The heads-up on GS being bashed by a criminal referral -- that Jim McTague of Barron's provided on Wednesday 28 from Beverly Hills, at the Milken Institute -- turns out to have been 20 hours ahead of the news of a criminal investigation. GS gyrated in thin trading overnight. Bid 150. Ask 155 or 157. The morning tells the tale, but no matter; the GS saga will dominate the Big Warren Buffett chat in Omaha this weekend. Buffett poured $5 billion into GS during the crisis of 2008. Who is sorry now? Rudy Giuliani stalked Drexel until he grabbed a RICO hammer and Drexel collapsed. Is this the end of Lloyd Blankfein Squared? Welcome chaos. Add GS to Greece and the Cameron anti-Euro boom and the easy talk that the EU is in failure, and what you get is uncertainty stew. Suddenly, jobs are not the only problem for POTUS, Congress and the midterm Democrats. There goes another fever in the banks too big to rationalize.
gs has moved from comedy to tragedy. can catastrophe be far behind?
the guys on gs desks will start getting headhunter calls today. some will be gone in a week, at a new desk in greenwich or westport or princeton or midtown. they'll take their roladex's and an email directory. a phone and a couple of bloomberg screens. banks and hedge funds begging - "please please use my balance sheet." they will make money. sweaty green sticky gobs of it. and like the old drexel guys they'll get together once in a while and have a drink and remember when.
this has become wanton slaughter by reckless political children with weapons of mass destruction. lloyd is starting to look like a harp seal pup.
i understand cds, and cdo's, and synthetics. i can even explain them to anyone willing to pay attention for half an hour per topic. i can also explain why they played an important role in the financial markets. so can a lot of people. but it is much easier though to merely ridicule these innovations, substitute silly obfuscation, latch on to meaningless cliches and focus on personalities.
think of this -
when someone sets up a cds - someone is long and someone is short.
in a cash instrument you go long- not short right? well yeah. the buyer goes long ...
but the issuer the company issuing the stock or the bond goes short - they sell it, they pay the carry and eventually they have to buy it back. my conclusion is that issuers are evil.
the comments of the senate finance committee showed they were clueless on finance though masters of sophistry. the world should cower and quaver at the thought of what will come from these idiots. sarbanes-oxley managed to kill small vc funded ipo's and as a result the silicon valley vc business all but died.
want to know how to crimp bubbles? don't empower bureaucrats at the fed to pick winners and losers.
make it possible to go short. sometimes it takes a while to rein in the bull but it will happen. when buy-low-sell-high slips into buy-high-sell-higher it is time for the sell-high-buy-low guys to clean some clocks.
I certainly never worked or played in the world of investing but all the reading and watching and listening has pointed to some obvious things getting swept under the rug. Charlie Rose has interviewed a bunch of people and so has JB. The Charlie Rose crowd indicated that two things were avoided at the Senate hearings. One was the AIG connection to Goldman Sachs, Geithner, and Hank Paulson and why did the government pay AIG 100 cents on the dollar when they were negotiating for 50 cents with GS. Just what happened and how much did Dodd affect any settlement?
The other is the "carry trade" or that Bernacke and Geithner lent GS and others at 1/4 percent and they then put the money in treasuries at 2 or 3 percent, essentially bequeathing on them billions in free money or as the song once said "Money for Nothing and the Chicks are Free." No wonder their earnings went up 91% and when the public learns this, what will happen. Will Obama blame it on Bush? But Geithner, H. Paulson and GS are hard core Democrats.
Then JB's guest, Robert Freeman, the other night and his comment that all the GS/John Paulson business was a side show as it was a zero sum game affecting these players alone and that it did not involve the issuing of any new mortgages or resulting in any new defaults. The real issue getting swept under the rug was that nearly 2 1/2 trillion in bad loans by Freddie and Fannie.
So the politicians are using GS to flog while the real issues are ignored. However, the AIG fiasco will eventually come out and GS, Geithner and H. Paulson may be fitted for some orange jump suits.
I have a question for ccdavis or anyone else about CDO's etc.. What were the interest rates that some of the investors were chasing in some of the tranches of these instruments. Say it starts out with a $400,000 mortgage at 7% but is then sliced and diced till some of the junk is paying much more than that if everything was ok and there were no defaults. Just what kind of interest rates were those German investors chasing while Paulson and others were shorting.
