Sen. Carl Levin says there's another big shoe to drop on the Goldman Sachs case, but seeing as how a whole load of tennies, hip waders and muck-lucks are already bouncing around the room, it's hard to imagine what else is still to be revealed.
Business Week has an article up on how Goldman and hedge fund managers may escape an SEC smack down by skating around the idea of what "selected" means.
While Magnetar avoided ordering managers to buy specific securities, it often pushed them to select ones with higher yields, according to a person who participated in some of the transactions and declined to be identified because the deals were private. The firm told banks and asset managers what its strategy was, the people said.
You got that? If the hedge funds were pointing out specific crappy loans and saying "buy that," they could be in trouble. But if they merely set "targets" for the quality of the loans in their CDOs, then they may skip merrily away. However, if the bankers, such as Goldmans, knew what the hedge funds were doing and still pressed these instruments on their clients as worthwhile investments, they won't get away so easily. That Goldman, Merrill, and the rest knew they were peddling the worst crap imaginable is beyond doubt. How they peddled it will require a careful review of every prospectus, email, meeting, and phone call involved.
It may even be that the banks played "fair." They may have put together a prospectus full of numbers, shoved them out there, whistled tunelessly, looked away, and waited for Real Smart People to rush in figuring they had a bargain. After all, with famous hedge fund managers snapping up the risky core of these things, the rest of the investment (the safer part) must have seemed pretty tasty.
Of course, there's also the little matter of whether the banks knew that the hedge funds were not just engaged in classic hedging by protecting their investments, but betting against the entire CDO. And since the banks were also peddling the credit default swaps (and the instruments created by bundling the credit default swaps, God help us), there's no doubt they knew what was happening. Now, is that illegal? We'll find out.
In the meantime, the SEC voted today to sue Goldman. And here's the really fun part.
The U.S. Securities and Exchange Commission split 3-2 along party lines to approve an enforcement case against Goldman Sachs Group Inc., according to two people with knowledge of the vote. ... Republican commissioners Kathleen Casey and Troy Paredes voted against suing, the person said.
Republicans voted not to sue over a little thing like purposely contriving to create instruments designed to fail, and peddling these intentionally faulty wares to customers. You have to ask, what would it take for a Republican to actually stand against Wall Street?
Now we start to dig for the details. There will be a prospectus on each of these CDOs, and it's very likely that numerically these babies are going to be correct. What it's going to come down to is the language of the prospectus and the discussions (verbal and email) that were held with clients.
Complicating things is that the "synthetic" CDOs at the heart of the Goldman / Paulson end of this deal where not regular CDOs built by bundling together loans. Complicated as those are, these were a couple of steps removed. These synthetic CDOs were composed from bundles made up of swaps, in this case the pay-out side of default swaps on other CDOs.
Here's how something like this might work (and I may well have missed a step, or even a whole waltz. After all, they've built this thing with the intention of tripping people up, so it's not surprising that it's hard to follow along.)
The Magnetar view
- Magnetar (or some other hedge fund) declares that they are interested in the equity "tranche" of a CDO. They set targets for what they want the in the tranche (really bad stuff).
- They then wait for the additional layers of the CDO to be formed and for the instrument to be sold to clients.
- Magnetar now takes a CDS against the larger tranches -- which may be 10x to 100x their initial environment.
- A. If the CDO actually makes targets, Magnetar takes a nice payout because they owned the riskiest bit. Probably around what it cost them to support the credit default swap on the larger instrument. So Magnetar breaks even.
- B. If the CDO unravels, Magnetar makes an even bigger payout by collecting on the default swaps. The little equity tranche investment is lost, but that loss is swapped by the CDS payout. Magnetar wins big.
The Paulson view
- Paulson (or another hedge fund) declares that they are interested in synthetic CDOs containing bundles of CDS obligations. They set targets for what they want in the lower tranche (really bad stuff).
- They wait while a synthetic CDO is formed around CDS swaps that include coverage for crap like that at the core of the Magnetar CDOs.
- Paulson then takes a secondary swap (it's not clear if these were always against the original CDO, or whether they also bet against the synthetic CDO).
- A. If the original CDOs hold and the synthetic CDO survives, Paulson pockets the payments for the original swap, which it uses to pay off the secondary swap (though probably at a loss). Paulson losses small.
- B. If the original CDO fails and the synthetic CDO fails because the CDS are forced to pay, Paulson's secondary CDO pays off at a much higher level of investment -- Paulson wins big.
The Goldman Sachs view
- Original CDO is formed.
- Original CDO sold to clients. Goldman takes a cut. Goldman wins.
- Synthetic CDS is formed.
- Synthetic CDS sold to clients. Goldman takes a cut. Goldman wins.
From this, it might appear that Goldman can't help but win no matter what happens. But there's one more piece:
Individual banker working at Goldman view
- Original CDO is formed, no matter how bad.
- Original CDO sold to clients, no matter how much BS is required or even if Goldman itself is client. Banker takes immediate cut. Banker wins.
- Synthetic CDO is formed, no matter how bad.
- Synthetic CDO sold to clients, no matter how much BS is required or even if Goldman itself is client. Banker takes immediate cut. Banker wins.
- A. Everything works out and clients and Goldman make money. Banker doesn't care. He got his money already.
- B. Everything falls apart and clients and Goldman lose money. Banker doesn't care. He got his money already.
Which makes it appear that the individual bankers went home with big bucks no mater what, except that... no wait. They did. And Republicans just voted not to disturb these guys while they're sunning on their yachts.
What looks to make all this possible is a drastic undervaluing of the cost of default swaps which in turn was made possible by an over-valuing of the intelligence and moral judgment of the people involved in the market. In short, there was an intrinsic expectation that people won't purposely buy crap, because most people didn't think it through to the "how to leave another guy holding the bag" stage. Which is exactly the weakness that Magnetar and other hedge funds spotted after spending months studying the market and talking to the people who sold these instruments.