Sunday, April 18, 2010

Too Much Reliance on FICC Can Be Dangerous

FICC is the abbreviation various banks, usually investment banks, use for their activities in fixed income, commodities and currencies. These activities have a common trait in that they derive most of these earnings from market making functions which often include proprietary positions. For sometime FICC earnings have driven the aggregate earnings (or at the least the incremental earnings) of such firms as Goldman Sachs*, Morgan Stanley*, Merrill Lynch/ Bank of America** and JP Morgan Chase**. I was recently asked what I thought about the published first quarter earnings of these banks. My almost immediate reaction was not to rely heavily on these results for future projections. In the first quarter we had volatile markets in each of these sectors, with particularly favorable price trends in currencies and commodities. There was lots of room for dealing profits.


In looking at the results from FICC activities, one should remember that these activities are governed only by the obligations of a market maker to state the terms of the trade honestly. There is no obligation or expectation to identify who is the party on the other side of the transaction, if known. These obligations are different from other parts of these investment banks. When they underwrite an issue, there are some well-defined disclosure liabilities for the underwriter. Each of these groups is also in the money management business. In these money management subsidiaries or divisions, the banks bear fiduciary responsibilities to place the interest of their clients ahead of those of the advisor. (Disclosure: I am a Registered Investment Advisor). When dealing with these complex organizations, one should recognize the differences of the cultures between their dealing, underwriting, and money management arms. These differences should be paramount in viewing the civil suit brought on Friday by the SEC against Goldman Sachs.


The focus of the suit is whether Goldman disclosed the names of all the parties that shaped the portfolio of a synthetic CDO that it sold in a private placement to a limited number of knowledgeable, sophisticated financial institutions. If the SEC is correct that there was a violation, it is immaterial whether the buyers made or lost money. Where the size of the loss and the almost equal and opposite gain could be significant to Goldman is in assessing fines and damages. In the context of Goldman’s balance sheet, the immediate potential size of the fines and damages is relatively small. What is of significance is the reputational loss to Goldman and its shareholders. But perhaps even more important is the coincidental impact of bringing this case on Friday before the week that the Congress is scheduled to take up the Administration’s proposed financial reform legislation. (The SEC has been investigating this particular single trade since 2008.)


In my opinion, few of the news articles about this suit give sufficient background as to what allegedly happened. Due to buyers’ thirst for income, there was not enough in the way of originated mortgage paper to go around, particularly in a structured format with different risk and income tranches. To fulfill the need for more paper, synthetic mortgage paper was created. These instruments did not actually own any of the mortgages but took their prices by reference to actual mortgages, usually in a structured format. (These and other techniques were so popular that there was more mortgage-related paper in the hands of investors around the world than the actual size of the originated mortgage market.) As almost all the participants in the market for synthetic paper appreciated the fact that the reference prices could go up as they did in the past or could go down (either because interest rates went up or because some portion could default). Wall Street, with its traditional role of finding an answer to investors’ needs, further developed their credit default obligations: if a credit event occurred, the risk would be paid for, in effect, by the party guarantying the instrument. CDOs were not traded on a listed market place as the number of investors was limited and each document could be quite different. These securities were traded in the over-the-counter market, usually with a single market maker who helped in the origination of the instrument.


Because market makers are not fiduciaries, in these instances sophisticated investors wanted a separate third party to select which mortgage securities were to be included. In this particular case, ACA Management was selected to be, in effect, the third party manager. There were a number of other candidates which included GSC Partners, Putnam Advisory, State Street Global Advisors. Also investors could have gone to other investment banks (Citigroup**, Merrill Lynch and UBS**) to secure similar investments.


(I have learned about these other investment banks and CDO managers from a well researched piece published in ProPublica, headed by my good friend Paul Steiger, (the former editor of The Wall Street Journal). The piece was on Magnetar, a hedge fund that also profited greatly from the collapse of the synthetic CDO mortgage market. From what was said in this article and in the rebuttal release from Goldman Sachs, it was somewhat common for the selector to receive suggestions from the market maker as well as potential investors, who could eventually take long or short positions. Based on the two sources mentioned, the identification of those who provided inputs were not included in the sales literature. In the Goldman case both the long side investor and the one shorting made suggestions to ACA. ACA itself became the largest buyer of this particular CDO. Unlike corporate investing where there is a fair amount of undisclosed company information, in this case a lot was known (e.g. location, loan to value, arm mortgages with resets and income documentation). If real estate prices went up the buyers would have made money; if prices dropped the shorts would make money. This fact was known day one.


From my vantage point, I do not see what Goldman Sachs* did wrong, but I do see that the reputational risk brought to the surface by this suit could be material. We may not have long to wait for an answer. Early Tuesday morning, Goldman will announce its first quarter earnings and my guess make a further statement on the suit. My bottom line for all investors: Know what you are doing when dealing with firms that make a lot of money from trading (with you).

* These are securities that my financial services hedge fund owns
** These are securities that I own personally

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