best interest in mind. It’s called trading as principal. As usual with PMs who have such an attitude, the Capital Advisors website does not appear to report any performance information.

DBRS noted:

Responding to the complaint, Goldman stated that the charges are unfounded and noted several critical points that it claims were missing from the SEC complaint. DBRS currently rates Goldman’s senior debt at A (high) and short-term instruments at R-1 (middle). The trend on all ratings is Stable.

DBRS is currently evaluating the potential impact of the allegation, which may have legal and financial ramifications for the Company. DBRS views this allegation as negatively affecting Goldman’s reputation, but the severity of any adverse impact is not yet known.

Goldman first fired back with the rather weak:

The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation

A little later, though, they got warmed up:

The Goldman Sachs Group, Inc. (NYSE: GS) said today:We are disappointed that the SEC would bring this action related to a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact.

We want to emphasize the following four critical points which were missing from the SEC’s complaint.

• Goldman Sachs Lost Money On The Transaction. Goldman Sachs, itself, lost more than $90 million. Our fee was $15 million. We were subject to losses and we did not structure a portfolio that was designed to lose money.

• Extensive Disclosure Was Provided. IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities. The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side.

• ACA, the Largest Investor, Selected The Portfolio. The portfolio of mortgage backed securities in this investment was selected by an independent and experienced portfolio selection agent after a series of discussions, including with Paulson & Co., which were entirely typical of these types of transactions. ACA had the largest exposure to the transaction, investing $951 million. It had an obligation and every incentive to select appropriate securities.

• Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor. The SEC’s complaint accuses the firm of fraud because it didn’t disclose to one party of the transaction who was on the other side of that transaction. As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor.

Background

In 2006, Paulson & Co. indicated its interest in positioning itself for a decline in housing prices. The firm structured a synthetic CDO through which Paulson benefitted from a decline in the value of the underlying securities. Those on the other side of the transaction, IKB and ACA Capital Management, the portfolio selection agent, would benefit from an increase in the value of the securities. ACA had a long established track record as a CDO manager, having 26 separate transactions before the transaction. Goldman Sachs retained a significant residual long risk position in the transaction

IKB, ACA and Paulson all provided their input regarding the composition of the underlying securities. ACA ultimately and independently approved the selection of 90 Residential Mortgage Backed Securities, which it stood behind as the portfolio selection agent and the largest investor in the transaction.

The offering documents for the transaction included every underlying mortgage security. The offering documents for each of these RMBS in turn disclosed the various categories of information required by the SEC, including detailed information concerning the mortgages held by the trust that issued the RMBS.

Any investor losses result from the overall negative performance of the entire sector, not because of which particular securities ended in the reference portfolio or how they were selected.

The transaction was not created as a way for Goldman Sachs to short the subprime market. To the contrary, Goldman Sachs’s substantial long position in the transaction lost money for the firm.

Hmm … let me see. Did tranche retention work in this instance? Would the SEC’s tranche retention idea have accomplished anything? Um … Nope.

But there are a few interesting things about the release. ACA Management LLC wasn’t a stand-alone management firm. It was a unit of the now defunct (I think) ACA Financial Guarantee Corp., a mono-line. No information is provided to indicate that it was not a shell firm, created to do some pretend-portfolio management. Goldman talks about its “experience”, always a suspicious sign … I know guys in this business with twenty, thirty, forty years of experience … and that experience has consisted of vapourizing client money. Don’t talk to me about “experience”.

Also, Goldman talks about losing money on the transaction. Define “transaction” please! Was it hedged? How was it positioned according to Goldman’s risk-management process?

All in all, however, it looks to me so far as if the charges are simply a mechanism whereby the boohoohoo brigade can blame Goldman for their bad investments. But we’ll see what comes out in court, if it ever gets that far.

There was an unsupported throwaway line in the DBRS response to the Basel 3 consultation that is certain to cause hilarity in some circles … so I might as well be the first to highlight it:

It is not clear to DBRS what is included or excluded from the definition of resecuritisation. DBRS would suggest that traditional ABCP be explicitly stipulated as excluded. Such assets generally performed well during the financial crisis.

A quiet day price-wise, but a heavy one volume-wise! PerpetualDiscounts lost 3bp while FixedResets lost 6bp and yields on the latter continued inching up towards 4%.

The financial reform process is getting chippy:

Banks, lobbyists and others have until tomorrow to submit comments to the committee, part of the Basel-based Bank for International Settlements. They have until the end of this month to tell their regulators how much the proposals will cost. The panel, made up of bank supervisors and central bankers from 27 countries and territories, will draft rules by the end of the year for lawmakers to implement by late 2012. The committee first published regulations in 1988 and revised them in 2004.

I was amused by this:

“That’s just a veiled threat,” [chief executive officer of the International Centre for Financial Regulation Barbara] Ridpath said. “You are going to make it too expensive for us to lend, so it is going to be your fault when there’s no economic growth. The truth, who knows? Who’s done the studies? Who has any real concept of what the real impact is of the price of credit and GDP growth?”

