Lawbitrage

Court Tells Goldman Sachs to Not Always Be Closing

The March 2012 New York Times editorial by former Goldman Sachs executive Greg Smith accused the firm's culture and practices of being centered around "ripping their clients off." Smith followed-up on his editoral yesterday by publishing a full-length book on his time at Goldman and an editorial criticizing much of the financial services industry.

While the soundness of Smith's criticisms leave much to be desired, last week the New York State Supreme Court refused to dismiss an October 2011 lawsuit against Goldman that, much like Smith, faulted Goldman for "putting profits above integrity...to the detriment of its own clients."  The case is Basis Yield Alpha Fund (Master) v. Goldman Sachs Group Inc et al., New York State Supreme Court, New York County, No. 652996/2011.

The suit was brought by a hedge fund claiming that Goldman sought to reduce its exposure to subprime mortgages by selling mortgage-related securities to the fund as sound investments without disclosing Goldman's negative view of the securities or its economic interest in their failure. 

The court refused to dismiss the fraud claims because it found that the fund laid out in sufficient detail specific misrepresentations by Goldman.* 

But the court went further. It held that the fund's fraud claim was also supported by Goldman's overly optimistic opinions about the value of the transactions allegedly made to the fund. These opinions included statements that the transaction was "attractive" and "rock solid."

Goldman argued in a motion that, even if the opinions were actually stated, they don't lay the basis for a fraud claim because they were merely sales talk and puffery--as distinct from misrepresentations of actual fact. A general principle of business and securities law is that opinions cannot serve as the basis for a fraud claim. Moreover, Goldman argued, any statements of opinion are irrelevant in light of the specific disclaimers that were made about the risks of the transactions. 

But the court didn't buy Goldman's arguments.

Relying on prior cases finding that it is fraudulent for a seller to state an opinion that's unreasonable or that the seller does not genuinely believe, the court found as sufficient the fund's allegations that Goldman believed the securities it sold were toxic and that Goldman was motivated to remove the securities from its balance sheet. Likewise, the court found the disclaimers in the transaction's offering documents insufficient to dispose of the fund's fraud claim. This is because of other allegedly fraudulent statements Goldman made outside of the offering documents--in emails to, and calls with, the fund.

A primary lesson from the case thus far is that, to avoid civil liability, firms that use securitization vehicles to transfer risk should not opine as to the quality of securities they are issuing. They should also give the buyer a breakdown of the transactions directly related to the securitization that they are involved in, as well as their relationship with third parties that help structure the vehicle.

A major problem with the opinion is that it allows sophisticated parties like hedge funds to bring suits on the basis of having relied upon opinions, albeit insincere ones. In doing so, it undermines the incentive for sophisticated buyers to do their own research and negotiate for more disclosures and favorable deal terms.

A primary cause of the subprime mortgage crisis was investors' failure to perform their own research or hire independent parties, and the court's decision does not alleviate that problem. To the contrary, it gives implicit approval to buyers to rely on the opinions of sellers when they probably should be ignoring them altogether.

_______________

*Those allegations relate to Goldman's internal valuation of the securities, the independence of the underlying asset selection process, and whether Goldman's interests were really aligned with the fund's. 

Research by Nobel Prize-Winning Economists Raises Doubts About Derivatives Regulation

The 2012 Nobel prize in economics was awarded today to Alvin Roth and Lloyd Shapley for their research on how markets are best designed.

Although neither has applied their research to derivatives markets, their winning ideas seem to undermine the case for designing derivatives markets around a central clearinghouse, which is precisely what the Dodd-Frank Act of 2010 and other reforms around the world seek to do.

In a 2008 article, Roth noted that well-functioning centralized markets should:

provide thickness, i.e. they need to attract a large enough proportion of the potential participants in the market...and they need to make it safe and sufficiently simple to participate in the market, as opposed to transacting outside of the market, or having to engage in costly and risky strategic behavior.

But when it comes to derivatives markets, there's a major problem: many types of derivatives markets will never be thick enough to function well if centralized clearing is required.

Take credit default swaps (CDSs), the notorious type of derivatives contract that motivated Dodd-Frank's central clearing requirement. Even with the contract standardization and other operational improvements that have taken place in recent years, the market for CDSs that use clearinghouses is very thin.

