A Wolf In Sheep’s Clothing

18 Apr

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.

Besides having a disproportionate amount of the report tilted towards trying to give everyone a peek inside two banks (Deutsche to some limited extent documenting Lippmann and a large portion dedicated to Goldman), in my humble opinion it left out what has happened at the institutions that posed a greater risk (and ultimately caused the most damage during their near collapse/collapse). The question I pose to the committee is why spend so much time focusing on Goldman (wait – I know the answer to this: they’re an easy populism target) when you could have put equal weighting on investigating the things that went on behind the scenes at: Lehman, Bear, New Century, Quick Loan Funding, etc. I realize this report contains some bias towards a certain point of view (namely the Government’s) but there’s some valuable lessons that can be gleaned from certain sections of the report.

I want to highlight some sections that were of particular interest to me:

Page 547:

Despite Goldman’s internal analysis that the value of the Timberwolf securities was in rapid decline, the firm did not lower the prices at which it marketed the securities to clients.  In a May 14 email, Mr. Sparks explained his Timberwolf pricing strategy to Mr. Mullen and Mr. Montag: “I think we should take the write-down, but market at much higher levels.  I’m a little concerned we are overly negative and ahead of the market, and that we could end up leaving some money on the table – but I’m not saying we shouldn’t find and hit some bids.”

As a result of the CDO valuation project, Goldman took substantial writedowns on the value of its CDO inventory on May 25, 2007.  For example, Goldman marked down the AAA rated Timberwolf A2 securities to a value of $80.  At the same time, Goldman continued to market them at inflated prices, selling Timberwolf A2 securities to clients at $87.00 on May 24, at $83.90 on May 30, and at $84.50 on June 11.  On May 25, Goldman also marked the AA rated Timberwolf B securities to an internal value of $65.00.

If this is indeed true, then I believe that there was a conflict of interest when you’re internally saying one thing, but pressing your sales force to represent the value of the securities at higher prices. Shame on GS (if this is indeed true).

Beware Of Overly Bullish Perspectives

We all learned that lesson when Bernanke early on in the crisis said that the “crisis was contained” and that all was well. When someone at a firm approaches you chirping that “all is well” and the market turmoil is “a distant memory” based on a small sampling of data points (or truncated time series in economic data) – run, don’t walk the other way. Or, at the very least question their motives.

Page 548:

Edwin Chin, a trader on the Mortgage Department’s ABS Desk, sent this upbeat commentary to both Goldman traders and clients:

“Incredible as it may seem, the subprime mortgage slump is already [a] distant memory for some.  It’s been two months since the ABX market plunged amid worries about a housing meltdown, and already investors (and some dealers) are beginning to get ‘complacent’ again. Blame it on the CDO bids, but with subprime production projected down 40-60% from last year’s level, appetite for spread products triumphs any risk concern in the marketplace right now.  ABX Index is trading higher as dealers short cover their single name positions after a month of range-bound trading.  Flows continue to weigh toward better seller of protection – longs outpace shorts by 3 to 1 as CDO demand has been robust the last two weeks. While warehouse activities might be slow, many CDOs are still looking to finish up their ramp post-closing.”

Daniel Sparks responded to Edwin Chin’s commentary by asking senior ABS traders, David Lehman, Mike Swenson, and Joshua Birnbaum:  “Is this a head fake or does this make you bullish on all spread product?”  Mr. Lehman responded:  “[G]iven the sizable short interest in ABS/subprime mkt it does not surprise me that short covering is pushing spds [spreads] tighter. Not sure I would enter new longs here.”  Mr. Swenson responded:  “I would characterize this as a great opportunity to be constructive on the market.”  (footnote: 2408)

Footnote 2408: Mr . Birnbaum responded directly to Mr. Swenson: “what a beautiful quote.”

If you listened to Mr. Chin during this time, you were probably living under a rock. “Sophisticated” investors took this bait hook, line and sinker as described here:

Page 549:

Mr. Maltezos was claiming that a Timberwolf investment could provide over a 60% return on invested capital, Goldman’s internal marks were showing that Timberwolf was continuing to fall in value.

For “sophisticated investors”, one would think that they would have learned the lesson that so many people should already know in less complex investments/business deals. If it sounds too good to be true, it probably is. Blame goes to the “investors” who believed Messrs. Chin and Maltezos for this one.

And Now, For the Wolf In Sheep’s Clothing

Fortunately, for Goldman, they found quite a few “sophisticated investors” who ate this line up hook, line and sinker. Basis Capital was one that was particularly highlighted in this report and it raises a big question in my mind: What is an Australian hedge fund doing dabbling in the US mortgage market (either by buying the actual underlying paper or synthetics attached to it) without doing proper due diligence? The kicker is, this particular “SI” had a previous experience with Goldman and it wasn’t pretty (or saw things that should have made them uneasy investing in Timberwolf).

Page 550-551:

On April 19, 2007, Basis Capital had purchased BBB rated Point Pleasant securities at a price of $81.72.  Goldman had provided the financing for this purchase.  Two weeks later, Goldman had marked down the value of the securities to $76.72, and asked Basis Capital to post additional cash collateral totaling $700,000.  When Basis Capital asked how the value of the security had fallen $5 in just two weeks, Goldman responded that the price had gone back up to $81.72, and no additional cash was required.

