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Guest Post: How Unicorn Math Made Goldman's CDOs An Excellent Buy
Submitted by Ratio
How Unicorn Math Made Goldman's CDOs an Excellent Buy
Recently, David Fiderer posted an informative piece entitled, “Goldman's Blueprint for Dumping Toxic Assets: How These CDOs Were Designed to Fail” in which he outlines certain mathematical points related to Goldman's wholesale creation of toxic CDOs. While these numbers are solid, in the sense that hindsight has shown them to be reckless given what we know now, they omit to consider the full hazard made possible by unchecked groupthink pervading the community of those who want to believe.
It is my contention that the mathematics of these CDOs is not necessarily suspect, as he asserted in his piece, when one views those models through the clouded eyes of the real estate optimist, circa 2002-2007. Given the defective assumptions concerning the housing market, made while the boom was in full swing, by those unflinching optimists who wanted to believe, the numbers were not only no cause for alarm, but also, mistakenly showed a certain strength to the toxic pools reflected in the intense demand for these assets by those bullish on housing.
The moral of this story is that, while blaming borrowers or greedy investment bankers is easy, and wholly appropriate in many cases, anyone who bought into the delusions of the boom, whether they be a bond investor or a lowly mortgage broker, must also blame themselves for accepting as fact the underlying assumptions which permitted these CDOs to be constructed with little regard towards the real risk of high default rates. For those who failed to see the wreck off in the distance, an introspective mea culpa is required prior to rightfully grabbing their torches and pitchforks in pursuit of the other, more willing culprits.
I'm not here to defend Goldman; I don't know what went on behind closed doors. Knowing the squid, the few people who could see the folly in the housing market were probably working there, instead of guzzling down the cognitive bias required to invest in this waste.
However, claiming that the lower tranches were mathematically designed to fail, from an outsider's perspective, simply doesn't hold up. While it is possible that the brewers of this toxic waste could have expected it to fail, when one adopts the perspective of an enthusiastic outsider, the numbers could plausibly have been much rosier. The bottom line is that, for an investor who foolishly disregards skepticism, these CDOs need not mathematically fail as stated; in fact, for the fool who bought into real estate bubblenomics, the default rate was even less of a worry than it had been in traditional end-user residential finance, even though the loans were riskier and not as well secured.
One big gulp of optimism, and suddenly the intoxication of yield chasing transforms "deficits don't matter" into "defaults don't matter."
What I'm about to tell you is literally what the bulls thought going into all this. I heard this math day in and day out. While the math is numerically sound, the underlying assumptions were ultimately faulty, but those drunk on yield chasing could never see the neighborhood for the empty McMansions.
Let me explain:
First, a 5% default rate does not translate into a 5% loss, as far as collateralized lending is concerned, even if the collateral is somewhat overvalued.
Second, and more complex, is how the losses would actually be realized.
Remember, at the time, housing values were soaring, especially in the markets most rich in toxic loans. 10% YoY increases on the original property were not abnormal; add in some travertine, granite, and Malibu lighting, with an idiotic 3-5x multiplier, and the increases become much rosier.
The following hypo is written using the assumptions that would have been "common sense" to anyone beer-bonging the FIRE Kool-aid.
Assume that Joe Homeowner, a SoCal resident, takes out a 100% LTV mortgage on a $200,000 home at 7%, with a 3 year hard prepayment penalty at of 6mo interest on 80% of the balance, and delinquency fees of 5% of the missed payment.
Joe Homeowner struggles to make his payment, then defaults six months in. Prior to the default, his balance is just a hair over $199k. For the next year and a half, he is not paying his mortgage.
Two years in, a final judgment is issued, and a writ of possession granted to the servicer as trustee. Here is where Joe stands:
The value of his home is now $242,000, thanks to the never-ending stream of suckers willing to buy it post-foreclosure, and the fast turn times and non-discriminatory pricing applied to REOs in those days.
As it is late, for easy math, let us assume no compounding on the fees and the back interest. On his $199k balance will be added
$22,110.48 in back interest and late fees, followed by a $6191.12 charge for non-satisfaction under the prepayment penalty clause.
