Guest Post: Goldman's CDOs Had Nothing to Do With the Real Estate Bubble

Submitted by David Fiderer

If Goldman Sachs wanted to reduce its exposure to subprime mortgage
investments, why didn't it simply sell the assets it owned? Two
reasons:

First, those large sales would have sent a signal that something was
terribly, terribly wrong, and thereby pushed prices down further.
That's how supply and demand normally works.

Second, Goldman professed to be market maker, which uses its trading
book to instill confidence. It ostensibly bought, sold and inventoried
mortgage securities to provide stability and liquidity to the
marketplace. Of course, we now know that such market confidence was
entirely misplaced.

To sidestep these issues, Goldman and other major banks found a
solution that subverted the laws of supply and demand, and escaped the
price discovery of a transparent marketplace. They fabricated synthetic
CDOs, such as Abacus 2007 AC-1. These toxic assets, invented out of thin air, made the meltdown worse than it otherwise would have been.

How much worse? Consider the numbers: According to the New York Fed,
about $1.275 trillion in subprime mortgage-backed bonds were issued
between 2004 and 2006. Of that amount, about $51 billion was rated in
the BBB range. (In virtually every subprime bond deal, about 3% to 4% of the total capital structure allocated to tranches rated BBB+, BBB, and BBB-. Four percent of $1.275 trillion is $51 billion.)

So if Wall Street wanted to trade BBB rated subprime bonds, it had
no more than $51 billion to work with. Some of those bonds were sold
outright; others were repackaged into CDOs. The unfortunate investors
who acquired those low-rated bonds, in whatever guise, could lose no
more than $51 billion outright.

So how many mezzanine CDOs--i.e. CDOs stuffed which tranches rated BBB--were actually issued? Between May 2006 and April 2007, about $107 billion in mezzanine CDOs were issued, more than twice the physical supply of lower-rated bonds.

Wall Street transcended the limitations of physical supply via naked credit default swaps,
which are like insurance policies on assets you never own. And a
synthetic CDO may be nothing more than an assemblage of naked credit
default swaps for cash settlement, meaning the reference mortgage bonds
need never be physically delivered when the beneficiary gets paid.
These deals were not financing anyone's home, directly or indirectly.
Their failure cannot be blamed on the real estate bubble or irrational
exuberance. As for hedging anyone's risk, the scant evidence available
suggests that, at the time of closing, the fix was in. The probability
of default had morphed from "highly likely" to "certain." Abacus 2007
AC-1 and its ilk served no legitimate business purpose.

Apparently, Fabrice Tourre saw Goldman's scheme for what it was. His emails read like a French epistolary novel, Les Courriels Dangereux, which tells a tale of love and betrayal amid the moral rot of the (financial) aristocracy. He writes:

"When I think that I had some input into the creation of
this product (which by the way is a product of pure intellectual
masturbation, the type of thing which you invent telling yourself:
'Well, what if we created a "thing", which has no purpose, which is
absolutely conceptual and highly theoretical and which nobody knows how
to price?') it sickens the heart to see it shot down in mid-flight...
It's a little like Frankenstein turning against his own inventor ;)"

Even the Wall Street expression "IBG YBG" (I'll be gone, you'll be gone) has a French antecedent: Apres moi, le deluge.

Comments

[aerojet]

So the question remains:  Will anyone see the inside of a prison cell?

[Postal]

Only if they watch 'Lockup'...

[casino capitalism]

It's far easier to get full value for a bunch of loans by packaging it up, get "third party" ratings (ha ha), and sell the resulting securities to "sophisticated" investors (a.k.a. yield hogs) who trust your underwriting process than it is to hit the bid on a bunch of garbage loans that, individually, aren't worth 20 cents on the dollar.  And, selling the loans means it's more likely that the buyer will actually do some due diligence on the loans.  Plus, buyers of the loans tend to be their securitization competitors - why sell perfectly good garbage collateral to competitors and give them the chance to securitize them.

[LeBalance]

/neck crack/ no...these are financial assets after all...no..../they wouldn't/

but....just like PMs, grains, and fruit....100x the "real" market.  Its just paper...

blown to the sky.  /omfg!/  ----mind blink out----  ----mind blink on----

There are no words for what is coming.

[Augustus]

The creation of the BBB rated CDO securities allowed the yield whores to buy and profit from putting these into their SIV and SPV.  They needed and sought out these particluar classes because of the higher yield.  They knew exactly what they wanted and specifically requested it.  Paulson and Goldman were not the only suppliers of this product.  There was demand for large $$$ of this debt. 

Everyone now is judging it with 20/20 hindsight.  If these geniuses were so darned smart why did they not have their shorts on for FNM and FRE?  Or maybe countrywide and Wachovia?

Put options were available in size and the % gains were greater than what Paulson generated.  All of the "Everyone KNEW" claims are simply Bull Snot.  The claimants only have to show that they were also able to make large profits from such an obvious opportunity.  All of the "connect the dots" people should be so damned rich that they could bail out Greece by themselves.

Making claims of conspiracy in hindsight is a whole lot different from making money in real time.  That is why paper traders cannot spend their "winnings."

[AnonymousMonetarist]

The rating agencies are the enemies of the people.

[GottaBKiddn]

Nobody who has read the SEC charges in this case can deny that this is a simple matter of lying and cheating. Supporters of the industry can only say that this is the way the game is played. Enough truth. But why is the feckless SEC moving on one of the biggest and smelliest rotting fish in the basket now? Could it be that they need this sideshow to cover their own legal problems, for example, the CMKX diamond fiasco, the biggest lawsuit in history?

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