In May and June 2007, Mr. Maltezos worked to convince Basis Capital to purchase $100 million in Timberwolf securities.  At one point Basis Capital pressed for a lower sales price, but was told by Mr. Maltezos:  “I don’t think the trading desk shares the sentiment with regard to such spread levels [lower prices].”  During the negotiations over the Timberwolf sale, on June 12, 2007, Goldman again marked down the value of the Point Pleasant securities to $75, and again asked Basis to post more cash collateral.  When Basis Capital asked Mr. Maltezos to justify the lower value, Mr. Maltezos wrote:

“[T]here has been further softening in the market since the Point Pleasant trade was put on 8 weeks ago.  We have infact [sic] traded some Point Pleasant BBBs at this level in the last 2 weeks.” 

In fact, no such sales had taken place, and the lower value could not be justified by any sales transactions.  The lower mark was instead related to Goldman’s CDO valuation project in May, which had concluded that its CDO securities had lost significant value.

Stuart Fowler at Basis Capital brought up the valuation issue in the context of the Timberwolf securities, and asked Mr. Maltezos:  “I need to be very clear on this and are we going to see a similar problem on [T]imberwolf?”  Mr. Maltezos responded:  “Stuart – I assure you no foul here,” and offered to set up some “1-on-1 time with the trading desk” to discuss pricing.

So let’s recap: Basis bought Point Pleasant and 2 weeks later got a lil somethin something from Goldman saying that they needed to post collateral because the price had “mysteriously” traded down to 76.72. After getting an explanation from Mr. Maltzeos that later proved to be a “lie” (or misrepresentation) during the negotiations to buy into Timberwolf, the so-called “SI” had enough red flags to say “thanks but no thanks” – but they didn’t.

This reminds me of the battered wife analogy: GS beat the “SI” on the first deal but when it came time for them to need Basis again, they kissed, made up and said “I love you” [“I assure you no foul here”].

Even after the “wife” or “SI” later found out that Maltezos had “lied” (No, honey I was not out at the bar with another girl!), the SI had yet another opportunity to decline to take part in Timberwolf:

Page 551:

Mr. Sparks was closely monitoring Mr. Maltezos’ ongoing effort to sell the Timberwolf securities to Basis Capital and, on June 13, 2007, sent this email to Mr. Maltezos: “Let me know if you need help tonight – or feel free to wake up [Mr. Lehman and Mr. Egol] in [S]pain.  I’d love to tell the senior guys on 30 at risk comm[ittee] Wednesday morning that you moved 100mm [$100 million].”

In response, Mr. Maltezos coordinated a call between Basis Capital and Mr. Lehman to “clarify any and all questions you have on the marking policy of Goldman, the actual marking of Point Pleasant, and the overall trading that has been seen by the [Goldman] desk in the last 1-6 months.”  In that telephone call with Basis Capital, Mr. Lehman apparently corrected Mr. Maltezos’ misstatement about recent Timberwolf sales, and Mr. Maltezos followed up with an email to Basis Capital: “[P]lease accept my sincerest apologies for the mis-information below.  As David mentioned, the 75 mark on Pt Pleasant BBB was more reflective of an interpretation of softer AAA-AA rated CDO-sqd paper translating to BBB part of the curve.”

Again, the “SI” had another red flag that should have gone off. If they were doing proper due diligence that “SI”‘s are supposed to do, they would not have proceeded further. Instead, like the battered wife, they believes that “he only did this because he loves me” (or, I can get a 60% return!!)

So many red flags, so little “due diligence” on the part of the “SI”. We all know what happens next, and it’s pretty brutal:

The “Wolf” Goes In For The Kill

Page 552:

Basis Capital had agreed to accept implied a cash price of $84 for the AAA securities and $76 for the AA securities.  Mr. Montag asked what Goldman’s internal mark was for the Timberwolf AA securities, and Mr. Lehman responded:  “$65.” The Timberwolf sale to Basis Capital was finalized on June 18, 2007.  Goldman provided the financing.  Just two weeks later, Goldman informed Basis Capital that the Timberwolf securities had lost value and required the hedge fund to post additional cash collateral.  Basis Capital immediately questioned the new value and asked to see a “comparable market data point for the Timberwolf marks.”  In response, Mr. Lehman complained internally: “I would like to know what the precedent there is here – does GS need (outside of the client issue) to provide the below info to justify our prices???”  After Goldman provided additional information, Basis Capital appeared to agree to post the additional collateral.
Eight days later, on July 12, Goldman again marked down the value of the Timberwolf securities to prices of $65 and $60, after having sold them to Basis Capital one month earlier at $84 and $76.  This repricing resulted in a $37.5 million movement in the value of the securities, and required Basis Capital to post substantially more cash collateral with the firm.  On July 13, 2007, Basis Capital told Goldman that one of its funds was “in real trouble.”  On July 16, Goldman again marked down Basis Capital’s securities to prices of $55 for AAA and $45 for AA.  These prices matched Goldman’s internal valuations.  By the end of July, Basis Capital was forced to liquidate its hedge fund.  Goldman bought back the Timberwolf securities from Basis Capital on July 31, at prices of $30 and $25.

It looks to me that blame is shared across the entire spectrum, not just squarely at Goldman. If a “SI” can’t be bothered to do their own due diligence and recognize the red flags from the previous deal (Point Pleasant) and the misrepresentation (or lie) regarding the marks that was uncovered during the conference call then they did indeed deserve this. Thoughts?

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