Corporate Governance

Financial Derivatives: Credit and Mortgage Products in SEC v. Goldman Sachs & Co.

By Benjamin Hager

A complex financial derivative structure exists at the center of the Securities Exchange Commission's ('SEC') complaint against Goldman Sachs & Co. and its vice president Fabrice Tourre (collectively, 'Goldman').  We previously discussed the SEC's allegations.  In addition, an earlier discussion introduced financial derivatives.  This post builds on both earlier posts to provide a lucid understanding of the derivative products set forth in the SEC's complaint.  Admittedly, credit derivatives are complex.  As such, this post oversimplifies certain aspects of these complex securities and transactions.  Allegedly, Goldman combined three types of financial derivatives to structure the transaction at issue: the (1) residential mortgage backed security, the (2) credit default swap, and the (3) synthetic collateralized debt obligation.  

Residential mortgage backed securities ('RMBS'), according to the SEC's recent complaint, provides investors with payments 'out of the principal and interest on the underlying [pool of residential] mortgages.'  Simply put, RMBS allows a mortgage holder (i.e., lender) to sell its risk and income stream in mortgages to an investor.  Generally, the buyer pays cash to the seller in exchange for a debt instrument that entitles the buyer to recover its original investment plus interest through a series of periodic payments.  Thus, a buyer likely invests in RMBS for exposure to interest rates normally associated with mortgages. 

Mortgages of different quality, as determined by credit rating agencies, underlie RMBS.  Lower quality loans, known as mid to subprime, have a higher propensity to experience adverse credit events.  That is, for example, the mortgagees declaring bankruptcy; this ultimately hinders the buyer's ability to receive payments from the RMBS.  Simply put, high mortgage default rates in RMBS can render a buyer's investment worthless.  Not surprisingly, however, a buyer receives higher interest income on an RMBS containing lower quality mortgages.  As such, some buyers are willing to risk higher default rates for exposure to increased return on investment generally offered by long exposure to mid and subprime RMBS.           

The SEC's complaint describes a Credit Default Swap ('CDS') as a 'derivative contract under which a protection buyer makes premium payments and the protection seller makes a contingent payment if a reference obligation experiences a credit event.'  Restated, a buyer makes payments to a seller over a fixed period of time in exchange for the sellers promise to pay the buyer a predetermined amount (i.e., CDS's notional amount) if an issuer defaults on the referenced credit obligation (i.e., underlying).  This transaction resembles insurance.  CDS insures against, among other things, corporate defaults, government defaults, RMBS defaults, and other indices' losses.  Notably, and unlike traditional insurance, neither CDS purchaser nor sellers must have an insurable interest in the underlying credit obligation. 

The SEC's complaint further explains a Synthetic Collateralized Debt Obligation ('SCDO') as 'debt . . . [security] collateralized by debt obligations including RMBS,' where the SCDO is not actually backed by the underlying debt obligations, but instead references a portfolio of those securities ('reference portfolio').  A CDS written against the reference portfolio completes this derivative structure.  Then, if an agreed upon credit event occurs, the CDS triggers resulting in the seller making a required payment to the buyer.  

Simply put, the protection buyer makes CDS premium payments in exchange for the contingent right to receive payment if a specified credit event, such as default, occurs.  On the other hand, the protection seller receives periodic interest payments, but must pay the buyer if a credit event occurs.  Consequently, a seller likely believes the reference portfolio will not experience a credit event, and thus, has an effective long position in the reference portfolio.  On the contrary, a buyer likely believes a default will occur, and thus, has an effective short position in the underlying.  Notably, this derivative generally uses a third-party trustee ('trustee') to manage the transfer of funds between parties.    

A SCDO operates as follows.  First, a seller will deposit their initial investment ('collateral') with the trustee.  Then, the buyer will make periodic CDS premium payments to the trustee.  If no credit event occurs, the payments collected from the buyer are used to make periodic interest payments to the seller, and the trustee eventually returns the collateral to the seller.  If, however, a credit event occurs, the buyer has a right to receive payment from the collateral.  Restated, payment to the buyer upon default comes out of the seller's initial investment.  Thus, a seller can potentially lose the entire initial investment.   

Full post as published by The Race to the Bottom on April 28, 2010 (boomark / email).