Book Review: Fatal Risk – A Cautionary Tale of AIG’s Corporate Suicide

A while back I asked seasoned financial reporter/investigator Roddy Boyd if I could review his book, Fatal Risk, about the rise and epic fall of AIG.  I finally finished it last week and while I didn’t think I’d ever say this, AIG was a REALLY ridiculously interesting story and one I absolutely recommend reading to anyone and everyone even tangentially interested in business, finance, investing, and economics.  This is truly one of the most important lessons in history, and as they say, those who fail to learn from history are doomed to repeat it…

 

 

 

At Goldman Sachs, Chinese Tech Companies Apparently Have the Same Risk As U.S. Ones

I’ve been analyzing YouKu.com (YOKU) for the past three weeks, and as I said most recently, I can’t possibly see how the stock could be worth more than about $21/share, using what I think are pretty optimistic assumptions.  I read Goldman Sachs’ – YOKU’s lead cheerleader underwriter – report before I published, and I’m still going through it and finding data, figures, conclusions and other “analysis” I find very puzzling, to put it nicely.  I’d made a note to myself during my first read-through to go back and check GS’s WACC calculation, since their Cost of Capital was only 12%, which seemed pretty low to me considering we’re trying to value a high-growth, relatively high-risk company in China.

Today, I finally went back and checked GS’ work, and what I found is at the very least EXTREMELY confusing, and at worst, deeply, deeply troubling.

Here’s why:

Reality vs. Matt Taibbi, Part I

Over the weekend I finally relented and read schmuck “journalist” Matt Taibbi’s most recent allegations against Goldman “Vampire Squid” Sachs.  The plan is to write a longer, more formal response, but in the interim I just want to take a few minutes to address the primary shortcoming of Taibbi’s “work,” namely, that he has no fucking clue what he’s talking about.

A Wolf In Sheep’s Clothing

Much has been written about Goldman and the Timberwolf deals since the now infamous “shitty deal” showdown between Senator Levin and GS officials last fall. In reading the majority/minority report issued last week in its entirety, there’s a few things that really stuck out to me.

On Materiality, Goldman, Abacus $GS

As my last post stated, the SEC – absent some sort of damning evidence we’ve yet to see – has its hands full proving Goldman’s lack of disclosure of Paulson & Co’s involvement in the Abacus CDO was material and amounts to fraud. They’re up against some interesting precedents, for example, TSC Industries Inc v. Northway, Inc, in which the judge’s logic went as follows, and found (see http://en.wikipedia.org/wiki/TSC_Industries,_Inc._v._Northway,_Inc.):

“If the test was too stringent, it would cause the dismissal of otherwise meritorious lawsuits; if it were too lenient, corporate officers would be inclined to overwhelm shareholders with such a large volume of information that truly valuable facts might escape them. He formulated the test as follows: an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. In other words, the court must determine whether under all the circumstances, the omitted fact would have assumed actual significance in the decision of the shareholder. Thus, materiality is a mixed question of fact and law.”

As I’ve argued, I don’t buy that full, explicit disclosure of Paulson’s involvement would have changed anything (excepting perhaps, as Steve Randy Waldman said, if IKB decided they’d be violating their mandate, but thats another conversation altogether).

I’ll try to post some more later,

On The SEC’s ABACUS Case Against Goldman Sachs

Back in Sophomore (maybe Junior) year Finance class, we learn some very basic approaches to investment analysis. Before we ever touch upon analytical methods, we learn high-level stuff, for example, first and foremost you should analyze a potential investment on its merits; extraneous information is, at best, of secondary, tertiary, or just no concern. If I’m considering buying the ABACUS synthetic CDO deal at the heart of the SEC’s case against Goldman, my primary focus is to analyze the RMBS transactions in the reference portfolio selected by ACA (NOT Paulson – ACA could have throw out EVERY/ANY security Paulson suggested if they thought it was a crap bond), the structure of the deal. Once I’ve done the granular analysis of EVERY bond in the reference portfolio – as close to loan-level as possible, especially with the 20+ person diligence team that IKB reportedly employed – and decided everything looked good, then and only then would I get into other considerations. Have we covered all our bases? Are we missing anything? What are other smart people doing with this/similar transactions?

I firmly believe this story pretty cut & dry: IKB/ACA/ABN did their diligence (well, let’s give them the benefit of the doubt they did, at least) and determined they wanted to buy the deal. They had the blessing of the Ratings Agencies (which, with the wisdom of hindsight – key word – we know was not a very bright idea), they had other “smart” people reinforcing their view (long live confirmation bias!), and the financial industry, as a whole, was generally still long housing.

Anyone who claims that the buyers (longs) would have backed-out if they knew some no-name Hedge Fund manager with ZERO mortgage investing experience suggested part of the reference portfolio is material is full of it. The buyers were arrogant, over-confident in their experience and ability to analyze complex structured finance transactions. Hell, if they WERE made explicitly aware of Paulson’s “involvement” they probably would have enjoyed a good, hearty laugh at his expense and quite possibly even bought MORE of the deal when they knew they were up against such a rube, a novice, a guy in WAY over his head.

One person on the other side of this debate says that in order for me to make such a claim I must be either clairvoyant or have worked on IKB’s deal team in 2007. While I think that’s a bit of a non-sequitur, I’ll allow it, and then accuse the SEC of the same apparent psychic abilities. How on Earth do they presume to prove what IKB WOULD have done? How could anyone prove what they WOULD have done in the past? Sure, I WOULD have prepared differently for the GMAT’s if I knew I was going to run out of time on the math section, but I didn’t KNOW that would be the outcome, since I knew the material very well. Similarly, IKB “KNEW” structured finance RMBS investing, they just didn’t know or expect the outcome we know so well with the benefit of hindsight.

