Submitted by David Fiderer
Goldman's Blueprint for Dumping Toxic Assets: How These CDOs Were Designed to Fail
"Although Goldman Sachs held various positions in residential
mortgage-related products in 2007, our short positions were not a 'bet
against our clients.'"
That claim, from Goldman's letter to its shareholders,
is easily refuted. The S.E.C. has brought fraud charges on one of
Goldman deals known as synthetic subprime mezzanine collateralized debt
obligations, or CDOs. While most of these deals remain shrouded in
secrecy, one of them, Anderson Mezzanine Funding 2007, Ltd.
lays out its blueprint in sufficient detail so that we can pinpoint how
and why this transaction's failure was never in doubt.
When the deal closed on March 20, 2007, there was virtual certainty
that investors would get wiped out and that Goldman would receive a
windfall. And that's exactly how things turned out. By December 2009,
Anderson Mezzanine's nominal value had shrunk by more than two-thirds,
from $307 million to $94 million, though remaining assets' fair market
value was far less. The investment portfolio, which held only two
performing assets, had an average credit rating of CC.
Anderson Mezzanine is by no means unique. More than $70 billion
worth of toxic assets were dumped into mezzanine CDOs during an
eight-month period between September 2006 and April 2007, when it
became obvious to Wall Street banks that the lower-rated slices, or
tranches, of mortgage-backed bonds were worthless. Other Goldman
deals--Hudson Mezzanine Funding I and Hudson Mezzanine Funding II,
various Abacus deals--were also designed to insulate the banks from
losses on assets it knew to be worthless.
Eventually The Risk of Failure Morphs Into Absolute Certainty
A CDO is like a mutual fund or a hedge fund. It's an investment
portfolio, which, subject to certain limitations, may be actively
managed. Sometimes a CDO, including Anderson, also acts like an
insurance company. It receives fees for insuring certain identifiable
risks, and, whenever called upon to pay out on an insured claim, it
will liquidate part of the investment portfolio.
But insurance companies take on risks when the outcome is in doubt.
Anderson Mezzanine was more like a life insurance company that insured
the lives of 61 patients with Stage IV lung cancer. Whenever a patient
died, Goldman, the insured beneficiary for all 61 patients, would
collect $5 million. If Anderson had insufficient cash on hand, Goldman
could dip into CDO's investment portfolio and decide which asset it
wanted to liquidate. If the asset could not be sold easily, Goldman
would arrange an auction, in which Goldman might end up as the winning
Cynics might argue that these arrangements smack of fraud and
abusive self-dealing, but Goldman could rightfully point to documents
that put investors on notice. All of these pitfalls were identified in
Playing the Ratings Game
But these pitfalls weren't exactly conspicuous. A potential investor
would need to spend a lot of time and effort deciphering the offering
circular and related documents, such as the Bond Indenture, the
Liquidation Agency Agreement, or the Forward Purchase Agreement, in
order to figure out what was really going on. He would also need to
conduct a financial analysis of the 61 different mortgage securities
being insured via credit default swaps.
Or he might take some shortcuts, and simply rely on the deal's
stellar ratings. The most senior tranches of the CDO, comprising 70% of
the capital structure, were rated AAA. After all, the rating agencies
had reviewed and rated all of the 61 insured mortgage bonds, so their
institutional memory and expertise was embedded inside the ratings
awarded the Anderson deal.
Anderson Mezzanine's structure, its business model, was defined by
credit ratings. Its investments, which were all acquired from Goldman
at par or close to par, were all rated AAA. The 61 mortgage securities
covered by credit default swaps were rated BBB or BBB-, except for one
CDO, which was rated BBB+. If any of those insured mortgage securities
were ever downgraded to CCC, Anderson was required to pay Goldman $5
million, the par value of the investment, in exchange for Goldman's
delivery of the underlying mortgage security. Again, this risk of
downgrade was part of the institutional knowledge that Moody's,
Standard & Poor's and Fitch brought to their ratings decisions on
Sixty-one credit default swaps, each for $5 million, total $305
million in contingent liabilities. Those obligations were backed up by
cash and investments totaling $306.5 million at closing. (Investors
contributed about $307.5 million, from which Goldman and others took
out $2 million in fees.) At first blush, the setup seemed like it
afforded scant margin for error, given that the AAA investment
portfolio was less than 1% larger than the credit default swap
obligations. But investors could take comfort in the fact that Goldman
had skin in the game. The bottom 10% of the capital structure--$21
million in equity plus $10 million in bonds rated BBB--would be funded
by Goldman itself. The other 90% of the deal was marketed to outsiders,
who bought tranches in the deal rated AAA, AA and A.