I have read lots of quick summaries of this and JB's guests are at best opaque to use a common term these days. Is there somewhere that actually lays out how the 7% or whatever the rate is gets distributed amongst the various slices?
We dutifully sit and debate the fine points of every issue. The points pulverize into the dust of a zillion minutiae as we continue to analyze endlessly. And before we can throw up our hands in frustration, a new crisis appears out of no where, complete with streamers bearing insult and hostility (which we do our best to counter).
The members of Congress sign their good names to bills they haven’t yet read. When they are asked to explain any given point, we find they are as confused as we are. All they know is that they’re fighting for their lives – as we are.
Mr. Smith’s stint in Washington is no longer fun or productive. Something alien seems to have taken hold of the city. Something’s been added, or something taken away. Something is missing. The newspapers seem to be in on it, but they won’t discuss it: the elephant in the room. There’s plenty of detail to fill their pages – screaming drama from all sides.
It’s classic Cloward-Piven: overwhelm the system; orchestrate crisis; gridlock. No way to get a handle on it. And even if we could, we would be appalled at what we’d find.
It’s time to stop playing. Every move we make (in good faith) sucks us deeper into the sinkhole. That’s how it was designed. The house always wins.
What’s missing is trust. Face it! We don’t trust our government. Anything it might intend has now become tainted with suspicion. It could fix health care; Wall Street; immigration; energy; education – whatever your pet peeve might be – and we wouldn’t trust it as far as we could throw the heads on Mt. Rushmore. We’ve gotten to the point where things can’t be fixed anymore. Everything needs to be replaced. We need to start from scratch.
Politically, we feel cornered - shut out. At the same time we sense danger in the pit of our stomachs. We’re even prepared to forego summer and sprint straight to November, only to discover, perhaps, that our faith in elections will be the last domino to fall.
What then? Move to Australia? Cuba? This dilemma is by no means new. It has been faced by countless peoples before us. Their dream destination was always America. And they came in droves, bringing all they could carry on their backs and in their hearts. America allowed them to make a fresh start. Eventually they would become Americans and prosper beyond their wildest dreams. But that was then…
It’s different now. America has become just like every other hell hole in the world. No need to bother packing.
http://peterkoelliker.blogspot.com/
drexelhill-
I will give a shot at answering your question but it will have to be late tonight so check back tomorrow.
I think it was prudent to lend GS, BoA, Chase, GM and others TARP and rescue dollars TO MAINTAIN LIQUIDITY. Having major banks collapse causes depressions and Bank Runs.
GM and Chrysler had liquidity issues, and are recovering. Wall street is recovering.
The housing market is not recovering, easy credit, fueled by Fannie, Freddie, and CDOs ruined the housing market in many states and Europe with easy credit and house flippers.
It is a very good thing the DoJ is pursuing criminal charges. If laws were broken, and board members approved illegal actions, they should pay the full price. What about Germany and Europe? will they seek repayment and take GS assets?
GS is very good at managing risk, at least in their minds. Their actions tend to make the markets more risky in general. Creating hi-yield and hi-risk instruments and then dumping them moments before instrument fails does not endear oneself to your clients.
Colleague had a Mortgage by Litton Loan (owned by GS) adjustable mortgage. He found it next to impossible to refinance, the compnay went out of their way to make refi impossible or difficult. Did GS benefit by taking those Mortgages and selling them as CDOs while demanding that Litton loan not refinance their customer loans?
