Goldman Sachs Tales

“Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a ‘bet against our clients.'”

That claim, from Goldman’s letter to its shareholders, is easily refuted. The S.E.C. has brought fraud charges on one of Goldman deals known as synthetic subprime mezzanine collateralized debt obligations, or CDOs. While most of these deals remain shrouded in secrecy, one of them, Anderson Mezzanine Funding 2007, Ltd. lays out its blueprint in sufficient detail so that we can pinpoint how and why this transaction’s failure was never in doubt.

When the deal closed on March 20, 2007, there was virtual certainty that investors would get wiped out and that Goldman would receive a windfall. And that’s exactly how things turned out. By December 2009, Anderson Mezzanine’s nominal value had shrunk by more than two-thirds, from $307 million to $94 million, though remaining assets’ fair market value was far less. The investment portfolio, which held only two performing assets, had an average credit rating of CC.

Anderson Mezzanine is by no means unique. More than $70 billion worth of toxic assets were dumped into mezzanine CDOs during an eight-month period between September 2006 and April 2007, when it became obvious to Wall Street banks that the lower-rated slices, or tranches, of mortgage-backed bonds were worthless. Other Goldman deals–Hudson Mezzanine Funding I and Hudson Mezzanine Funding II, various Abacus deals–were also designed to insulate the banks from losses on assets it knew to be worthless.

Eventually The Risk of Failure Morphs Into Absolute Certainty

A CDO is like a mutual fund or a hedge fund. It’s an investment portfolio, which, subject to certain limitations, may be actively managed. Sometimes a CDO, including Anderson, also acts like an insurance company. It receives fees for insuring certain identifiable risks, and, whenever called upon to pay out on an insured claim, it will liquidate part of the investment portfolio.

But insurance companies take on risks when the outcome is in doubt. Anderson Mezzanine was more like a life insurance company that insured the lives of 61 patients with Stage IV lung cancer. Whenever a patient died, Goldman, the insured beneficiary for all 61 patients, would collect $5 million. If Anderson had insufficient cash on hand, Goldman could dip into CDO’s investment portfolio and decide which asset it wanted to liquidate. If the asset could not be sold easily, Goldman would arrange an auction, in which Goldman might end up as the winning bidder.

Cynics might argue that these arrangements smack of fraud and abusive self-dealing, but Goldman could rightfully point to documents that put investors on notice. All of these pitfalls were identified in writing.

Playing the Ratings Game

But these pitfalls weren’t exactly conspicuous. A potential investor would need to spend a lot of time and effort deciphering the offering circular and related documents, such as the Bond Indenture, the Liquidation Agency Agreement, or the Forward Purchase Agreement, in order to figure out what was really going on. He would also need to conduct a financial analysis of the 61 different mortgage securities being insured via credit default swaps.

Or he might take some shortcuts, and simply rely on the deal’s stellar ratings. The most senior tranches of the CDO, comprising 70% of the capital structure, were rated AAA. After all, the rating agencies had reviewed and rated all of the 61 insured mortgage bonds, so their institutional memory and expertise was embedded inside the ratings awarded the Anderson deal.

David Fiderer: Goldman’s Blueprint for Dumping Toxic Assets: How These CDOs Were Designed to Fail

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