Goldman Sachs hedge fund CDO?
May 10th, 2010
Buyers, sellers and users beware of opposite outcomes and opposing forces. What if the Abacus and Timberwolf synthetic CDO deals had not blown up? Brilliant buyers cited as gurus for their perspicacious positioning? Goldman Sachs called to testify for not disclosing to shorts that winning longs were betting against them? Would there be a case? Would it be on front pages? Rely on deal arrangers or do your own homework? Caveat emptor, caveat venditor, caveat utilitor.
Would Michael Lewis have written “The Big Long” on credit experts picking off bears wandering into the doomsday machine? Or Gregory Zuckerman on the “The Worst Trade Ever” how a merger arbitrage specialist, John Paulson, went out of business style drifting with subprime CDOs? Magnetar sucked into a black hole? Dr. Michael Burry back on double shifts at the hospital? What if Paulson HAD bought and the next day reversed to the other side. Would it have changed ACA’s loan portfolio selection choices or the bond “rating”?
Today I naively took the risk of renting a car. After closing the deal I was astonished to see some vehicles moving in the OPPOSITE direction. The salesperson and documentation made NO disclosure about this risky two-way flow. More due diligence revealed that despite heavy regulation and licensing, these dubious inventions KILL over 1,000 people every day from such collisions! Again zero mention in the legal paperwork of these hazards. Did they commit fraud by failing to inform of the danger? CDOs can’t be traded by some individuals but calamitous CARs are widely available.
Abolish CARs? I even saw a “rogue” employee knowingly bet against me driving north while I headed south. Such conflicts of interest and idiotic innovation needs to stop before even more people die in toxic tort products like cars. Ban derivatives trading so ban driving since it is much riskier? Subpoena to Congress those merchants of mayhem and dealers in destruction like car rental firms? The world thrived for a long time before “monstrousities” like C-D-Os and C-A-Rs were created. Get CDOs wrong and just lose money but outlawing CARs would save lives.
Wary of misrepresention of risk and non-disclosure of agents of automobile armageddon, I fled to the relative safety of finance. I chose 500 dodgy, in my humble opinion at the time, reference securities to bet against. Luckily some broker’s quantitative geeks had already assembled a structured derivative product for that equity tranche. I short sold the basket portfolio but the intermediary neglected to alert longs that I and possibly traders at the sponsoring firm might bet against them. Even the broker herself confided in an email that she was also personally bearish but her function was facilitating CLIENT transactions regardless of private or her firm’s market views. Anyone long the SPY ETF asset-backed security and not made aware of this has recourse to regulators?
Alpha capture is a war and battles have casualties. Finding alpha is a zero-sum ADVERSARIAL game of losers AND winners. Zero-skill, crowded beta is “cheap” but insightful analysis and variant perception costs 2 and 20 or more. Contrasting views make a market. It is dumb and suboptimal to presume a counterparty is on your side. The juxtaposition of ideas helps prick bubbles earlier than a one-way market. If I buy I want as many smart people as possible hoping I am wrong. If I short sell I am most comfortable when sophisticated professionals are buying and A-list analysts regard it as a core long.
You can ONLY produce alpha when others lose. The most alpha appears when most are wrong. A rating of “strong buy” on a stock or “AAA” for a bond is just someone else’s opinion. It is up to investors to do their own analysis or trust advisors working FOR them. Do your own due diligence or hire someone to do it for YOU with rare investment expertise and whose interests and INCENTIVES are aligned with yours. Cheerleaders cheer the team that pays them not necessarily YOUR team.
Harry Hindsight lives. The first casualty of war is truth and the first casualty of finance is memory. Casual emails gain overweighted(?) prominence when LDL conversations aren’t recorded. I wonder about that fateful meeting in January 2007 between Goldman Sachs, ACA and Paulson. Would buyers have walked away if all deal materials had stated in bold red ink “A merger arbitrage manager you likely haven’t heard of with no known expertise or track record in credit may have helped choose the underlying loans and will likely bet against them”. Or “Fabulous Fab and some of the <a href="http://news.yahoo.com/s/nm/20100503/bs_nm/us_berkshire_buffett
“target=_blank>Goldman Sachs GS proprietary credit traders are at this moment in time bearish on subprime credit but they have been right AND wrong in the past”. How might this have changed things?