-Wisdom
For those who are interested, Blankfein will be interviewed by Charlie Rose tonight. It is taking place at this moment but won't be aired till later tonight. I would hope he would ask him about AIG and the carry trade which are the real issues and not the John Paulson side show. I am sure he will ask him about client trust in GS and how this will play out. How often do you get an interview with the CEO of a firm under both civil and criminal investigation?
to understand a cdo first start with a mutual fund.
a mutual fund buys a portfolio of stocks and sells fund shares to finance the purchase of those assets. gains and losses are shared equally among the holders of the fund's stock.
a leveraged mutual fund works the same way except that it also borrows money to buy additional shares. gains and losses are equally shared among shareholders but only after the debt has been paid back.
a bond fund is like a mutual fund except the asset portfolio is made up of bonds rather than stocks. there are several big consequences of this (subject to some special cases).
first, bonds pay periodic interest so there is cash flowing to the fund.
second, the principal in bonds is supposed to be repaid at maturity but only the principal.
third, a bond can default resulting in a loss of both interest and principal.
these three difference make
the bond fund investor return equal to interest + principal - default
if interest is high enough it can more than offset default. the investor return is shared equally among the holders of the shares of the bond fund.
but some investors need returns other than equity returns. for example, insurance companies and pension funds are typically required by regulators to invest much of their funds in fixed income instruments that are investment grade. this is why the investment grade/junk distinction is important. when a bond is downgraded (like greece) these regulated entities have to sell their holdings.
in the last decade many institutions found themselves having made promises based on an assumed 8% long term rate of return (CalPers for example) but they were only able to find investment grade debt at much lower rates. this created a need for a new type of financial vehicle, a bond capable of generating suitable returns (say 8%) while they were rated at least investment grade, and higher ratings could be paired with somewhat lower interest rates because the customers had big portfolios with many different asset types.
New York and London and Tokyo and Berlin and Paris and Zurich all helped create these new solutions because once you saw how they were made almost anyone could do it. They were called CDO's (portfolios of bonds), CMO's(mortgage backed securities), CLO's(bank loans).
Like the funds above these entities were built by assembling a portfolio of assets that was diversified, of appropriate quality and generating attractive cashflow. so far no different from a bond fund.
the change comes because the customers don't want shares they want, they need investmet grade debt instruments that pay higher than usual returns. this is the heart of the CXO (X=D or M or L).
so here is how we finance our portfolio. (i will exaggerate the numbers a bit to make it clear).
first, we estimate based on all factors we can figure out what the expected default rate of the portfolio is. we poke, prod and delve to get the best idea we can get. suppose that we come up with the estimate that over the life of the portfolio. assume that the number we come up with is 2%- that is we expect that by the time all the portfolio bonds mature and pay the CDO back it principal 2% will have defaulted so if $100 million was invested then $98 million will have been recovered but $2 million will have been lost.
who takes the first loss? the customers interested in bonds don't want it so they require a first loss cushion called the equity tranche to take the loss. but further the customers want to make really really sure they have no loss so the require, say 5x the expected default rate in first loss cushion. so they require $10 million in total equity.
that is good but the customers want even more safety so they decide to require a second loss tranche, call it the Mezzanine or Mezz tranche. if the defaults are greater that 10% the equity tranche gets wiped out absorbing the first 10% and the additional loss hits the Mezz. by arcane calculation and negotiation the investors decide that $20 million of Mezz is enough, 10 times the expected default rate on top of 5% to the equity tranche.
now they feel safe and have enough cushion so that after looking at everything S&P agrees to give the debt, the Senior debt, the last loss debt, a rating of AAA.
What will these safe senior investors get in interest income (in the summer of 07 AAA paper paid something like 25bps or 0.25% more than treasuries.)?
imagine that the portfolio is made of BBB+ and pays average 7.5% on the 98 million (after the defaults are allowed for. Then the Seniors with their 15x cushion and AAA rating could get 6.5%, the Mezz 10% and the equity would still get more than $4 million per year (40%) after recovering the expected defaulted principal.
for the Seniors that is a great solution to their problem.
there are of course lots of ways for this to get messed up but thousands of these structures were done and a small minority went bad or were rotten from the start.
hope this helps.
oops
made a calc error in the above
edit the numbers as follows
average portfolio coupon from 7.5% -> 8.5%
Senior coupon from 6.5% to 6%
Mezz from 10% to 7.5%
Equity gets $2.3 million, 23%, after reserving for the defaults rather than $4 million, 40%
more tuning can improve this picture, especially improving the yield on the portfolio at the price of increases in the expected default rate.
make a model like this if you can and play with it - you will understand the trade-offs the designers made.
ccdavis,
Thank you. I have some questions but have to leave in 20 minutes for the weekend. I will ask them when I come back or on another post in a couple days.