Excluding attorneys' fees, the balance at time of foreclosure settlement will be $219,302.60, leaving an LTV of roughly 90.6%.
The calculations were made assuming the seller's market of the boom, so even at the full 6% for the Realtors, and no seller concessions, Joe Homeowner will walk away from the foreclosure sale with $8177.40, less attorneys' fees, less my underestimation for not compounding back interest, and probably less the force-placed insurance. Add in any improvements Joe ran up on his platinum Mastercard, or did personally at the prodding of his wife and/or the "shame" of failing to keep up with the Joneses, and the equity cushion improves. Also, add in the possibility of this loan being subject to recourse, for which Joe might receive a paycheck garnishment should an actual loss be realized.
Suddenly, that toxic loan isn't looking so toxic after all.
This is hardly a huge bath for the irrationally exuberant subprime mortgage company and those who snatched up its toxic bonds. They have been made whole on their having received two years at 7% interest, closing fees, late fees, and the prepayment penalty.
Mathematically, this is actually a better outcome than if Joe Homeowner paid his bills. In this scenario, their gross return was above the note rate. That money can then be recklessly lent out again to ruin another American dream.
What this has effectively allowed is for the backers to speculate on the real estate appreciation by using long-term home ownership, made possible by these supposedly "innovative" products, as a convenient psuedo-fiction abstracting the underlying strength of the portfolio, which at that time, lay primarily in continued irrational appreciation in a booming seller's market. Remember, due to the prevailing rates of appreciation, the backers wouldn't have come out much worse than had they bought the house and let it sit empty. Of course, they couldn't do that, because it was harder to get institutional financing to buy a bunch of property and let it sit empty than it was to throw as much paper against the wall as humanly possible, expecting to make profit on both that which stuck and that which fell. By putting an indebted homeowner in the unit, the appreciating market and steady stream of greater fools gave them a de facto put option on the collateral, should the lender get stuck with the house.
One can mathematically rationalize away the toxicity of these loans so long as the bubble machine is well-oiled and running.
Here is the key to all of this: when one blindly accepts the assumptions of the real estate market during the housing boom, the default rate can be rationalized away as irrelevant. Had I tweaked the interest rate to between 7.5-10%, based on common risk and LTV adjustments, and capped the LTV at 95% with a pool average of 90%, assuming that, once again, we're looking through rose-colored glasses and not seeing goosed up prices resulting in fake equity coming from the seller, I could easily rationalize away a staggering 20% default rate in the first two years.
The scheme flew apart for three core reasons:
1. Appraisals were highly overinflated by the appraisers, acting on behalf of crooked mortgage originators, sharky Realtors, and juiced- in developers/flippers, for both purchases and all flavors of refi.
If Joe's house was only worth $160,000 from the start, the whole deal now swings to a serious loss.
2. The scheme required continued inflation of the property bubble at excessive and unsustainable rates of appreciation.
3. The scheme required a fast turn time from the lender's repossession to the sale of the REO.
If this was a cash out refi, then:
4. Joe didn't care what an appraiser said his house was worth, because he needed a fraudulent appraisal to go out and buy two jetskis and a big screen TV (both of which will leave with Joe after foreclosure). The crooked originator was more than happy to make his Ferarri payment with the ludicrous origination fee and yield spread premium made possible by the mortgage magicians. The appraiser, if he wanted to stay afloat and get any business at all, had to lower his ethics to somewhere around a barely-competent personal injury attorney living next to a peel-laden banana factory.
If Joe lived in a formerly redlined area, or was part of some underserved group, then:
5. The lender didn't care about a little loss, so long as it could keep its HMDA reports clean and politically correct long enough for a merger to go through with the blessing of politicians, yielding a huge windfall to the executives.
What we have here is a conspiracy of fools, closely following the old maxim that it is often unnecessary to attribute to malice what can be adequately explained by stupidity. The brass at Goldman may or may not have known this, however this example shows how it is mathematically possible for anyone who wants to be under the ether of bubblenomics to claim that default risk is not much of a risk at all.
