Explaining Derivatives, And Goldman's Dominance Thereof, In Four Simple Charts

Attached are several charts used to explain to confused politicians all they need to know about the biggest ponzi scheme market ever created (synthetic derivatives), how these derivatives are created, how the leverage attributed to just one asset can result in infinite amplification of risk, and how Goldman is in the very middle of a web which encompasses tens if not hundreds of trillions in derivative counterparty exposure with virtually every single other financial company in the world.

Amplification: this explains how you take a small pool of assets (in this case mortgages) and increase the bettable risk almost to infinity courtesy of synthetic products like CDOs which are nothing but side bets with an unlimited cap on the total risk exposure. The original mortgage is cut up into tranches, which are subsequentlly split up into CDOs, whereby risk can be held, sold off, or side-betted via CDS (which is what AIG would be doing by selling CDS on milions of assorted CDO tranches). In the example below the Glacier Funding CDO 2006-4A C has an original value of $15 million which trough CDO-intermediated amplification, or process in which bits and pieces of it are repakcaged in various synthetic afterproducts, ends up being $85 million. In theory there is no limit to what the total amplified value could be, as synthetic products by definition are created out of thin air, and just need a willing buyer and seller.

Deal Creation: For those who have not spent hours poring over the Abacus org chart, this is a summary of how a traditional CDO was structured and subsequently insured (incidentally, this is not the infamous "John Paulson" Abacus deal for which Goldman is currently being sued). Of particular note here is the box in the lower left, the CDS issuers, AIG, TCW and GSC, who were the dumb money, or those infamously collecting pennies before the housing crash steamroller. As the chart shows, they were collecting $3 million a year in CDS payments, and stood on the hook for $1.8 billion in case the CDO collapsed, or specifically if the underlying reference assets stopped generating enough cash through specific attachment levels.


Leverage: here are the key counterparties on the hook for just the above deal, Abacus 2004-1. No surprise, the biggest counterparty, with total downside loss is AIG, at $1.76 billion. The running annual CDS premium payment? $2.1 million. As the exhibit notes, in the end "Goldman negotiated $800 million from AIG." Other losers included TCW and GSC, and Abacus itself via secondary market holders.

Counterparties: The money chart, this shows who Goldman's key derivative counterparties were as of June 2008. While oddly enough AIG is not on this chart (potentially as this is pro forma for the bailout), it shows just what a great web of interconnected synthetic exposure derivatives create. As of this snapshot, Goldman had $20 trillion in notional counterparty exposure. This number has since ballooned. It also shows that the collapse of any individual actor in this maze would very likely result in the collapse of the entire financial system. While we do not know whether the notional depicted is gross or net, we are comfortable that the $2 trillion in Interest Rate Product counterparty exposure between Goldman and JPM and RBS (for example) would be sufficient to blow up either of these parties should the interest rate complex move violently in a direction and amplitude presumed impossible by either firm's VaR models. We are amused to note that Blue Mountain, a hedge fund, has $590 billion in counterparty exposure to Goldman yet no discount window access. Same goes for Citadel in Equity Products, which incidentally we learn is Goldman's largest counterparty in this category. In the very much maligned Commodity Product category, Goldman's key counterparties are Morgan Stanley with $96 billion, Barclays with $69 billion and Tempo Master with $55 billion, etc. So next time you wonder who aside from JPMorgan is writing all those synthetic gold shorts out of thin air, now you will know. Yet the most notable take home from this chart is that courtesy of its extensive network, Goldman knows full well just how every single bank and hedge fund is positioned, and can easily make prop trading decision based simply on counterparty exposure (Goldman tracks every single trade inception, transfer and novation with all its counterparties to know up to the minute who owns what). Welcome to completely legal frontrunning.

via FCIC