The woeful performance of some C.D.O.’s issued by Goldman made them ideal for betting against. As of September 2007, for example, just five months after Goldman had sold a new Abacus C.D.O., the ratings on 84 percent of the mortgages underlying it had been downgraded, indicating growing concerns about borrowers’ ability to repay the loans, according to research from UBS, the big Swiss bank. Of more than 500 C.D.O.’s analyzed by UBS, only two were worse than the Abacus deal.
Goldman created other mortgage-linked C.D.O.’s that performed poorly, too. One, in October 2006, was a $800 million C.D.O. known as Hudson Mezzanine. It included credit insurance on mortgage and subprime mortgage bonds that were in the ABX index; Hudson buyers would make money if the housing market stayed healthy — but lose money if it collapsed. Goldman kept a significant amount of the financial bets against securities in Hudson, so it would profit if they failed, according to three of the former Goldman employees.
A Goldman salesman involved in Hudson said the deal was one of the earliest in which outside investors raised questions about Goldman’s incentives. “Here we are selling this, but we think the market is going the other way,” he said.
The question now should be, did Goldman advise clients of what they were doing? Goldman does claim they did:
The Goldman salesman said that C.D.O. buyers were not misled because they were advised that Goldman was placing large bets against the securities. “We were very open with all the risks that we thought we sold. When you’re facing a tidal wave of people who want to invest, it’s hard to stop them,” he said.
To be absolutely fair, GS is making a good point. There were probably a ton of blind speculators out there who were happily buying these C.D.O.'s up despite being told that the instruments' very creator was betting against them. However, it seems GS and other banks still worked to tilt the field in their favor, as they were in the best position to understand just how awful the underlying securities in their C.D.O.'s were and what was likely to happen (crash).
Banks also set up ever more complex deals that favored those betting against C.D.O.’s. Morgan Stanley established a series of C.D.O.’s named after United States presidents (Buchanan and Jackson) with an unusual feature: short-sellers could lock in very cheap bets against mortgages, even beyond the life of the mortgage bonds. It was akin to allowing someone paying a low insurance premium for coverage on one automobile to pay the same on another one even if premiums over all had increased because of high accident rates.
At Goldman, Mr. Egol structured some Abacus deals in a way that enabled those betting on a mortgage-market collapse to multiply the value of their bets, to as much as six or seven times the face value of those C.D.O.’s. When the mortgage market tumbled, this meant bigger profits for Goldman and other short sellers — and bigger losses for other investors.
This behavior was not illegal, but perhaps it should be illegal. It simply seems wrong that a bank could create, market, and sell an instrument that it is planning to bet against. This kind of pure profit-chasing can have awful consequences, as we all recently witnessed. One thought I had: require that a bank that creates any security it markets to clients must not be allowed to invest in it. A bank could naturally advise clients on what it has created, but at that point it would have incentive to create securities that have a clear chance at good performance. Naturally, they could still go long or short securities created by other banks. I think this seems like a more balanced state of affairs than what was described in the NYT article.
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