Thursday, May 20, 2010

Goldman's Virtual CDO

More: Today, Scott Brown (R-MA), the former male model who took Ted Kennedy's seat voted for cloture (ending debate) with Olympia Snow and Susan Collins (ME-R). So the 'reform' package moves to the House without the real changes wanted by Cantwell and Feingold. There are simply not enough progressive Democrats to make a difference in the Senate.  Progressives should now concentrate on passing the "Volker Rule" which bars banks from proprietary trading or playing the market with their own capital.   Positive development: Arlen Specter, the Repugnant turned faux Democrat, lost his Senate seat in the Democratic primary. Arlen's claim to fame will forever be the "magic bullet" theory he peddled to the Warren Commission.

Update: Two progressive senators, Russ Feingold (D-WI) and Maria Cantwell (D-WA) voted against the proposed package of legislation intended to rein in the irresponsible financial gambling by banks on Wall Street. Both senators voted with Repugnants to block the legislation because they believe it is not tough enough. Ms. Cantwell took the floor to say she wanted tighter rules on the trading of derivates. Her proposal would require derivates to be traded thorough an exchange and empower regulators to stop a deal if banks knowingly violated trading requirements. Ms. Cantwell also wants a vote on re-establishing the Glass-Stegall Act prohibition against co-mingling commercial and investment banking activity. Mr. Feingold also wants the Depression era reform law restored.

{5.10.10} US Person wrote some a while back {4.18.10} about Goldman creating a synthetic collateralized debt obligation (CDO) with the help of John Paulson who then shorted the security and made a bundle.  Goldman also made a bundle selling the long position mainly to European banks.  At the time the post was written, he did not do a good job explaining what a synthetic CDO really is.  The deal was complex enough without throwing another level of complexity on top of it.  A real CDO bundles real mortgages together into a security that can be traded like a bond.  There are real home owners provide the income stream upon which the security is built. That is until they stop paying.  A synthetic CDO has no actual mortgages involved.  It is a totally created security--a fiction if you will--based on computer models.  Sounds fantastic?  It is, but the big boys were trading the blue sky because there were not enough real mortgages to bundle and securitize.  John Mauldin explains the situation better than I can:

Let me see if I can simplify this. It [a synthetic index] exists only as a spreadsheet and performs in conjunction with the components it's modeled upon.  Numerous hedge funds did not think the rating agencies knew what they were talking about when it came to the mortgage ratings. They also believed we were in a housing bubble. So they went to a number of investment banks and asked them to construct synthetic (derivative) CDOs [based on BBB mortgage tranches] that they could short. And there were buyers on the other side who wanted the yield, who trusted the agencies, and who believed that housing could only go up. As to the Goldman deal, the buyers had to know there was someone short on the other side. By definition there was a short. The hedge funds that shorted the synthetic CDOs took real risk. [but Paulson had a hand in creating the synthetic and knew what components were being modeled] They had to pay the interest on the underlying tranches to the investors who were long. And if the housing market continued to rise, and the bubble did not burst, they could easily lose a lot, if not all, of their money....Let's be very clear. This was purely gambling. No money was invested in mortgages or any productive enterprise. This was one group betting against another, and a LOT of these deals were done all over New York and London.
Paulson & Co. had a hand in creating the synthetic and therefore knew what components were being modeled.  Perhaps not the same as dealing poker with a stacked deck because the banks could have checked the deck themselves. But as Mauldin points out, they wanted the yield. Who was underwriting this fanciful gambling between card sharks? Answer: US taxpayers. When the housing market did collapse, Goldman and other Wall Street firms "too big to fail" were hauled out of the mess they created with taxpayer funds doled out by the Treasury Department and the Federal Reserve. The underlying investments that failed served absolutely no useful public service.  Heads I win, tails you loose, and a textbook case of why we need derivative trading in a regulated market and the re-establishment of the Glass-Steagall Act prohibition against banks owning other financial institutions.