That’s it. Everything else is irrelevant. IKB knew the material that was going to be on the test (the composition of the reference portfolio and all other relevant deal information), they had the ability (experienced deal team) to prepare for the test (analyze the deal), they just came to what turned out to be the wrong conclusion, and didn’t do as well as they expected.

Ultimately, whether Paulson’s involvement will be decided in court, and what I have to say is, unfortunately, just words on a page.  I agree there is the possibility that when all of the information is made available (emails, etc), there may have been an intent to deceive, or scienter,but that’s for the courts/lawyers/etc to decide.

Update: Since I published this in haste (my bad), I should have rephrased the bolded text three paragraphs up, to ask “How does the SEC believe they can use the ‘reasonable person’ test in this situation?”  That is, this is a market, which by definition necessarily includes two parties both of whom believe themselves to be reasonable with different, nay, opposing views.   Thanks to @_phlox for the legal edit.

Guest Post: Quote From Colonel L. Blankfein Jessup Before a Commission of Inquiry

From 1-2 aka @onetwoko

“You want the truth? You can’t handle the truth. Son, we live in a
country with an investment gap. And that gap needs to be filled by men with money. Who’s gonna do it? You? You, Middle Class Consumer?

Goldman Sachs has a greater responsibility than you can possibly fathom.

You weep for Lehman and you curse derivatives. You have that luxury.
You have the luxury of not knowing what we know: that Lehman’s death, while tragic, probably saved the financial system. And that Goldman’s existence, while grotesque and incomprehensible to you, saves pension
funds.

You don’t want the truth. Because deep down, in places you don’t talk about at parties, you want us to fill that investment gap. You need us to fill that gap.

“We use words like credit default swaps, collateralized debt obligation, and securitization… We use these words as the backbone of a life spent investing in something. You use ‘em as a punchline. We have neither the time nor the inclination to explain ourselves to a commoner who rises and sleeps under the blanket of the very credit we provide, and then questions the manner in which we provide it!

We’d rather you just said thank you and paid your taxes on time.

Otherwise, we suggest you get an account and start trading. Either way, we don’t give a damn what you think you’re entitled to!”

On The Goldman Sachs Fraud Charges

I’ve been painfully busy this week so I was only able to get out my thoughts in a few tweets and comments on other blogs, forgive me.  Felix Salmon, Kid Dynamite, Henry Blodget and others have all beat me to the punch, and largely, I share many of their thoughts, especially Dynamite’s most recent take (wherein he quotes Blodget).

I won’t rehash the charges as they’ve already been beaten to death by everyone else, however, I will say after reading the SEC’s complaint, the Abacus pitchbook, and Goldman’s defense, I’ve come to the following conclusions (I’m neither a lawyer or structured finance professional, so keep that in mind):

Not only do I not see how/why GS was under any obligation to disclose the party (parties) on the other side of the Abacus synthetic CDO transaction (see page 8 of the pitchbook), I can’t figure out how it’d matter if they had (more on this below).  I also haven’t seen anything yet that explicitly says whether Paulson & Co. did or did not buy into the equity tranche of the deal.  The SEC complaint seems to imply that they did not, however if that is, in fact, the case, I’m very curious why they danced around saying so clearly…

Also, as KD wrote (emphasis mine):

Note that no one is arguing the merits of GS’s disclosure (or lack thereof) here, but I am absolutely arguing that the disclosure shouldn’t have mattered IF ACA HAD DONE THEIR JOB. The underlying securities in the synthetic CDO are what they are, regardless of who put them on the list, or who takes the other side of the trade.  They need to be evaluated based on risk metrics, cash flows, etc.  The real issue is that ACA didn’t do this work to the level that they needed.

GS may be guilty of insufficient disclosure – let’s just pretend they are.  My point is that even given this failure to disclose, the buyers of the securities in question were grossly negligent in failing to properly assess the values and prospects of the synthetic CDOs, and they are trying to remedy their bad trade by diverting blame.

Again, while I’m not a lawyer, from what we’ve seen so far, it looks like the investors’ shareholders may have merits to file suit against the firm’s management for breach of fiduciary duty, since its seems pretty clear that both ACA and IKB (and/or others) didn’t come anywhere close to conducting the kind of diligence required prior to undertaking such a transaction.  They were given a list of all the underlying RMBS and could have easily done the same research Paulson & Co. apparently did, but it seems that either they did – and simply had a rosier outlook for MBS/over-reliance on Ratings – and/or didn’t, in which case they have no one else to blame but themselves.

At best, Goldman’s role(s) in this Abacus transaction teeter(s) on the edge of what most would call ethical business practices, however, I’m not sure the SEC – especially up against the all-star legal team GS is likely to bring – will be able to prove fraud on any meaningful scale.  Given the emails involving “Fab” Tourre the SEC complaint cites, I wouldn’t be surprised if he gets thrown under the bus here by his squid overlords to save their butts.  If that happens, I also wouldn’t be surprised if he tries to shift the blame onto one or two of his higher-ups, an action which GS senior management may deem necessary to protect the firm as a whole.  Ultimately, my guess at this point is that Goldman ends up paying a $50-$100 million fine -tops – after a year or two of courtroom haggling, while “neither admitting or denying any wrongdoing.”  My friend, The Reformed Broker explains what’ll likely come of this in it far better detail, here.

As far as the bigger picture goes, I’m glad the SEC looks like they may finally be getting their shit together.  Unfortunately, unless they have an ace up their sleeve, I doubt this case is the slam dunk they likely thought it was.