Alpha Waves: The Chauffeur Always Dies First

3/28/2011 12:00:00 AM

William Cohan is the modern chronicler of the great or supposedly great houses of Wall Street. He has written the definitive books on both Lazard and Bear Stearns and is in process on what I am sure he hopes will be the definitive book on Goldman Sachs (due out April 12th). I met Bill when he was researching Bear Stearns after its spectacular collapse in early 2008. As the ex-CEO of Bear Stearns Asset Management (BSAM) I had a front row seat for the first act of the financial "mystery" which was set on the stage of the sub-prime market, co-starring the asset-backed securities (ABS) market and with a brief cameo by BSAM that exited stage left in the first scene with the falsely high-grade CDO chorus. Everyone loves to posit that the collapse of the two Bear hedge funds in 2007 was what led to the fall of Bear Stearns. But Bill was too good an investigative reporter to make such an obvious and simple leap. He spent the time and went to the trouble of interviewing many people and learning about the underlying cause of the collapse of the Bear hedge funds.

What he reported in House of Cards was that perhaps it was the pricing of thinly traded CDOs held by the funds obtained by BSAM from Goldman Sachs in May 2007 that preemptively began the downward spiral in CDO prices. In the book, Bill writes that “as a counterparty to trades in the funds, Goldman was obligated to report its thinking about the value of the securities in the funds on a monthly basis” and the marks went “suddenly” from 98 to 50 and 60, while other counterparties were still citing 98. SEC rules that oblige fund managers to incorporate new pricing information into NAV calculations meant the value of units in the fund plunged, after averaging the various prices received. As Bill reports, a fund that was down 6 per cent one week was down 19 per cent the next, creating massive profits for anyone who had shorted the market. The ensuing loss of confidence gave rise to the classic hedge fund collapse cycle:

1. "Improbable" market crisis causing precipitous collapse in prices

2. Leverage and illiquidity leading to margin calls

3. Investor redemptions that exceed available liquidity

4. Liquidation of positions at highly
unfavorable prices

Bill went on to report in House of Cards that Gary Cohn, Goldman's President, when asked about this, said Goldman “did not make nearly as much money as people think it did” and that “as for the marks themselves, Cohn said that Goldman was aggressive about marking down these kinds of securities, especially during the third quarter of 2007, much to the detriment of its own income statement and those of some of their clients who would then have to account for the new Goldman marks.” Cohn also told Bill a story in which he offered to sell $10 billion of the securities at 55 cents to KKR Financial Holdings, which had argued other counterparties were still valuing them at 80-85 cents. In the end KKR did not make the trade, eventually concluding the Goldman mark was an accurate reflection of the market. “We respect the markets,” Cohn told Bill, as reported in the book, “and we marked our books what we thought we could transact because some of this stuff wasn’t transacting. Or where we had actually transacted. We were not misleading ourselves or our investors. We got blamed for this, by the way. We were not misleading people that bought securities with us at 98 on the first of the month, and we didn’t feel like, `Oh, my God, we sold these to investors at 98. How can we mark them any lower than 93?’ We sold stuff at 98 and marked it at 55 a month later. People didn’t like that. Our clients didn’t like that. They were pissed.”

In other words, Cohn put to Bill the usual trader's defensive question: was there a better bid in the market? Naturally, this ignored the obvious questions about what had changed in a market without significant trades but with significant short positions.

In early 2010, after the acquittal of the ex-BSAM hedge fund managers Ralph Cioffi and Matt Tannin (I was proud to be called as one of the three witnesses for the defense.the only unpaid one I might add), Bill Cohan and I had occasion to hold a closed-door two-hour debate about the financial crisis for the Cornell Law School and Business School community. I gave Bill a ride home to NYC the next day and we spent the whole ride talking about Goldman’s role in the financial crisis, which was by then under extreme scrutiny by the SEC and the rest of the regulatory crowd. He had long since come around to believing that Goldman was the initiating cause of the Bear hedge fund debacle.

For those of you who missed it, on February 17, 2011, Bill Cohan published an opinion piece in the New York Times entitled “How Goldman Killed AIG.” It was about the Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, and the role played by Goldman Sachs in the collapse of AIG. In the preamble to that piece Bill quotes a passage from the report which reads as follows:

As the crisis unfolded, Goldman marked mortgage-related securities at prices that were significantly lower than those of other companies. Goldman knew that those lower marks might hurt those other companies – including some clients – because they could require marking down those assets and similar assets. In addition, Goldman’s marks would get picked up by competitors in dealer surveys. As a result, Goldman’s marks could contribute to other companies recording `mark-to-market’ losses: that is, the reported value of their assets could fall and their earnings would decline.

Bill did not quote the early part of the same paragraph, which says:

In addition to selling its subprime securities to customers, the firm took short positions using credit default swaps; it also took short positions on the ABX indices and on some of the financial firms with which it did business. Like every market participant, Goldman `marked,’ or valued, its securities after considering both actual market trades and surveys of how other institutions valued the assets.

Nor did Bill quote the subsequent paragraph in his article, but the report goes on to say that:

The markdown of those assets could also require that companies reduce their repo borrowings or post additional collateral to counterparties to whom they had sold credit default protection. In a May 11 e-mail, Craig Broderick, who as Goldman’s chief risk officer was responsible for tracking how much of the company’s money was at risk, noted to colleagues that the mortgage group was `in the process of considering making significant downward adjustments to the marks on their mortgage portfolio [especially] CDOs and CDO squared.

This will potentially have a big [profit and loss] impact on us, but also to our clients due to the marks and associated margin calls on repos, derivatives, and other products. We need to survey our clients and take a shot at determining the most vulnerable clients, knock on implications, etc. This is getting lots of 30th floor attention right now.’ Broderick was right about the impact of Goldman’s marks on clients and counterparties. The first significant dispute about these marks began in May 2007: it concerned the two high-flying, mortgage-focused hedge funds run by Bear Stearns Asset Management (BSAM).

Like an Agatha Christie murder mystery, it has taken the world four years to discover that the murderer was Colonel Mustard, who used the blunt instrument of illiquid mark-to-market pricing to mangle the toe of the Chauffeur such that he could not run away fast enough to miss the later death blow to his head (the proprietary mortgage, ABS and CMBS books). The irony and depressing thing to those of us in the parlor at the time is that the Chauffeur only got it because the real target, Professor Plumb (AIG) was in the same house.....and that house was in a high density neighborhood made up of the U.S. economy and even much of the rest of the world.

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