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Felix Salmon's Henry Blodgett Smackdown


Siwoti Sunday: Blodget’s bizarre Goldman apologia: Now Blodget... the SEC case against Goldman Sachs... his case for the defense is so weak that one suspects it was written more as a pageview magnet.... Blodget kicks off with what he calls “some important background to keep in mind”. The problem is that Bloget’s “important background” seems to have been lifted from a fictional planet: it certainly doesn’t reflect reality. For starters, in BlodgetWorld, this CDO was structured in the wake of numerous failed attempts to bet against the housing market. He talks about the “huge losses” which were suffered by “dozens of other investors who bet against the housing market from 2003-2007”, and goes on to reiterate:

Plenty of firms had been betting on the collapse of the housing market for years, and they’d all been wrong. In 2007, the housing market had not yet collapsed, and everyone who had bet on it collapsing had lost huge amounts of money, gone bankrupt, and/or otherwise been rendered fools.

I have no idea what Blodget is talking about here, and I don’t think he has much of a clue either, because he names no names and provides no links.... The fact is that for most of recorded history it has been pretty much impossible to short houses. At the end of the housing bubble, Robert Shiller tried to create a market in housing futures, but it failed, plagued by low volumes and illiquidity. And until John Paulson came along, it was pretty much impossible to short mortgages, too. In general, it’s extremely difficult to short any bonds other than Treasuries. That’s one of the reasons that credit default swaps became so popular so quickly: they allowed people to go short credit instruments.... As the housing bubble grew and the quality of subprime mortgages sank, various fund managers, including Paulson, started asking the likes of Goldman Sachs to sell them credit protection on subprime loans.... But there was no such thing as subprime CDS in 2003, or even in 2005, which means that no one was shorting those bonds back then. Let alone going bankrupt doing so.... [And] he’s laughably, spectacularly wrong about the institutions which went long.

So much money had been made betting on further appreciation of the housing market, meanwhile, that investors were DESPERATE for vehicles that allowed them to make these bets in a more efficient fashion. That’s why the buyers of Goldman’s CDO bought the CDO: They thought housing prices were headed higher, and they wanted to make a killing on it.

This is one of the silliest things I’ve seen in a very long time. The decision to buy into Abacus was not an attempt “to make a killing” by “betting on further appreciation of the housing market”. To the contrary, it was an attempt to lock in a modest yield pick-up over Treasury bonds, in return for accepting a very high degree of illiquidity. That’s why Abacus was carefully structured to get a triple-A credit rating: the buyers of the instrument wanted no risk at all with regards to their payment stream. Buying triple-A mortgage-backed securities and collecting coupon payments on them is not making money by betting on house prices going up, any more than buying Treasury bonds and collecting coupon payments is making money by betting on tax revenues going up. The whole reason for the overcollateralization and the waterfall structures and the equity tranche and the built-in diversification and all the other bells and whistles which so impressed the ratings agencies was to try to make it impossible that investors in the triple-A part of the structure could lose money.... Blodget then continues:

As Goldman has observed, with CDOs like the one in question, there is ALWAYS a short side and a long side: The buyers of the CDO knew that someone was going to be betting against them.

This is true, but also misleading, because the central point of the SEC’s suit is that Paulson was represented to ACA as ACA’s friend and coinvestor in the deal, while in fact they were ACA’s enemy.... [T]he CDO was designed, in the eyes of ACA and IKB, to confine speculative activity to the equity tranche. Equity investors can lose money — or make a lot. And if they lose, then some unknown short will have gained. The bond investors, by contrast, were the boring ones, clipping coupons and sleeping well at night because they didn’t need to worry about losing their principal. Finally, there was the super-senior tranche... “quadruple-A”.... In reality, however, something very different was going on. It’s a little unclear, but it looks very much as though the equity tranche here was unfunded: Paulson certainly didn’t want it, and Goldman never even tried to find someone so bullish on the subprime housing sector that they would buy it.... Goldman was leading ACA to believe that Paulson was speculating on house prices going up, in fact Paulson was betting that they would go down so much that the entire CDO would be wiped out.... Goldman knew full well what Paulson was seeing, and deliberately kept its client ACA in the dark as to what Paulson’s motivations were, and what the risks were in the structure. While Goldman was trying to persuade the ratings agencies that the bond part of the structure was perfectly safe, it was also listening to Paulson explain why in fact the structure could blow up spectacularly. Neither ACA nor the ratings agencies ever suspected the true reason for the structure’s existence — because Goldman never told them what it was.

Which brings us to the meat of Blodget’s argument:

If Paulson had had control over which securities were selected for the CDO, this would OBVIOUSLY be fraud: Paulson wanted BAD bonds in the CDO, not good ones. The buyers of the CDO, meanwhile, wanted GOOD bonds. That would be a direct conflict of interest that should obviously have been disclosed. But… Paulson did NOT have control over which securities were selected for the CDO.

This seems to me to be tantamount to an admission of defeat.... Blodget then goes on to explain why he thinks that Paulson did not have such control, but he’s pathetically unconvincing... in the end there were 90 securities in the CDO. Of those 90, it seems that 55 were chosen by Paulson.... Paulson had come up with his longlist of 123 securities precisely because all of them were particularly toxic. That’s a material fact which, if ACA had known it, would surely have sufficed to get them to exit the deal entirely. But it’s actually worse than that: the fact is that Paulson not only proposed 55 of the 90 securities, but also had veto power over the other 35, and signed off on all of them.... Given all that, it makes no sense to say that ACA had full control over which securities were included.... At this point, Blodget starts just making stuff up.... Blodget concludes with a conditional statement: “the SEC may criminalize this lack of disclosure in hindsight,” he writes, “but if it was a standard industry practice at the time, Goldman likely has a solid defense.”... [I]t’s going to be very hard indeed for Goldman to make the case that it was standard industry practice for a speculative short to be given veto power over a CDO manager’s picks, without the CDO manager knowing of the speculator’s position or motives. Henry might be rooting for his Goldman Sachs home team here, but if this is their best defense, it’s looking decidedly rocky.