Umm…. Central Bankers, maybe? I suspect she was misquoted – or it’s just awkward construction – because she’s been in the business a while, not just as a regulator.

The U.S. banks argue that the liquidity rules could force lenders around the world to sell $6 trillion of new debt to meet the requirements. Under the rules, banks would have to maintain a “net stable funding ratio” of 100 percent, meaning they would need an amount of longer-term loans or deposits equal to their financing needs for 12 months, including off-balance-sheet commitments and anticipated securitizations. This would require that some short-term funding be replaced by longer-term debt.

Higher capital requirements and a stricter definition of capital may reduce lenders’ return on equity to 12.9 percent from the 13.8 percent estimated for 2012, according to UBS AG analysts. Britain’s Royal Bank of Scotland Group Plc, Germany’s Commerzbank AG and France’s Credit Agricole SA are among seven European lenders that may need to raise 60 billion euros ($82 billion) to comply with Basel’s capital rules, JPMorgan analyst Kian Abouhossein said in February.

The market’s telling the EU to put its money where its mouth is:

The 10-year bonds were little changed today after declining the past two days. The yield premium investors demand to hold the securities instead of benchmark German bunds rose above 400 basis points for the first time since euro-region finance ministers announced the aid package last weekend. The parliaments of Germany, France and Ireland will have to vote on whether to contribute their share of the loans, government spokesmen said yesterday. Dutch lawmakers will discuss Greek aid today.

“There are concerns that the money will not be available,” said Toby Nangle, who helps oversee 46 billion euros as director of asset-allocation research at Baring Investment Services Ltd. in London. “There are people who are willing to place their own money at risk in anticipation of this thing not going through.”
…
Pacific Investment Management Co., which owns the world’s largest bond fund, said this week it’s not yet ready to buy Greek bonds. BlackRock Inc., the world’s biggest asset manager, said that donor countries need to demonstrate they can withstand a backlash from their citizens.

I suspect that Nangle is talking about CDS protection buyers, but has to use code for fear of arrest and imprisonment.

In fact, late news brought the following:

Greek Prime Minister George Papandreou yesterday asked for a meeting with the EU, the International Monetary Fund and the European Central Bank, which agreed last week to back a 45 billion-euro ($61 billion) rescue package for the cash-strapped nation. Talks will begin in Athens on April 19.
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The government’s request came after the yield on Greece’s benchmark 10-year government bond surged to 7.319 percent yesterday, higher than the level before the rescue package was announced on April 11. Papandreou said that the Athens talks didn’t mean Greece was activating the aid request and still planned to finance its debt in financial markets.

Municipal authorities everywhere are attempting to evade responsibility for their decisions:

The town followed the advice of Deutsche Bank in taking out bets on interest rates in 2004 and 2005, according to Susanne Weishaar, Pforzheim’s budget director until March.

The bank gave her a 10-year chart showing long-term rates were consistently higher than short-term, she said. During an initial phase of guaranteed rates, the town paid 1.5 percent to the bank on 60 million euros of debt while receiving 3 percent to 3.75 percent.

In 2005 and 2006, the difference between long- and short- term rates collapsed. As potential losses soared in 2006, Weishaar bought more swaps from JPMorgan Chase & Co. in a vain attempt to protect the town budget. Today Pforzheim owes 55 million euros to New York-based JPMorgan, she said. That’s 11 percent of this year’s spending.

The Deutsche Bank swaps have a positive value for the city of about 9 million euros, Weishaar said, offset by the negative value of JPMorgan swaps set up to protect the city.

“It’s like Easter eggs,” said Weishaar, 45, who holds a degree in math and economics from the University of Ulm. “You want to buy one and somebody sells you a painted hand grenade instead.”

If the grenades explode — or when local officials decide to cut their losses and get out of long-term contracts when the market is against them — taxpayers foot the bill.

It’s always hard to tell exactly what’s going on from news reports, but it looks like Pforzheim sold fixed-rate debt and swapped it into floating. That’s a little strange (where’s the hedge?) but then doubling down when the market moved against the position is straight speculation. Ms. Weishaar appears to be either incompetent or disingenuous, one or the other.

OSFI’s Pension boss, Judy Cameron, testified today:

Two years ago, we reported that the December 2007 average solvency ratio of federal plans was estimated at 1.05. In other words, pension plan assets, on average, exceeded liabilities by an estimated five per cent. A year later, at year-end 2008, the ratio had declined to 0.85, meaning that the market value of pension plan assets would have been sufficient to cover, on average, only 85 percent of promised benefits on plan termination.

Our most recent estimates show that the average ratio has increased modestly to 0.90 at December 2009. An indicator that has shown a more marked improvement is the proportion of materially under-funded plans. Based on OSFI’s estimates, at the end of 2009, only 15 per cent of all federally regulated pension plans had a solvency ratio of less than 0.80, whereas at the end of 2008, the comparable proportion was 40 per cent.

The recent bounce in PerpetualDiscounts came to earth today, with PerpetualDiscounts losing 14bp and FixedResets down 9bp, bringing yields on the latter up to 3.96%. Volume remains at elevated levels.