Insuring Assets For 30% More Than Their Mark-to-Market Value
For Goldman, $31 million spent on equity and BBB bonds was the cost
of putting the deal together. Given the market value of the securities
being insured, Goldman got a big windfall on day one. On March 20,
2007, the market value of the mortgage securities was about 70% of par,
or 70 cents on the dollar. Since the beginning of 2006, the valuations
of subprime mortgage securities had been benchmarked against a market
index known as the ABX. The BBB tranche of the ABX had not traded at par since November 2006. At the end of March 2007, the BBB and BBB- tranches of the ABX traded in the range of around 70.
Accountants would have picked up on the problem right away. Under
the new accounting rules, exotic instruments like Anderson Mezzanine
were required to be measured according their fair value. Since there
was very little trading of subprime securitizations, the FASB specifically directed that the ABX
be used as a proxy to ascertain fair value. For better or worse,
accounting rules could have mandated that investors recognize an
instant 30% loss, based on the fair value of the 61 assets insured via
credit default swaps.
Chronicles of Defaults Foretold
But accountants usually wait to receive the financial statements
before conducting any review. The wait for Anderson's statements was
exceptionally long. The first financial statement was issued on July
12, 2007, well after most companies had closed their books for the
first and second calendar quarters. As it happened, July 12, 2007 was
the first date that one of Anderson's credit default swaps became due
and payable. On July 12, 2007, Standard & Poor's downgraded Argent Securities Trust 2006-W4 M-9 from BBB to CCC.
The downgrade was no surprise. In fact, it was amazing that the
bonds had not been downgraded much earlier. Long before the Anderson
deal closed, it was obvious that the Argent bonds were worthless. In
February 2007, Argent 2006-W4 had attained a foreclosure rate of 9%.
For any mortgage deal, a 9% foreclosure rate in the first year is
astronomical, literally off the charts. By the time of the S&P
downgrade in July, the foreclosure rate had spiked to 11%.
Consider that it takes quite a while before a residential property
is foreclosed upon. In general, the foreclosure process cannot begin
unless a borrower has been delinquent in his payments for at least four
months. The process of resolving a loan default--from the date of
initial delinquency, to the date when foreclosure proceedings commence,
to the date when final sale proceeds are applied against the loan
balance to calculate the true loss--can take about a year. That's why
Moody's rule of thumb, for evaluating a pool of mortgages, was to
assume that only 3% of the losses were incurred in the first year.
It's worth remembering that all of these insured mortgage bonds were
comprised of 30-year, and sometimes 40-year, loans; and a lot of bad
things can happen over that timeframe. And subprime loans had all sorts
of features that virtually assured a high degree of nonperformance. In
many ways, Argent 2006-W4
was a typical subprime securitization, very much like those referenced
by the ABX. About 40% of the loans were "stated income" loans, also
known, for obvious reasons, as liar loans. About half the loans were
"cashouts," where the borrower increases the size of the loan on his
existing home. Cashouts are susceptible to inflated appraisals, since
they are not tied to the reality check of an arms length home purchase.
There were other signs that things would play out worse than
expected during the weeks preceding the closing date of Anderson
Mezzanine. The two largest subprime lenders had suddenly shut down
operations. On February 22, HSBC, the largest subprime lender,
announced that it was withdrawing form the market, after revealing a
stunning $10.5 billion loss. New Century Financial, the second-largest
subprime lender, faced a liquidity crisis following its announcement
that the firm was the target of a criminal investigation for securities
New Century was the originator for at least 10 of the 61 mortgage
bonds insured by Anderson Mezzanine. The foreclosure rate for a number
of the New Century bonds, like that of the Argent bonds, was
extraordinarily high. By February 2007, many of the New Century bonds
had attained a foreclosure rate that exceeded 5%.
The 5% threshold is important. Any subprime bond with an initial
rating of BBB or BBB-, including all the bonds insured by Anderson, is
located in the bottom 5% of the capital structure. Subprime bonds, for
all their complexity, followed a very standardized cookie cutter
capital structure, which was inevitably linked to credit ratings.
Even though large numbers of borrowers had stopped making their
monthly mortgage payments, the mortgage bonds were still paying out
interest and principal to investors. Within each mortgage bond, the
distribution of cash flows may be extraordinarily complex, based on
individualized reserve funds, delinquency triggers and default
triggers. While some homeowners had stopped paying, other homeowners
were prepaying their mortgages, providing sufficient cash to keep all
the bond investors current. Still, the business intent behind each of
these deals was that the lower-rated tranches, those rated BBB and
BBB-, would get wiped out before the higher-rated tranches,
representing 95% of the deal, lost a single dollar.
And since more foreclosures were happening sooner than expected, it
was inevitable that the bonds rated BBB and BBB- would get wiped out.