Deception? Designed to fail? There are always bears on anything. If then unknown Paolo Pelligrini had shouted from the rooftops his negative views on subprime how many would have acted on it? We now know he was correct but AT THE TIME OF THE DEAL this was an outlier opinion ignored by the street. Even I wrote several bearish posts in 2007 and investors that followed that advice made high returns but the general population ignored those too. To make money out of the credit meltdown you didnt have to specifically short subprime. Was Fabrice Tourre wrong in his “smoking gun” email to express his then view that shorts were more likely to win than the longs? There have been many securities constructed on reverse enquiry from hedge funds where the client ended up being very wrong. I also know of IPOs done for “overvalued” companies considered “bound to fail” that have subsequently gone up 1,000% after listing. Everyone including insiders gets it wrong sometimes.
If I buy the more shorts the better since there is higher probability of a short squeeze. If everyone is buying, it is often time to short sell. Rather than being horrified that others think differently, it is excellent and favorable news. When I buy a security I assume and expect people are betting against me. If a market maker has a bid-offer spread and I take the offer, they are often left short temporarily if they don’t have inventory. They are then technically betting against a client but does it matter? Any market participant surely knows there will be opposing positions. Investors are free to choose pure execution-only brokers or investment banks well-known to have large proprietary trading operations that may or may not be betting in a different direction. The only Chinese Wall in the world passes just north of Beijing.
Would regulation and transparency have prevented the credit crisis? There have been many financial panics and real estate crashes in the past. Did CDOs and shorts “cause” those also? Why have there been worse ones where there were no derivatives or shorting? No security EVER trades for what it is worth; differences of opinion fuel all markets. If you short sell something you need as many people as possible to be bullish. Shorting rarely causes a security to go down. When you buy, the preferred situation is that many others are short. Exploiting the madness of crowds is the key factor for alpha. The more investors doing the opposite is POSITIVE if you have an edge. If you’ve done you’re research it ought to increase trade conviction. If you don’t have an edge why are you investing? Some think security analysis is a waste of time and John Bogle was as accurate as usual in ridiculing people who bother with skilled hard work.
All deals produce winners and losers. For every buyer there must be a seller and often a short seller. Is it always necessary to disclose that others including originators might bet against you? And if they do should it change your view or rating given your analytical edge? If you are bullish surely more bears should make you more bullish if you are confident of your ability. Blame the crisis on 2 and 20 and deal structurers or the 2 and 28 ARM lenders? Or on the inevitable boom and bust, greed and fear of the crowd. Manage risk and invest in skill to survive PREDICTABLE cyclical behaviour. Variant perception is what creates value for clients. Some speculate on conspiracy and collusion but it is usually just the Emotional Markets Hypothesis at work. All securities at all times are wrongly priced.
Short selling does not force securities to implode. It can however slow bubbles from turning into superbubbles and potentially worse problems. It may be counterintuitive but short selling subprime may have prevented larger losses and bigger issues. Some argue that credit repackaging exacerbated and perpetuated it but do not explain earlier crashes and meltdowns. With only longs, the Japanese credit bubble of the 1980s happened without CDOs, structured products or hedge funds betting against it. Subprime lending was invented in Japan and the crash’s effects still exist with the stock AND real estate markets 75% below high water marks. Short sellers and transfer of risk are positives not negatives for economic growth. Real estate booms and busts have occured for centuries. Sovereign defaults and bailouts are common yet rookies treat the Greek situation like it is unprecedented. Greece has been bankrupt more often than not since 1810.
One of the strangest results of the 2007-2008 post mortem was the slow motion reverberation from credit to equity. Even if you missed the credit short there was plenty of time to get short of equities. No-one could have predicted the crisis? Really? Many correlation “traders” short sold correlation at 0.3 and watched helpless as it gapped straight up to 1.0. Gaussian copulas absurdly assume constant default probabilities just like gaussian Black-Scholes crazily relies on constant volatility to allegedly “price” derivatives. The added complication with credit is the non-linear binary payoff. Either the debt is serviced or bankrupt. With low interest rates, yields often do not compensate for default risk. All an investor can do is their own analysis or hire an expert whose interests are the same as theirs.
If you need a friend get a dog. Full transparency: at this instant I am short the S&P 500 and numerous other asset-backed equity and credit structured products, however I might reverse and buy between 20 milliseconds and 20 years from now. Whatever or whenever an investor buys or sells, it is certain that others are betting the opposite way. To generate consistent alpha it is necessary to have counterparties with different opinions. It is obligatory for others to disagree with you. Their existence is mandatory for seeking alpha.
Related posts:
Posted in Hedge Fund