The mathematical possibility outlined above does not justify the defective thinking; it merely explains how a bunch of people sitting around, wanting to believe that A=B, could find such an identity to be true, provided they failed to question the assumptions underlying the math. When bogus assumptions are allowed to infiltrate risk models, unchecked, it is possible to demonstrate
2+2 does indeed equal 5, for very large values of 2. When that
identity involved the high yields needed to bail out an underwater pension fund or underperforming asset management division, the numbers lined up, the due diligence was considered done, and the asset manager rode off into the sunset on his unicorn.
The rest of us were left to clean up the mess.
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Yup - housing prices always go up...until they don't.
They get paid multi millions each year for what superior expertise and ability?
Just why is GS a premier investment bank?
Housing prices always go up. Analysis with $5bn in bonuses. I should think there is a higher level of intelligence and ability required than being caught up in the emotion of it all.
Much like Microsoft, their product isn't any better than the competition ... if anything, it's inferior.
It all comes down to aggressive marketing.
These super high bonuses are going to come back to bite GS hard. As they will no doubt be mentioned and examined as part of the case maybe as to why they should be so high.
Either
Profiteering / theft undeserved OR
Deserved = ultra superiour intelligence and ability...errr no I mean..
Is GS all hype or are they really a superior bank with loads of intelligence? Will they admit to not deserving these bonuses in order to protect themselves in court?
I think you should re-read this part of the SEC
'text: "According to the SEC's complaint, the deal closed on April 26, 2007, and Paulson & Co. paid Goldman Sachs approximately $15 million for structuring and marketing ABACUS. By Oct. 24, 2007, 83 percent of the RMBS in the ABACUS portfolio had been downgraded and 17 percent were on negative watch. By Jan. 29, 2008, 99 percent of the portfolio had been downgraded."
9 months to fail, whatever GS claims, meanwhile
I have been reading both David Fiderer, Yves Smith, and Janet
Takavoli's pieces on the subject, it seems, however
legitimate, your argument, your are swimming against
the current. RABO bank just announced it would
be liaising with the SEC in relation to a lawsuit
filed against Merrill Lynch, regarding the ' other
failed CDO-"Norma", this one assembled by Magnetar
playbook: step #1. 'group frenzy' has to be created. step #2. the 'group genius' creates 'believeable' unbelievable math. GS can't be blamed for #2, because of course there was #1.
is it historically odd that GS is consistently at the scene of crime. look into step #1 see GS's role in its creation
Unicorn math, thats great.
Well ... Greenspan said there was a housing bubble. Our government said there was no housing bubble.
What did the Fed know and when did they know it?
If the Fed can't be trusted/expected to see bubbles in the making then they shouldn't be trusted/expected to manage them behind closed doors.
Audit the Fed so we can make judgements for ourselves.
The books don't balance, the books have NEVER balanced. Humans don't need to see the books, because the books is what all you guys are running from.
The whole system from the beginning has been unicorn Math. What humans are trying to do is ignore the Truth, within time the downward spiral will continue.
Too bad JPM's math wasn't as good. remember the dud they laid from the Magnetar trades...
http://www.propublica.org/feature/the-magnetar-trade-how-one-hedge-fund-helped-keep-the-housing-bubble-going
LET'S CALL A SPADE A SPADE----GREED AND STUPIDITY!
Beneath all the fraud and all the complexity is the fact that we have a three hundred year old monetary system based on debt. While it was a far more effective accounting method than the vagaries of precious metals, or the insatiable desires of kings for larger empires, it is still a flawed model. The result is our financial system has incorporated modern technological advances in computing ability to turn the entire economy into a machine to produce spurious debt and enormous circulation loops to create and store illusionary wealth. We need to really go back to the drawing board and design some form of production based currency, since productivity is the real basis of value for any currency. Given all our modern computational abilities, it shouldn't be impossible to devise a workable formula. At the very least we could do much better than what we have now.
Wouldn't the more realistic model be that his house (at that price it had to be a condo) declined 40% to $120,000, and that maybe at foreclosure it got bid up to $130,000. Thus the loss would be huge, not net even.
What you are saying about the math and risk models is that they were tautological in that they made sense internally but only if you ignored the Black Swan?
Also, since these were all B-level tranches, any hits would be taken by them, not the A tranches. So, any cash coming out of the sale would go to satisfy the returns of the A tranches because of all the defaults and the Bs are worthless?