For example, of the 1000 most active single-name CDSs, there are over 900 that reference corporations. However, the largest CDS clearinghouse (the Intercontinental Exchange) only clears 253 single-name corporate CDSs, or about 28 percent of the most active CDSs. In fact, the value of the currently outstanding CDSs on the Intercontinental Exchange's clearinghouses ($1.5 trillion in open interest) constitutes only 5 percent of the total value of CDSs ($28 trillion in notional value as of year end 2011).

These statistics show that using clearinghouses is a market design that doesn't appeal to a lot of CDS market participants--that it lacks Roth's "thickness" standard.

Roth also notes that well-functioning markets must be safe, which in finance means systemically stable. Although many aspects of derivatives regulation and practice are still evolving, designing the market around clearinghouses reduces safety in a way that may ultimately impede the market from functioning.

In a 2012 article, I noted the risks that the clearinghouse model will introduce, including clearinghouses becoming undercapitalized due to technical risk-management failures or because a clearinghouse reduces its standards to attract business. In addition, clearinghouses may create moral hazard by removing the direct incentive for CDS counterparties to consider counterparty risk upon entering a trade since that risk is shifted to the clearinghouse.

The beauty of Roth and Shapely's research is its practical orientation. Unfortunately, when applied to how derivatives markets are effectively being redesigned by global regulation, it's hard to conclude that the result will be the most functional.

As Credit Markets Evolve, Banks and Derivatives Take a Back Seat

Credit markets continue to evolve in light of lessons learned from the 2008 financial crisis, more stringent regulation, and technological improvements.

Whatever ultimate impact the foregoing changes have on credit markets, they are likely driving two important trends.

The first trend is commercial banks playing a smaller role in the economy. A good reflection of this trend is the shrinking share of banks as investors in loans made by multiple lenders (i.e., leveraged/syndicated loans). As Steve Miller reports, bank participation in leveraged loans relative to that of non-banks hit a record low in the third quarter of 2012, down to 13%. The following chart from the story shows significantly reduced bank participation in the leveraged loan market since 2009 (and also that this trend is the culmination of a phenomenon underway for nearly two decades).

A second important trend in credit markets is the reduced use of credit derivatives. The September 2012 quarterly report by the Bank for International Settlements contains the following chart that shows the decline in the notional value of credit default swap (CDS) derivatives since 2008.

CDS trading is also decreasing. As Stephen Folely recently reported in the Financial Times, so far in 2012 "trading in individual corporate CDS is down 23 per cent." 

Additional regulatory requirements are likely driving the steady decline of CDSs, which will soon not offer banks the capital relief they once did--quite the opposite. But the ability to transfer credit risk through other means is also likely behind the decline. The willingness of investors to buy bonds backed by corporate debt (i.e., collateralized loan obligations) at prices attractive to issuers decreases the benefit of transferring that same risk through the use of derivatives.

If these trends hold, we can expect that banks and credit derivatives will play a smaller role in the financial system of the future. The key question is what will take their place.

JP Morgan Loss Shows Credit Derivatives Have Come A Long Way Since AIG

JP Morgan's ongoing multibilion dollar loss from credit default swap (CDS) trades shares some disturbing similarities to the CDS trades that caused AIG to collapse in 2008. In both cases, the firms sold massive amounts of CDS protection. By 2007, AIG had sold in notional value $78 billion in ultimately ruinous CDSs. By some estimates, JP Morgan is currently long as much as $100 billion in losing CDS positions. In both cases, the regulators and executives that should have prevented or at least known more about the trades were caught blindsided. Reliance on flawed risk models also enabled both firms' losses.

Yet as Congress focuses on JP Morgan's CDS losses in its hearing today with bank regulators, and next week with JP Morgan CEO Jamie Dimon, it is worth noting that there are crucial differences between JP Morgan's and AIG's CDS losses. The differences are important because they indicate that the CDS market has become much safer than it was prior to the financial crisis, even if particular firms still misuse the instruments.

Different Underlyings: Corporate Bonds Versus Mortgage-Related Securities

The first and most significant difference is that JP Morgan sold protection referencing a far more rationally priced and liquid market than did AIG.

JP Morgan's losing trades reference an index of North American investment grade bonds (the Markit CDX NA IG Series 9). Although bonds are not as liquid as stocks, the market for corporate bonds is robust and pricing is readily available. AIG, by contrast, sold CDSs referencing residential mortgage-related securities. When AIG was selling these CDSs, residential mortgage-related securities were mispriced, and the instruments were rarely traded and difficult to value.

