27 May 2010
The word ‘sophisticated’ gets used a lot in the world of derivatives. The dictionary defines the term as ‘experienced, worldly, cultured; discriminating in taste or judgement, subtle, showing awareness of the complexities of a subject’. In high finance, it matters whether the definition is satisfied.
“These were sophisticated investors” has become banks’ standard defence against alleged wrongdoing when their clients lose money. It is central to Goldman Sachs’ rebuttal of charges by the U.S. Securities and Exchange Commission relating to its activities in the subprime market. The bank describes clients at the centre of the case as “among the most sophisticated mortgage investors in the world”.
The concept dates back to the SEC’s 1933 Securities Act. So long as securities issuers restricted access to large institutions or ultra rich people, they were exempt from filing a prospectus. Fast forward the end of the century and the invention of over-the-counter derivatives to hedge risks like interest-rate and currency fluctuations. In 2000, U.S. Congress exempted derivatives from regulation on the basis that their users were sophisticated.
But the explosion of financial innovation in the last decade created a topsy-turvy world. The traditional idea of the sophisticated investor got undermined by ever increasing complexity, while the arrangers of structured products had commercial incentives to apply the label as broadly as possible.
Take the lawsuit that settled after a one-day hearing at London’s High Court in February 2010. A small Italian bank, Banca Popolare di Intra (BPI) had lost money on a synthetic collateralised debt obligation sold by Barclays Capital in 2000. A key part of the evidence was not the legal contract behind the CDO itself, but a side agreement. In this, BPI agreed to ensure that it “fully understood” the terms of transaction and its “significant” risks, which were of “a complex nature”. Effectively, BPI had to declare that it was sophisticated enough to buy Barclays’ derivative. In doing so, it waived its right to sue Barclays for negligence.
But BPI’s declarations were hard to square with its expectations from the investment, which made no financial sense. It wanted to earn substantially higher returns than from a low-risk bond, but without taking extra risk.
Now consider Goldman’s Abacus 2007-AC1 deal at the centre of the SEC probe. At first glance, Goldman’s argument that the clients involved — Germany’s IKB and the UK’s Royal Bank of Scotland — were sophisticated is much stronger than in the Barclays-BPI spat. Both IKB and RBS themselves repackaged subprime assets for sale.
Yet the willingness of IKB and RBS to hold triple-A rated subprime synthetic CDOs was as financially nonsensical as BPI’s investment objectives. Like BPI, they saw themselves as cautious bankers using derivatives to generate additional returns for minimal risk. Rating agencies had given triple-A status to synthetic CDOs. Investing in these kite-marked instruments was encouraged by Basel II banking regulations, even though they were severely mispriced for the risks. The regulatory framework removed the need for sophistication that the legal documentation demanded.
It stretches credulity to suggest that investors on each side of credit-bubble bets like this were evenly matched. But, as if by alchemy, the legal documentation deemed unsophisticated clients sophisticated.
So who is a real sophisticated investor? A good candidate would be John Paulson, the hedge fund manager who plays a starring role in the Goldman lawsuit. He made $6 billion by betting against subprime mortgages and banks like IKB and RBS that invested in them. Paulson understood how ratings and regulatory pressures to buy subprime CDOs had turned his counterparties into fools. After all, it is hard to see how genuinely sophisticated investors would have allowed regulatory capital arbitrage to lure them into a gambling den where genuine sophisticates like Paulson could relieve them of their capital.
The SEC describes a meeting in March 2007, during which Goldman’s “Fabulous Fab” Tourre emails his girlfriend saying it was “surreal” to see a Paulson employee and the subprime collateral manager ACA, which was helping assemble the deal, in the same room. That aptly characterised the absurdity of the situation. On display was the legal choreography in which equally opposed, sophisticated counterparties come together, subverted by the ratings and regulatory-driven world in which ACA, RBS and IKB operated.
The legal actions currently underway against CDO dealers may yet come to nothing. But it is clear that the concept of sophistication concealed toxic complexity sanctioned by flawed regulation during the credit boom. Arguably, the word became inverted into a badge of idiocy — something which the smart money noticed to devastating effect.
This article originally appeared on www.breakingviews.com. If you wish to take out a free trial to breakingviews, click here.
Copyright © breakingviews 2010
