Comment by svdad | Hacker News Reader

Comment by svdad | Hacker News Reader

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Full disclosure: I worked on a Magnetar trade; not the one that was in the press, but another deal basically identical. And I bought, sold and analyzed Abacus.

All of these transactions are explicitly caveat emptor. My grandma couldn't go out and buy a piece of ABACUS 2007-ACA; sales are restricted to "qualified investors".

Of course we all know that's basically meaningless, at least the assumption that "qualified investors" always understand what they're doing. I know from experience that "qualified investors" in this kind of deal mostly don't do any serious due diligence. [On Abacus, it was practically impossible anyway. There were O(1,000,000) loans underlying the deal and there is no way you'd have been able to get the loan details for even a significant fraction.]

But I wonder whether we're expecting more from GS/MS/etc. than we expect from our local car dealer, and whether the remedy should be any different. That is, everyone is told to be suspicious of used car dealers, so you poke around, kick the tires, look for leaks, get a mechanic to look it over, read the repair records, etc. before you buy. If it still turns out to be a lemon, and you discover the dealer told you something explicitly false about the car, you have a legal remedy; otherwise (IANAL) I don't think you do. But you have a social/market remedy, i.e. don't buy from that dealer again and tell your friends not to buy from that dealer again. Likewise, if you find a dealer who always tells it straight and prices it fair, you go back to that dealer the next time and tell your friends about him.

Why isn't that the right remedy for these CDO deals as well? Sure, if GS said something provably false about the deal, there's a fraud case. But if (as I suspect is more accurate) they just sold it for what it was (namely an extraordinarly complex and impossible-to-price derivative financial instrument, offering an attractively high risk-weighted rate of return), and the buyers didn't bother (or have the computational resources, as almost none of them did) to do their own pricing analysis, is that the fault of GS? If you buy a CDO and lose your shirt, well, don't buy CDOs again and maybe don't buy from GS if you didn't like how they sold it.

Hey ! Nice to run into someone who actually worked on Magnetar.

At this point I've spent a lot(!) of time trying to express my thoughts, but it keeps over expanding once I start discussing or thinking about social proof and the Salesman analogy -

Let me see if I can create a framework, or at least tease a few distinct strands apart.

1) Qualified Investors: I tend to agree, it seems not many investors know whats going on in the things/CDOs they expose themselves to. Its a word which carries a legacy meaning that I think needs to be updated, or at least "Qualified Investor" should stop meaning "Patsy".

2) The Car Salesman analogy. If it is describing an ideal of where we should reach, then I think we agree - yes buyers should have genuine ability to decipher the complexity/accurately asses the security. They should have genuine choice between them and other banks. They should not suffer information asymmetries.

This means that we have, at the very least, working rating agencies, strong regulators to enforce rules and break up abuse, among many other prereqs.

3) Social proof - I am not satisfied with my arguments/ability to put it across but here is a rough draft -

Social proof should be working but its not. There are probably a constellation of reasons for this likely - Lack of choice/competitors in major banks, network and reputation effects enjoyed by the big banks, talent asymmetry, information asymmetry, regulatory capture/weakening.

Social proof, for that people have to have a choice between trustworthy and less trust worthy banks. If all banks are tarnished, then the choice is irrelevant. You end up choosing between different levels of competence and equal levels of avarice. All the car salesman are out to get you, maybe go for a scooter.

There are honestly far too many ways to approach this analogy/point and I would love to get away from it.

4) Finally in your last para you are essentially saying "Caveat emptor".

Come now.

Caveat emptor right now ends up ignoring wall street attitudes, obvious and even proven(! "can you imagine the idiots got caught") malfeasance, industry acceptance of morally agnostic standards, constant and now expected abuse of information/talent/power asymmetries.

I think you will also agree that the letter of the law is seen often as an obstacle course that people have to find the shortest path through. Heck the sheer artistry and creativity in the financial instruments being created is impressive. How many times have you come across a structure and said - wow, nice way to get out of that restriction.

I liken wall streeters to hackers - they like finding imaginative ways they can make their bets. They just don't see it in a moral sense. Its about optimum paths and optimum outcomes. If you plan wrong, you suffer. Your punitive lessons are your losses. The strong survive.

Ok I need a break, I really am hesitant to put this out there, because I can see a few angles of attack, which are arising from an overlap between different portions of finance and because I've generalized/glossed over details in some places. This was done in the interest of not getting too focused/bogged down. Probably needs to be addressed though.

For the most part I completely agree with your analysis here - really well done.

But at some point, does a product like this become such a toxic POS that it is obvious it shouldn't be in the market? We don't let people create and market, for instance, a phone that happens to explode on contact with air. We don't allow cars that, say, don't have brakes. Should there be some regulatory structure in place that looks at new offerings like this and a least provides an opinion to the validity of the product? Now, naturally, this would be very difficult - both because the SEC and CFTC both suffer from lack of funding, not being staffed by appropriate experts and being (depending on how you view it) captured. But it just strikes me that these things should never have been allowed on the market in the first place - especially given, as you rightly point out, that most buyers are not going to have the ability to actually perform the appropriate level of due-diligence.

