LAWMAY 2, 2010
Senate's Goldman Probe Shows Toxic Magnification
By CARRICK MOLLENKAMP And SERENA NG
Even at its peak, subprime lending accounted for a relatively small portion of overall mortgage lending. Yet losses from these mortgages caused deep damage to the financial system.
Now, documents released by Senate investigators last week provide clues in understanding why the losses were so severe. The documents show how Wall Street banks packaged and repackaged the same risky bonds into securities that ultimately helped magnify the impact of defaulting subprime mortgages on the financial system.
In one case, a $38 million subprime-mortgage bond created in June 2006 ended up in more than 30 debt pools and ultimately caused roughly $280 million in losses to investors by the time the bond's principal was wiped out in 2008, according to data reviewed by The Wall Street Journal.
This was a central finding of the Senate investigative panel probing Goldman Sachs Group Inc.'s actions in the mortgage market. In a memo last week, panel Chairman Sen. Carl Levin (D., Mich.) said Goldman's work "magnified the impact of toxic mortgages" by replicating mortgage securities in debt pools known as collateralized debt obligations as well as CDO derivatives, and also in an index that tracks subprime bonds.
The subprime mortgages that caused big losses generally were packaged into CDOs, in which dozens of mortgage-backed bonds were pooled together and slices of the CDOs were sold to investors. Another version of these CDOs didn't contain actual mortgage bonds but were linked to them via derivatives called credit-default swaps. Through the use of derivatives, banks created many of these synthetic CDOs using the same mortgage securities, all of which would rise or fall in value depending on how the mortgages were performing. With synthetic CDOs, those who had bet that the loans would perform well were on the hook if their performance deteriorated.
In effect, the documents said, Wall Street was "copying and pasting" what turned out to be the worst-performing securities of the mortgage boom. Such activity helped multiply opportunities for hedge funds and traders who wanted to short the housing market, but magnified the losses of those on the other side of the trades. To short a trade, in this instance, is to bet the housing market will turn down.
"There was a limited number of similar bonds," said Darrell Duffie, a finance professor and derivatives authority at Stanford University. "So they are likely to show up in multiple deals."
A Goldman spokesman declined to comment.
An important moment in the housing cycle came in January 2006, a year before the downturn of the housing market had crystallized. That month, a consortium of banks, including Goldman and Deutsche Bank AG, with the help of a London data firm, launched an index, known as the ABX, which served as a proxy for subprime loans.
For the first time, banks and hedge funds had an indicator of the prices of subprime-mortgage securities, and a somewhat active market to buy and sell credit protection against housing-market losses. There were four ABX indexes, each tied to 20 subprime bonds, some of which reappeared in numerous CDOs.
By late 2006, Goldman had a large bullish position on the ABX, because it had taken the other side of bearish bets by hedge-fund clients, according to the Senate documents. Subsequent deals would help reverse that position.
One mortgage bond, Soundview Home Loan Trust 2006-OPT5 M8, was a component of the ABX and showed up in more than 30 CDOs.
The Soundview deal in June 2006 bundled together roughly $3.1 billion in subprime home loans made by Option One Mortgage Corp. to 15,746 individuals across the country, with a high concentration in California and Florida, two states that were among the worst hit by the housing downturn. The securities from the deal were sold in slices with different credit ratings, interest rates and risk levels.
One slice of the Soundview bonds, called "M8," began making its way through Wall Street. About $38 million of the "M8" bond was issued, and it stood to lose money if roughly 5% of the loans in the pool were wiped out by losses.
In July 2006, the Soundview deal was picked by Wall Street banks to be one component of the ABX, and the Soundview M8 bond also was replicated in multiple CDOs. They included Hudson Mezzanine Funding 2006-1, a Goldman-arranged CDO, which took on a $15 million exposure to the Soundview M8 bond in late 2006, according to documents released last week by the Senate panel.
Hudson represented Goldman's bearish view on housing. According to the Senate inquiry, Goldman used the CDO to protect itself against losses by the $2 billion of assets referenced in the pool. Among the assets was $1.2 billion in bullish bets on bonds underpinning the ABX indexes. Goldman was the buyer of protection from Hudson, meaning that the bank had a bearish position on the same bonds.
The Soundview M8 bond appeared again in a CDO called Abacus 2007-AC1, the mortgage deal at the center of the Securities and Exchange Commission's civil-fraud lawsuit against Goldman. That CDO, which closed in April 2007, had a $22.2 million bullish position on the Soundview bond. Goldman has denied any wrongdoing in the case.
Some Goldman employees appeared to be aware that the Soundview M8 bond was shaky by early 2007. In an April 2007 email, a Goldman employee included it in a list of what he called "dirty '06 originations," referring to the period in which lending standards loosened. By that time, about 8% of the loans in the Soundview pool already were at least 60 days past due.
In July 2007, Mizuho International PLC, a unit of Japan's Mizuho Financial Group Inc. and seeking to break into the CDO business, included the Soundview bond in a CDO called Delphinus CDO 2007-1. That CDO had a $13 million exposure to the Soundview M8 bond, according to documents reviewed by The Wall Street Journal.
In all, more than $280 million of bullish positions on the Soundview M8 bond were in at least 30 CDOs underwritten by various banks, according to data reviewed by the Journal. As defaults among the subprime loans backing the deal mounted in 2007, the M8 bond's value fell. Its entire $38 million face amount eventually was wiped out.
Anthony Sanders, a real-estate finance professor and authority in securitization at George Mason University in Fairfax, Va., said the problem was that the same mortgage bonds ended up in many deals, potentially multiplying the losses.
"Serious problems with common [asset-backed securities] deals can decimate all CDO deals," Mr. Sanders said.
http://online.wsj.com/article/SB1000...651236446.html
Originally Posted by GGT
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Everyone knows risk is part of the system, it's outrageous and outsized risk with over leveraged and under capitalized aggregate that causes problems (AIG). Markets (as in exchanges) are separated to a degree already, MBTE-NYSE-NASDAQ, and they have legal requirements for membership/certification, etc. The concept seems to allude you, if you think it's all about "new taxes and barriers to growth". 