Indeed, the efficiency of the corporate bond market underlying JP Morgan's trade explains why JP Morgan's massive CDS position distorted the CDS market in a way that became readily apparent to its counterparties. In the case of AIG, the market distortions caused by its mortgage-related CDS trades led it to become the "golden goose" underlying the mispriced synthetic securitization market of the better part of the last decade.

Importantly, the CDS market today poses much less of a risk to the financial system because CDSs are rarely written on illiquid mortgage-related securities any longer, in large part because of the shut down of private-label mortgage securitization since the financial crisis. This shut down is reflected in the following figure by Paul Rowady (page 68), which shows the collapse of special purpose shell entities selling mortgage-related CDSs:

 

 

Different Types of Risks: Market Value Versus Cash Crunch

The second major difference is the types of risks that arose from JP Morgan's and AIG's CDS trades. While JP Morgan's failed CDS trades are causing it unrealized paper losses, AIG's CDS trades caused it to practically run out of cash overnight and created risk for its counterparties and the economy.

AIG posted nearly $20 billion in collateral by August 2008 as the market value of the securities referenced by its CDSs plummeted. AIG was later bailed out by the government when it was unable to meet a second $20 billion collateral call from its mortgaged-related CDSs. AIG's collateral posting obligations were so large and sudden in part because it never posted collateral when the trades were first executed.

By contrast, the losses to JP Morgan from its CDS trades require the firm to reduce the balance sheet value of its CDS positions. JP Morgan was required to mark down the value of its CDS trade because the price of the reference index increased, thereby decreasing the value of the CDS protection it sold. Although JP Morgan's paper loss will reduce its profits, may require it to set aside or raise more capital, and lead to a realized loss once the trade comes to completion, it is unlikely that JP Morgan will actually have to make a cash pay out under its CDS trades. This is because the likelihood of default of any of the investment grade companies making up the referenced index is low.

Due to these differences, one should think twice before drawing conclusions about the CDS market based upon analogizing between JP Morgan and AIG.

The Volcker Rule's Hedging Exemption May Encourage JP Morgan-Style Risk Taking

Many details of the credit derivatives position that caused JP Morgan (JPM) to recently lose at least $2 billion are unknown. Yet based on the company's disclosures and media accounts of the trade, the Volcker Rule as proposed in October 2011 may end up encouraging the type of risk taking underlying JPM's losing position, if the Rule is implemented as proposed.

The Volcker Rule bans proprietary trading by banks and their holding companies, affiliates, and subsidiaries. As noted on page 67 of the proposal, the Rule's "hedging exemption" permits banks to engage in otherwise prohibited trading to hedge, but only if the hedging transaction does "not give rise, at the inception of the hedge, to significant exposures that are not themselves hedged in a [second] contemporaneous transaction."

The problem is that while entering into a secondary hedging transaction may initially reduce risk, it may also leave banks with even riskier positions that are difficult to manage in the long-run. Indeed, JPM's losing trade exemplifies just this sort of risky secondary hedging transaction.

To hedge its exposures from holding high-grade corporate bonds, JPM bought credit protection on a credit default swap (CDS) index referencing corporate bonds. However, this primary hedging transaction itself exposed JPM to at least two new risks. First, in accordance with accounting rules, JPM had to mark-to-market the value of its CDS index hedging transaction, which means that the primary hedge exposed JPM to market price risk. Second, the primary hedge also exposed JPM to the risk that the other side of the hedging transaction would be unable to pay, or counterparty risk.

To hedge these new risks, JPM also entered into another hedging transaction where it sold protection on a related CDS bond index. To borrow a metaphor from the New York Times, JPM put an umbrella on an umbrella. Importantly, not only was this sale of CDS protection the part of the transaction that ultimately led to JPM's $2 billion loss, but it was also the type of secondary hedging transaction that could be required by the Volcker Rule. When the secondary hedge was entered into 2011, it seems to have been an appropriate hedge for the primary hedging transaction.

None of the foregoing implies that JPM's loss was caused by anything other than its own mismanagement. However, given that secondary hedging transactions seem ripe for such mismanagement, the fact that the Volcker Rule seems to encourage them to qualify for one of its exemptions is troubling. It suggests attempts to micro-manage bank risk taking through regulation could seriously backfire, and that higher capital requirements or limiting the size of banks will be more effective in reducing systemic risk than the Volcker Rule.