Doing God's work or sleeping with the Devil?

SERIOUS MONEY:GARY OLDMAN portrayed Bram Stoker's Draculato good effect in Francis Ford Coppola's 1992 remake of the classic novel.

Almost two decades later and the world's most influential investment bank – which has a similar-sounding name to the lead actor in Coppola's Dracula– stands accused of being nothing more than a blood-sucking vampire.

Goldman Sachs’ love affair with the money-making structured finance machine has led to accusations by the US Securities and Exchange Commission that it loaded the dice in a deal that appears to illustrate all that was wrong with the US’s self-styled casino capitalism.

Dissection of the allegations is not possible without an appreciation of the financial innovations that precipitated a radical change in the credit markets and ensured that a seemingly containable US problem would infect the global stage.

Structured finance products created confusion for the average investor. Even the supposed professionals stood idly by or did not understand the developments that put the global financial system at risk.

The products were difficult to understand but the basic principles were not. The word “securitisation” may be anathema now but, in essence, what it means is to convert illiquid assets into marketable financial securities.

Securitisation has a long history, but in a US context, the story begins four decades ago with the establishment of the Government National Mortgage Association (Ginnie Mae).

The market did not gain momentum, however, until the quasi-government entities, Fannie and Freddie, entered the fray in 1981. It did not take long for private banks to join the market and, by the mid-1980s, securitisation was considered mainstream.

The basic structure was relatively simple. A special-purpose vehicle purchased mortgages from several originating banks and sliced those assets into a prioritised structure. The financial securities sold to investors were rated according to a strict “first pay, last loss” structure. Financial alchemy was born.

Securitisation worked well for all parties. It provided regulatory capital relief to originating mortgage banks and enabled them to make more loans, while the prioritised structure opened the market to pension funds, as investment-grade ratings were assigned to roughly 90 per cent of the pooled assets. The ultra-low interest rates under the command of former US Federal Reserve chairman Alan Greenspan resulted in the world of structured finance gravitating towards fever pitch.

The collateralised debt obligation (CDO) was born at the hands of the junk bond powerhouse king, Drexel Burnham Lambert, in 1987, but it was not until 1995 that this structure entered the world of “re-securitisations”, as residential mortgage-backed securities became part and parcel of the asset pool.

Re-securitisation came into its own during the subprime fiasco, as junk was ultimately rated as investment-grade debt. The prioritised structures resulted in CDOs purchasing below investment-grade debt from subprime residential mortgage-backed securities, and then a further CDO would do likewise. In the end, roughly 95 per cent of mortgages that began life as high-risk subprime mortgages were sold to investors as low-risk investment-grade securities.

At the height of the bubble, roughly 64,000 structured finance securities had an AAA credit rating; just nine private companies and a handful of sovereigns commanded the same rating.

The madness did not end there. The seemingly insatiable demand for product gave birth to the synthetic CDO, which became the dominant structure in the middle of the decade.

The synthetic CDO gained exposure to credit risk by selling protection to interested parties through a credit default swap, which functioned as an insurance contract in economic terms, but not in legal terms. The product allowed an originating bank to obtain regulatory capital relief and manage the credit risk on its balance sheet. An investor earned incremental yield on a seemingly low-risk portfolio in a low-return world.

The synthetic CDO is central to the accusations of fraud that confront Goldman Sachs. It is alleged that the short side of this particular deal in the name of John Paulson was not transferring his credit risk, but betting that the mortgage market was heading for trouble. As the deal’s architect, the other side should have been made aware of this.

If these allegations are true, Goldman has not been doing God’s work as claimed, but has been sleeping with the Devil all along.

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