The capital structures allowed for almost no margin for error. The way
the deals were structured, every $100 in debt was backed up by $103 in
mortgages. There was a $3 dollar equity cushion. Yet the rating
agencies had assumed a 6% credit loss, meaning that every $100 would
lose $6 from defaults. How could a $3 equity cushion offset a $6 loss?
The idea was that the losses would be spread out over time, say $1 each
year, so that interest income earned over subsequent periods would
offset future losses from defaults. But if the losses were frontloaded,
due to high-than-expected foreclosures in the first year, it quickly
becomes obvious that the $3 equity cushion will not insulate the
lower-rated tranches from suffering losses.
A 5% foreclosure rate does not translate into 5% in losses. But a 5%
foreclosure rate in the first year is a distillation of several other
trends--higher-than-expected delinquency rates, foreclosure rates and
prepayment rates--that, when taken together, all foretold the
inevitability of major losses in the tranches rated BBB and BBB-. Put
another way, if a subprime mortgage bond suffered a 5% foreclosure rate
in its first year, it didn't really matter if housing prices
stabilized, got better, or got worse. There simply was no way to
mathematically construct a plausible scenario where the lower-rated
tranches came out whole.
That's why it was certain by March 2007 that the BBB tranches would
get wiped out. Yet, at the time that Anderson Mezzanine closed, all 61
mortgage deals were still rated investment grade. In October 2007, 14
additional subprime bonds were downgraded to CCC and 14 additional
credit default swaps became due and payable to Goldman Sachs. In
January, an additional 10 downgrades triggered an additional $50
million payable to Goldman.
The Mad Rush to Dump Worthless Assets Into CDOs
Anyone who had done a cursory analysis of the 61 mortgage bonds
could see that it was only a matter of time before the bonds would be
downgraded, and that they would default. As it happened, Goldman, and
the other large investment banks were in a race against time. After
HSBC and New Century had announced their disastrous results, Wall
Street banks went into overdrive. During March 2007, they sold almost
$21 billion worth of mezzanine CDOs, triple February's volume and a new
The rating agencies were swamped. They were asked to review and rate
31 mezzanine CDOs issued during a five-week period, between February 28
and April 5, 2007. "It was a massive volume and we did not have the
capacity to handle it," one rating agency executive confided to me. The
agency analysts were certain susceptible to pressure from their Wall
Street clients. One noted expert on structured finance and CDOs had
spoken of a bank that trained its people how to pressure analysts at
the rating agencies to get higher ratings for its CDOs.
Investors in many of the mezzanine CDOs issued during that five-week
period have subsequently brought lawsuits alleging fraud on behalf of
the underwriting banks, and, in some instances, the rating agencies as
Anderson's Declining Asset Portfolio
Anderson Mezzanine assumed two kinds of credit risks. There was the
risk that 61 mortgage securities would fail, or at least be downgraded
to CCC. There was also the risk that the structured securities held in
Anderson's investment portfolio would either default or, if ever
liquidated, sell at a discount. Unlike the 61 credit default swaps, we
cannot identify the investments, specially selected by Goldman, which
were acquired by Anderson. We know of a few investment criteria. All of
the newly acquired assets were to be rated AAA. All of the investments
were to be structured securitizations, holding pieces of loans in
residential real estate, commercial real estate, or some other
structured deal with an insurance guaranty. No more than 12.5% of the
portfolio could be in CDOs. Though the 61 credit default swaps
obligations were fixed at closing, substitutions were allowed within
the AAA investment portfolio.
The structure made no pretense of risk diversification. The minimum
number of investments in the AAA portfolio was two. Or rather, no more
than 50% of the investments could have indirect exposure to a single
issuer of mortgage securities, a single mortgage servicer, or a single
Though we cannot identify Anderson's AAA holdings, we do know that
that by July 2007, when Anderson's investors received their first
monthly statement, market prices for structured mortgage deals were
beginning to collapse. As more credit default swaps became payable,
with CCC downgrades announced in October 2007, January 2008 and later,
the market prices of all structured real estate deals kept declining.
Nominally, whenever a credit default swap became due and payable to
Goldman, Anderson did not hand over $5 million in exchange for nothing.
These were physical delivery swaps, meaning that Goldman would exchange
a mortgage bond, which once had a par value of $5 million, in exchange
for $5 million in cash. Now presumably, Anderson's newly acquired
mortgage bond had some value, albeit a small fraction of the original
$5 million. Anderson was required to sell that distressed bond in the
marketplace. The party in charge of selling that distressed bond was
Goldman Sachs, though it could take its sweet time about. Goldman had a
one-year deadline for closing the sale.
On June 12, 2009,
Anderson Mezzanine alerted investors that there was insufficient cash
to make debt service on behalf of investors in the tranche initially rated
AA. But those investors had been disabused of any hope of getting their
money back at a much earlier date.