This post will continue my effort to understand Goldman Sach’s huge first-priority exposure to a few of the CDOs in Maiden Lane III.
Yves Smith has some nice clues to what was going on, pointing out that the November Blackrock memo at the time of Maiden Lane III’s formation states: “Access to assets: Goldman has said that it does not hold the cash CDOs, but has back-to-back swaps on most of the positions”. (I’ll address the remarkable fact that a 20% synthetic CDO could be considered a “cash CDO” in another post.) This indicates that Goldman probably sold the first priority exposure in Broderick I on to customers, offering a Goldman guarantee on the returns in the form of a swap. Goldman then transferred this risk to AIG using another swap. In other words, this was Goldman’s clients’ CDO exposure that was protected first by a Goldman and then by an AIG swap. That this is a likely explanation is confirmed by the fact that $7.4 billion of the CDOs in Maiden Lane settled almost a month after the first CDOs were transferred because they were “contingent upon the ability of the related counterparty to obtain the related multi-sector CDOs”. In short, Goldman probably had to buy Broderick I from its clients before it could make use of the Maiden Lane facility.
However, if we are interpreting the available facts correctly and, if Goldman took almost all of the first priority Broderick I exposure in order to sell it on to clients, then we still need an explanation for why Merrill Lynch rather than Goldman was the firm originating the CDOs. The answer is probably that Merrill had the collateral and Goldman had the clients. Although Merrill wasn’t a big player in the mortgage market (and purchased First Franklin in order to change that situation), Merrill was one of the lead issuers of CDOs (2004 thru 2006). It is likely that Merrill had established an RMBS pipeline while GS had clients to whom senior CDO tranches could be sold.
It occurs to me that because the senior CDOs that Goldman was selling to clients were like covered bonds (that is investors were protected by the guarantee of the bank in case the mortgages themselves went into default) and the legal structure for the covered bond market does not exist in the US, there may have legal reasons for the issuer of the CDO and its guarantor to be distinct parties.
This innocuous explanation of Goldman’s large first priority exposure to Maiden Lane’s CDOs does not, however, obviate the main concern of my previous post: There is still plenty of reason to be concerned that Maiden Lane III has far too much synthetic exposure for taxpayers’ comfort — in part because the CDOs in question were issued right at the time that synthetic RMBS started to become more common. More in the next post.
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