PrefBlog

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.

Price volatility slowed considerably today, although recent trends continued weakly, with PerpetualDiscounts gaining 7bp and FixedResets losing 7bp on continued heavy volume.

PerpetualDiscounts now yield 6.17%, equivalent to 8.64% at the standard equivalency factor of 1.4x. Long Corporates now yield about 5.7%, so the pre-tax interest-equivalent spread is now about 295bp, down substantially from the peak of 310bp reported April 7 though still wider than the 285bp reported at month-end.

Citigroup’s liquidity guarantees are attracting scrutiny:

Financial Crisis Inquiry Commission investigators may conclude a primary cause of Citigroup’s 2008 bailout was the use of “liquidity puts” by traders to bolster sales, Chairman Phil Angelides said in an interview yesterday. Those puts allowed customers to sell debt securities back to the bank at face value if credit markets froze, something that Citigroup’s traders bet would never happen, according to Angelides.
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To raise money to buy the assets, Citigroup sold commercial paper, with the assets pledged as collateral. Commercial paper is a type of debt that matures in less than a year and was popular with money-market funds and corporate treasurers who want to invest their surplus cash in readily redeemable funds while earning higher yields.

Liquidity puts were added to “facilitate” the sales of the commercial paper, [Citigroup CDO boss Nestor] Dominguez said; investors could “put back” the commercial paper to Citigroup if the market went cold. Dominguez described this as a “significant widening in credit spreads or a temporary inability to issue commercial paper.” Widening credit spreads, or the gap between a bond’s yield and benchmark rates, indicate slackening investor demand.
…
Citigroup used the liquidity puts partly because they required less capital support than backup credit lines that bank’s typically offer, Georgiou said.

The liquidity puts were subject to a 0.8 percent capital charge, [commission member Byron] Georgiou said. Put another way, the bank had to set aside $1 of capital for every $125 of commercial paper. That compares with Citigroup’s overall ratio of $1 for every $14.50 of loans, securities and other investments as of Dec. 31.

The International Monetary Fund has released the April 2010 Global Financial Stability Report. I haven’t had a chance to do much besides skim it, but the big news is that they’re recommending capital charges on “systemically important” banks based on regulatory fiat, rather than any kind of formula:

Regulators may find it necessary to weigh “direct preemptive measures,” including constraining the size of certain activities to limit the emergence of “systemically important” firms, the Washington-based IMF said today in its bi-annual Global Financial Stability Report.

The report precedes an April 23 meeting of the Group of 20 nations in Washington, where the IMF plans to detail for finance chiefs ways that financial firms may help pay for the costs of bailouts. Since the start of the credit crisis, governments and central banks have spent more than $11 trillion to support the financial industry, according to the Paris-based Organization for Economic Cooperation and Development.

The capital surcharge would be “a buffer” designed to increase “the resiliency of the institution to sustain different shocks,” Juan Sole, one of the report’s authors, told reporters in Washington today.

Political momentum to overhaul financial regulations in some countries may be weakening as economic growth returns, IMF Managing Director Dominique Strauss-Kahn said in an interview in Kenya last month.

Parts of the financial industry have gone “back to practices of risk taking, which is probably not the most appropriate to have a stable financial system at the global level,” he said.

Now, more than ever, it is important for large banks to offer cushy jobs to ex-regulators!

The rebound in the market continued today on heavy volume, with PerpetualDiscounts up 26bp while FixedResets lost 4bp … taking the yield on the latter index within striking distance of 4%!