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
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
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.