It is of course all over the news. The US has decided to sue Goldman over the Abacus deals. I had predicted that one for a long time. The Abacus series was a bunch of naked CDS, they are finally attracting the spotlight as the nefarious instruments they are.
A primer on naked CDS and CDS
A CDS is an insurance contract on debt. If you have emitted debt (you are a bank or a particular lending by buying bonds) you can protect against the default of the payer by buying a CDS. If default occurs then your counterparty owes you the amount of the debt, usually to be settled in cash.
The Credit Default Swap or CDS is used everywhere in the economy. It is used as a way for companies to manage their operations. Risk transfer through CDS is a valid and useful economic tool. It has it's uses in everyday economic activity. It transfers risk. That is a good thing. So in the case of housing and sub-prime this reads that a banks can protect, dollar for dollar, its capital exposure to sub-prime".... we have not created debt just protected our existing capital. CDS transfers existing debt but does not create it. From a macro monetary perspective it does not count.
Naked CDS however creates debt, lots of it, of the bad kind. From a monetary perspective, it counts and a lot. As documented in the greatest trade ever book, Paulson, the hedge fund, not the treasury head, wanted to bet against sub-prime. The instrument he used to achieve this was the naked CDS.
Basically for a naked CDS, first you create a giant synthetic mortgage and second you buy protection on that. So they created baskets that REPLICATED existing mortgages, preferentially in the shitty sub-prime category. For every mortgage out there, they replicated it many times in these shadow mortgages. So on the one hand someone is long sub-prime (ACA), and someone is short subprime (Paulson). So when subprime defaulted, for every dollar that defaulted, the speculator made a multiple..
Not only did we create debt, we MULTIPLIED IT.
We have realized a debt that is many times the size of the original capital committed, in cash. We have created debt. In fact we have created bad debt. This is an instrument that takes a bad debt and magnifies, leverages, its effects. Are you sure you want that around in your economic system? The naked CDS is a bad debt multiplier. It shows up as a big red alert in monetary analysis.
The impact is a liquidity implosion in theory. Aug 2007 has been attributed by academics (Lo at MIT) by a large unwinding of a proprietary desk. Such unwinding can be triggered by a cash call settlement by Paulson et al. And the bottom line is that someone made a killing at the cost of the taxpayer, we have a massive recession on our hands and the beauty of it is that it wasn't even illegal. That may change very soon.
Our super-president is emboldened by his recent cosmic achievements and has decided to take on the case. It may be a populist move, but it is a good one and a necessary one. The case against GS is simply made by publishing the email of the young frenchman in charge of selling the product. It clearly shows that "Fabulous Fab" as he refers to himself in the 3rd person, had not a single clue what he was doing. He understands the product enough to state that "we are creating massive amounts of toxic debt" in the system. He realizes the danger of the instrument claiming he will be the only survivor, hence the "fab fab". He stops short of wondering why it is even legal in the first place. Nice... punk-rock in a way! Here is some advice for the fab fab: RUN! RUN!
So this jack-ass makes for an easy scapegoat.... My guess is that GS will come out of this un-scathed. They did not do anything illegal. GS was a middleman in the deal and in fact claims to have lost money on the deal. They were slightly on the long end. There are other deals where GS was aligned with Paulson in the very abacus series that is being brought under the spotlight. Meaning they made a killing on the short side of subprime and every one knows it. They made a killing in fees by pushing toxic instruments. But it wasn't illegal. The case is clear.
I hope naked CDS will be banned.... but the case is juicy.