Saturday, April 17, 2010


This time no contribution directly related to Emerging Markets, but a more general one illustrating what goes wrong when people without sufficient knowledge enter the investment arena.

Goldman Sachs, by far the most prestigious Western bank at the moment, is charged with fraud by the Securities and Exchange Commission. The Washington Post reports on the details of the case in a lengthy, excellent article. The case is illustrative of what was going on in Wes...tern financial markets - both at the private and institutional level - when the Global Credit Crisis happened.

At the heart of the fraud charges was Goldman's collateralized debt obligation (CDO) product Abacus. Abacus represented a basket of sub-prime mortgage securities that was sold long (i.e. with the basic assumption of buyers to gain from expected value appreciation) to outside investors. German bank IKB and Dutch ABN Amro were buyers according to the Washington Post article. And - maybe not surprisingly - both were bailed out by their respective governments in the crisis. Abacus was not the only thing that went wrong in these banks.

Goldman's Abacus Product: Did clients have a fair chance to make money with it?
And did Goldman fulfill its fiduciary duties?

What was going wrong was that the culture amongst long investors was one in which they were buying products they didn't understand as long as the creator of the product was a 'fancy', blue chip name on Wall Street OR a good performing hedge fund with strong momentum, good publicity and crazy astronomical returns on earlier products or in earlier years. Hedge fund managers were seen as the new superstars because they created seemingly impossible results that were often more related to excess leverage than skill. But unfortunately market participants - like so often - didn't want to hear the warnings by independent, outside consultants. Actually: we saw the craze happening. Already back in 1999, at the beginning of the 'securitization' cult that created so many complex synthetic products LMG Emerge principal Erik van Dijk and Noble Prize Laureate Dr Harry Markowitz warned the audience in a seminar organized by Dutch business school Nyenrode University that 'securitization' would only work when a) the created basket was well-diversified; and b) sufficiently transparent for investors to understand what they were buying.

But during the first decade of the 21st century and the 1990s the buyside investment community fell for a new type of trap. Good consultants did and do always warn investors not to believe in miracles. Examples: don't believe that you can earn far more than 10-15 percent maximum on equity strategies or 5-10 percent on bonds in good years ON AVERAGE and be prepared for bad, negative years when investing in equities during the wrong period and flat, zero-return periods when opting for bonds and other fixed income products. Real estate? OK, there were countries that presented good returns like the Netherlands during a long period of time, but neighbor country Germany didn't do well in that asset class at all. Private equity: sure, good returns possible, but highly illiquid and that is also risk. The more investors learned about asset classes, the more they felt that success stories in other regions (Emerging and Frontier investing) or in different type of stocks (small or micro caps) could present the holy grail of risk-adjusted excess returns. At the same time we continued to believe in that one or two superb specialists that were really the ultimate Guru. Guys like Warren Buffett or Pimco's Bill Gross. Or maybe Bernard Madoff. But like so often - as always Guru's are human as well. And market's cannot be easily beaten other than maybe score a 3-5 percent excess return over longer periods of time. Nope, people wanted to believe far more than that was and is possible.

With the rise of Emerging Markets and cheaper investment possibilities in small and mid-sized stocks during the first ten years of this century, growing numbers of investors learned that previously secretive, mysterious markets were not part of the holy grail they were looking for. But instead of accepting that there ain't such thing as a free lunch in the form of a holy grail with astronomical returns, they fell for the hedge fund trap: returns on highly levered portfolios, i.e. portfolios financed with exceptional levels of debt, look great when interest rates paid on the debt are low historically and even going down (what we saw happening during the last 10-20 years when markets moved into a demographic situation of structural change with populations getting older and with the negative correlation between interest rate levels and population age doing the rest). But: this free lunch only works when a) hedge fund managers are exceptional stock pickers and b) negative returns or even returns lower than the interest rate paid on the debt can be avoided. As always: this is possible as long as it is possible, and sooner or later even these superstars turn out to be superstars in making money only. Making money for themselves that is, and that is something else than making money for their clients. Sadly enough at the time of the crisis thousands of investors learned this the hard way.

But some hedge fund managers are better than others. Far better. Just like some basketball players are like Kobe Bryant and others like us: good-willing amateurs.

