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Blankfein Plays Dumb, But Did Tourre Just Sink Wall Street?

How do you justify selling a security that's designed to fail, designed in fact by the guy who is betting against it?
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Lots of ink will be spilled over Lloyd Blankstare, I mean, Blankfein and the wide range of grimaces he managed to conjure as he was questioned. But the hoped for admission of guilt (a smoking gun?) came today from none other than the only individual named in the SEC lawsuit against Goldman: Fabrice Tourre.

And with this admission, he confirmed what Yves Smith (of Naked Capitalism) blogged about just a month ago in his post: Debunking Michael Lewis' The Big Short

In Llyod's Defense, Idiocy

Yes, we now know what Llyod's defense strategy will be: play dumb. Just like Alan Greenspan has done for the better part of two years now.

Lloyd will have an inscrutable stare plastered on his face for the next year or so as the SEC case wends its way through the courts. He will look bemused. Sometimes irritated, squishing up his face as if to say, "Say what?" Once in a while he'll flash a warm homespun PR smile.

And all the while, the man at the head of one of the most sophisticated financial and trading operations the world has ever know will claim:
  • I didn't know what the firm's aggregate risk position was relative to the housing market.
  • I had nothing to do with the day-to-day operations of the mortgage desk (which accounted for more than half the risk of the entire firm, even though it was only a small fraction of revenues).
  • We had no official short position on housing... ever... and even if we did I would have no idea what it was.
  • I was out golfing for charity every time the risk management committee met.
  • I was windsurfing with John Kerry every time the Board discussed the firm's risk profile.
  • I don't know what you mean when you ask about "making a bet against clients"... are those words in English?

Basically this man will claim to know nothing. That the firm knew nothing. Took long and short positions all the time without having the least sense of what the aggregate position of the firm was. Had absolutely no clue as to the quality of the underlying mortgages in the pools it was peddling (even though Sen. McCaskill produced a risk report from a lowly analyst that indicates Goldman was parsing every mortgage in every pool.)

Couldn't have known. Didn't know.

"Whaddaya want from me? Didn't Greenspan already tell you clowns that we're just innocent market makers? And this is how 'free markets' operate?"

(Cue blank stare and squinty look of befuddlement.)

Fabulous Fabrice Tourre's Smoking Gun

The most important moment of the day came at the end of Sen. McCaskill's 20 minutes of pontification, which was impressive, if somewhat unfocused.

She was railing against the Abacus deal and asking Mr. Tourre whether it was common-sensical to let short sellers (i.e., "protection buyers") pick the securities in a pool that would be sold to investors... without telling the investors how the securities were picked. She kept rubbing her face with her palms, maybe hoping a genie would materialize and explain what she just didn't understand: how do you justify selling a security that's designed to fail, designed in fact by the guy who is betting against it?

She asked whether that was common practice. And here is when the SEC was surely taking notes and smiling ... and when every major market maker in CDOs got on the phone to their lawyers.

Mr. Tourre replied: "In every synthetic CDO transaction, the protection buyer [i.e., short seller] has to be involved in some shape or form in creating the portfolio, otherwise there would be no transaction ... Without a protection buyer, there is no deal.

Billions Up In Smoke

So here now we finally have the truth.

All those synthetic CDOs, in which investors lost tens of billions of dollars, were created to fail, and they were designed by the people betting against them. It was not only common practice, it was the whole reason these instruments existed in the first place -- exclusively as vehicles for short sellers to buy protection against.

If true, that means all the firms that sold such vehicles are on the hook for exactly the same scam as Goldman: letting short sellers pick the securities in the reference portfolio and not telling the buyers who selected the portfolio constituents, how those constituents were chosen, and that in fact the whole deal was concocted as a vehicle simply to give the short seller something to bet against.

Tourre admitted it: the short seller has to pick the portfolio or there is no deal.

Short sellers are too smart (and too greedy) to bet against something that they have not designed to fail. So the higher the demand by shorts, the more synthetic CDOs are created... and who takes the long side of those deals?

Institutional investors lured in by the fraudulently high ratings.

This is exactly what Yves Smith was saying in his post. The short sellers are not heroes for calling BS on the housing bubble, they are the arsonists who threw gasoline on the fire. They stoked demand for instruments they could "buy protection" against.

It was "the shorts" who fueled the explosion of the synthetic CDO market (literally), because without their demand for something to bet against, these securities never would have been created or sold in the first place.

How Far Will The Dominoes Fall?

It remains to be seen whether Mr. Tourre's admission turns out to be correct. But if he is, if every synthetic CDO deal was the result of short sellers picking portfolios, and placement agents keeping that information from buyers, then there will be a whole lot more suits like the one we are now seeing against Goldman.

Things just get curiouser and curiouser.