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Fraud or Due Diligence Failure?

Interesting discussion on The Stool today:

First this from Trader Joe

I’m starting to get a better handle on what is driving the SEC charges against Goldman and why Paulson’s involvement matters

But first…

A Little Bit About CDO’s, CDS’s and Synthetic CDO’s

CDO’s were developed by Mike Milken of Drexel Burn’em fame back in the 80’s

JP Morgan took the idea a step further in the 90’s and created CDS

…fast forward to the late 90’s and the beginning of synthetic CDO’s

This is what Paulson was short, a synthetic CDO.

Synthetic CDO’s are basically the outpoop of an amalgamation of CDS

Step [1] Set up a special purpose vehicle (SPV) in say the Cayman’s

Step [2] Then create CDS’s in the fund against a number of companies, usually about 100 (or in the case of Abacus, RMBS).

Step [3] Set the default parameters, which state that if 6 companies on “the list” default then the SPV pays the bank 30% of the SPV, if 7 default the bank gets 60% and if 8 or more default the bank gets 100% of the SPV

Step [4] Sell ownership of the SPV to investors…but what do the investors get?…..back in the day, about 1-2% annually on the notional amount bought

This is where the Paulson involvement comes in. Being that only several RMBS have to go bust before the Synthetic CDO pays out 100% to the bank (and then to Paulson, as he was short the CDO)….well you get the idea of how important including a few select RMBS was, and why knowing this and that Paulson was shorting this synthetic CDO, would be an important factoid.

And this, also from TJ

Asked and answered your Honor…

The issuer (GS) then sells the deal, tranched up nicely, to its clients. The clients are not necessarily dumb but should understand that a AAA ‘bond’ offering 150bps over Swap is maybe ‘not’ AAA – the fact of the matter was that the buyers of the tranches had all (or a lot) of the information to judge the deal, but often did not as they were caught up in the chase/grab for yield (sound familiar?).

To which Jimi responded:

The notion that qualified institutional investors should have stood up and taken note that the AAA securities were yielding an advantage of 150bps is totally reasonable.

On the other hand, my failure at complete due diligence does not absolve you of your lack of material disclosure and/or material misrepresentation. It may – but it doesn’t ipso-facto. That would be for a jury to decide given the case and the context.

With regard to that context, any qualified institutional investor, I believe, is going to have been assessing all this stuff through the small-minded theoretical tyranny of a portfolio perspective. That is, Big Pensions were all sold the promise of non-correlated returns available from subprime CDOs vis-a-vis the traditional stock/bond blend. They’d all been habituated to non-traditional assets by the non-correlated absolute return experience with different hedge funds styles. Non-correlated returns are the only “free lunch” in economics, so you had a stampede effect (especially after Yale and other places had made bank on these strategies before everyone and their mother piled in).

So, you have your MBA graduates sitting across from one another in their $3,000 suits, with one set trying to hawk you this or that tranche of this or that CDO, and the other taking the meeting and entertaining the prospect because they’re desperate to get the incremental risk-adjusted return for their 11-figure fund (which is chronically under-funded).

The one side is going to pitch this stuff from a portfolio perspective, and the other side is going to assess it from a portfolio perspective… because that’s pretty much the cornerstone of larger “prudent investor” and “fiduciary obligation” criteria.

For securitization to really possess any functional value from that portfolio perspective, the selection of assets with which to fund the securities must be done with some purposefulness (by the geeky-ass quants who wear the cheap suits and have to keep their socially-dysfunctional mouths shut through client meetings) so that the ensuing sliced & diced tranches have some chance of affording the historic risk-adjusted returns represented in the pitch.

In this case (and I’ve been too busy with real work to review the entire pitchbook but absolutely intend to read every word of it), Big Pension Suits taking that meeting need to have some assurance that those assembling the securities are doing so purposefully to approximate the historic risk-return characteristics they are aiming to provide.

“Past performance is no guarantee,” obviously, and you can say that anyone still investing in this idiocy at such a late stage can probably only barely be trusted to flip a burger. It seems to me one thing to have been duped by historic performance to believe these credits would perform; or to take a bath because, while even though the investment style is doing well, the specific securities you’re backing turn out to be dogs. The Monte Carlo simulation thingie is going to spit out “00” on occasion even for relatively safe investments (e.g., Lehman bond holders).

But it is entirely something different from a portfolio perspective if the securities selected are done so with an intention that they will purposefully not provide the historic risk-adjusted returns invoked by all. Should everyone have been doing better due dilligence? Duh.

Were these securities ever assembled with the purpose of approximating the non-correlated return of interest to investors? Obviously not.

It just seems to me that my lack of due diligence does not absolve you your misdeeds. It may if your attorneys are persuasive. But it mustn’t.

Follow the discussion.

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