But in a market we cannot expect to always be on the side of the Bryant's and win time and again. Problem with markets is that by acting in the market, information is disseminated between investors. And the more successful an outperforming manager, the more known he gets and the quicker the dissemination of his information. Result: his outperformance potential drops when he gets more famous. In other words: good managers do have a maximum holding period. One manager that was making himself a name was John Paulson - no family of former Goldman CEO Hank Paulson, who later became US Treasure Secretary under George W Bush. John Paulson was one of the best so-called 'short selling' specialists.

One of the World's best short-sellers involved in the creation of a long product?

Short-sellers are specialists in finding underperforming securities. By selling short poor performing securities they make money the same way put option investors do. When prices go down, they win. And their win is their counterparty's loss. Short-selling is never very popular because of that. You are not betting on economic growth and new wealth, but against it. Normally this strategy is statistically not too good: on average economic growth in the world and in most tradable securities is positive. Short-sellers are therefore using the smaller window of opportunities. But obviously, with most people having a tendency to be too optimistic they do get their periods when they can make huge profits. And when markets were gradually moving in the direction of the crisis John Paulson and his former lieutenant Paulo Pellegrini were grandmasters in this game. Paulson's grandmaster status was definitely becoming 'significant' information.

But the quest for the holy grail did also go in another direction. Complex, structured products was another name of the game. A terrible tendency to believe that when a complicated product was too complicated to understand, that it was probably lousy when the provider was unknown and probably fantastic when it was created by a well-known brand name provider, entered the market.

Both directors of pension plans and banks on the one hand, and private investors on the other (and even in some cases consultants that were afraid to be negative about products created by well-known parties that there potential clients liked) were lured into a situation in which did not want to pay for those negative consultants (like ourselves to a certain extent), but instead 'trusted' the brand-name provider.


So what went wrong? So far nothing wrong with Abacus and Goldman. What did go wrong is the following:
i) Allegedly Goldman did not tell clients for Abacus that the world's best short-seller Paulsen was involved in selecting securities for the product (i.e. on the long side!). Instead marketing material does only reveal that a firm called ACA Management helped select the securities. That is like saying that the Lakers are playing without Kobe Bryant but with me instead. Definitely a case of withholding material information.
But is this fraud? Normally not, because of the fact that if clients do poorly because of this, Goldman would on the one hand receive fees on product sales but on the other suffer reputation damage when performance is lousy. Point ii) explains how things got more tricky:
ii) Paulson allegedly paid (!) Goldman for the right to select securities for the Abacus vehicle. Short-sellers need opponents. Like top poker players cannot make money without having opponents that are silly enough to challenge them. Well, the Washington Post article claims that Paulson paid USD 15 million to Goldman in exchange for Goldman finding clients to play on the long side. In other words: amateurs trusting Goldman as their advisor, were lured into a game with Paulson and not ACA as their opponent. And yep: they were dead meat.

Goldman defended itself saying that they were not the fiduciary partner of clients buying Abacus. That might be true, but it would be strange that product sellers in the long market do not have some kind of fiduciary duty in that clients expect some kind of quality level that is correlated with the reputation of the provider. Compare it with the Toyota case. If you buy a luxury car made by the number one car seller on the globe, you expect the brakes to function properly. Even if you don't know exactly who made the brakes or how Toyota selected the brakes maker, you still need to be able to rely on the car maker as your fiduciary. In a 2007 email the responsible Goldman manager stated himself that he didnt totally understand the product and that the CDO market (of which Abacus was a part) was almost dead....

So all in all, we do believe that the SEC has a point here. This was a bad product, and when constructed as suggested it implies that Goldman did misuse fiduciary trust placed upon it by clients. However, we do also believe that in the end investors do have their own responsibility, be it when dealing with Goldman or when dealing with any other product maker. Unknown and obscure isn't always bad; and brand name not always good. You need to understand what you buy. When you don't know how to drive you better don't buy a formula 1 car. Unless you buy it and only look at it without testing it at a race track.

What the financial world needs is:
a) a return to simplicity (KISS principle)
b) a structured approach to risk management
c) regulated transparency and outside evaluation of products, and
d) continued investment education to help avoid that grandmasters can continue games for money with poor amateurs who will loose without any chance.

Will be continued...


Click here for the Washington Post article

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