And while you're right that grandma can't go out and buy Abacus, her pension fund could, and therefore it does effect her.

I do love the idea of comparing GS to a local car dealer - but I can't remember another business I've ever seen that is so willing to throw their own customers/clients under the bus to make a buck. So I'd actually put them below the local car dealer. :)

You can definitely make some kind of self-igniting phone as long as you warn the buyer. In fact it sounds like a completely reasonable piece of modern art. And you can make a car without brakes but you can't take it on the road. Maybe that could be an analogy for a financial instrument that you couldn't sell as a stock.

There are few things that you can't sell with proper warning labels. And even these toxic packages of bad loans had some value. They didn't pay out anywhere near expectations but they paid out something.

Well using the art bucket to sell it is really really stretching the analogy to try and make the point, and the weakness does show.

An art product isn't going to sell or be sold as widely as a commodity or even a CDO.

And even under the auspices of art people won't let you sell toxic waste.

And Some of those toxic products made 0 money. You may have had some interest roll in from a tranche, but if it lost its value even before it reached market (some CDOs lost value between inception/assembly and final release on the market.)

The money that rolls in is irrelevant, since the net effect is wealth destruction.

Well I was only using art to explain why it might be bought, not why it is possible to sell. Toxic waste is only restricted because it can leak out and harm the area. A bad bond is merely useless. You could sell broken blenders for scrap, for example.

Edit: wait, how is wealth destroyed? I don't see how selling bad bonds would inherently destroy wealth, such as if they cost a fair price of pennies, nor do I understand how overcharging would destroy wealth as opposed to taking wealth. Am I missing something?

What I was saying is that the people who held the bonds may have received some interest but then the bonds went south and they made a net loss.

Also when a bond fails, wealth is destroyed - a bond is a promise of payment, upon which other things are built. If it defaults wealth is destroyed. Which is why having working rating agencies for bonds was and is a big deal.

I ageee and am not saying selling bad bonds Is inherently wealth destructive.

Anyway- I understand you are describing a way these things could be sold, is all.

My overall point is that a product like this should probably be reviewed by some agency before being allowed on the market.

Well said. I'm an ex-quant, and one thing that is supremely irritating about discussions of Abacus is the inability of people to distinguish between acting as a fiduciary and acting as a market maker.

When a counterparty calls GS up for a quote on the JPY/USD cross, they don't care one iota what GS's internal positioning is, or where GS thinks the JPY/USD will be in 3mths time, or any other number of things. These are sophisticated counterparties (as you pointed out) who

1) know that GS doesn't owe them a fiduciary duty, and 2) don't expect it to.

It seems like theres a whole population of people out there who think that GS is playing some sort of trusted financial advisor role in OTC derivative trades, when in fact it's in a bidding war between 4 other banks to get you the lowest rate.

That's the case in Abacus as well, AFAICT. If you don't want to trade thinly traded opaque credit derivatives, don't trade them. No-one is forcing you to. But if you don't understand your risks, you trade, and your position moves against you, don't blame your counterparty. Blame yourself.

The OP did point out that even the "qualified investors" had no clue what they were doing. Just to make sure we both read it the same way.

Also, and correct me If I am wrong - you've moved to discussing a quote from GS for a product (JPY/USD cross to be specific), and not CDOs in particular.

This is in order to point out that:

GS has no fiduciary duties to the buyer

This point is reiterated in your last line as well - no one is to blame if you made a bad trade, other than yourself.

So in essence, you are arguing caveat emptor - correct?

I'm agreeing with svdad, who emphasized the role of caveat emptor in OTC derivative transactions.

There's no significant distinction (IMO) between a trade on a 3m butterfly on the JPY/USD vs. a the 3%-7% tranche of Abacus - both are derivative transactions with well-defined risk/rewards, and you do your own research and come to your own conclusions on the value of the product. Sure, one is more liquid, more transparent, etc. but that's a factor to be taken into account when buying, not a reason for complaining when MTM moves against you.

Well the similarities between the two are sufficient for a caveat emptor argument.

But the distinctions are also important. With a CDO, you have the ability to stuff it with bad debt, which is what banks did.

When bankers are intentionally creating debt instruments which are going to explode, then it's different from just calling a bank to get their quote.

And at that juncture we can also ask, if a situation where mortgage payout =x, but banks are aiming for 30x by betting that the owner defaults - aren't the incentives off?

Also, when the bank is shorting the instrument and doesn't disclose it... Well generally that at the very least sounds like something most people here would want to disrupt, because it's well, not what regular people consider to be fair business.

The standard cabeat emptor defense also stands because we believe in the qualified investor aspect of the equation. And right now, not most investors are qualified for it. As svdad said - most investors aren't doing their diligence, and couldn't do it even if they tried. So perhaps that needs to be fixed, or we need a stronger regulator to gate entry.

(And reaching a situation where our regulators are not powered enough to grok the derivative, is just something we want the system to move away from over time.)

Edit: above is opinion, I'm open to listening, I do have a pretty firm idea, but work actively to dislodge it. Standard boiler plate. As I said before, I'm not the most eloquent.

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