Goldman at the Poker Table: Two Points Blankfein Must Make on Synthetic CDOs

As Senator Carl Levin (D-Mich.) of the Senate Permanent Subcommittee on Investigations grills Goldman Sachs (GS) executives Tuesday, Goldman CEO Lloyd Blankfein must find a way to explain synthetic CDOs and other complex mortgage bets. He could help his case enormously by describing synthetic CDOs in simple terms and arguing forcefully that as a broker running such deals, it fulfilled its duty to participants.

Levin wants to show that Goldman was basically operating a mortgage gambling casino. To do so, he released binders of e-mails from Goldman that highlight its involvement in six complex mortgage deals including a few more synthetic Collateralized Debt Obligation (CDOs) deals like Abacus 2007-AC1 which is the subject of an SEC fraud charge against Goldman. (The political irony here is that one of the big losers in Abacus was not the American people, but German bank, IKB.)

Among the difficult challenges facing Blankfein today is explaining synthetic CDOs to senators and the American public in simple enough terms that they can understand them. In so doing, Blankfein needs to make two points: first, synthetic CDOs were legal and all parties involved knew what they were doing; and second, Goldman did not owe those synthetic CDO participants a fiduciary duty to protect their interests.

A New Kind of Investment

To help Blankfein with the first point, he could suggest that synthetic CDOs are a whole new kind of investment. Ann Rutledge, who runs an independent structured finance ratings agency, provided me with an intriguing explanation of CDOs. In her view, synthetic CDOs are essentially mortgage betting tables -- a place for market players to gamble on whether a pool of mortgages will keep paying or not.

A synthetic CDO differs from a regular CDO which lets banks shift debt off of their balance sheets so they can borrow more money. As Rutledge says, "The investors in synthetic CDOs do not have title to the collateral [such as mortgages]; the collateral stays on the balance sheet of the originators, which tend to be banks."

With synthetic CDOs, participants use insurance contracts called credit default swaps (CDSs) to bet on whether mortgages will keep producing cash or stop doing so. If mortgages in a synthetic CDO stop paying, the players who bet that the mortgages would keep cash flowing must pay the ones who bet they would drop in value. The amount of that payment depends on how much unpaid money was owed and the risk rating of the mortgage.

As Rutledge described this in a recent email, "Rather, they write [CDSs] on the collateral and earn premium in exchange for guaranteeing to pay the accrued payable on the collateral in the event of default, commensurate with a pre-determined risk grade." This means that the safer the collateral, as determined by the ratings agencies, the higher the payoff from the CDS in the event of a default.

Acting as a Broker

Blankfein also needs to explain why participants in a synthetic CDO are gamblers and that legally Goldman does not owe them the fiduciary duty to put clients' best interest first as it would if they had entrusted their money to Goldman to invest. Knut Rostad, Chairman of The Committee for the Fiduciary Standard, contacted me on this point on April 25th after reading my piece on Goldman's "unsure defense."

Blankfein needs to point out that Goldman plays two roles: broker and fiduciary. These roles have different legal requirements. As Rostad said, "Brokers are generally permitted to further his and his firm's interests at the expense of customers; a fiduciary is required in law to put his client's best interests first. This difference is why the fiduciary standard is important."

Blankfein has already made it clear that Goldman was acting as a broker in the Abacus transaction. Blankfein testified in January 2010 before the Financial Crisis Inquiry Commission when he explained Goldman's role as a broker, "We are not a fiduciary." He stressed that Goldman must "fully disclose what an instrument is and be honest in our dealings, but we are not managing somebody else's money."

Neither of these points will help Goldman win in today's political theater. That's because the senators are trying to make it appear that Goldman was betting against its clients and betting against the American housing market. Moreover, the goal of the senators is to provide media soundbites that will help push a few senators who oppose financial reform to the other side.

While Levin and many of his colleagues want Blankfein to help provide theater to win votes for financial reform, Blankfein wants to preserve the Goldman franchise from further erosion. Making the two points outlined above may help achieve that end.