New source of bank capital comes with new type of risk

In his Wall Street Journal column, Simon Nixon looks at how turning depositors into creditors directly effects the ability of a bank to use its capital to absorb losses.

Spanish banks have added a unique twist of effectively turning some depositors into equity holders. That puts customers on the front line. 

Some banks started by persuading depositors to switch from low, interest-bearing accounts into preference shares, which paid a fixed, higher interest rate. The benefit for the banks was that these securities counted as core capital under banking rules. 

UBS says Spanish banks issued €32 billion ($42.7 billion) of such instruments from 2007 to 2010. 

But as the crisis deepened, these instruments became illiquid, trading at deep discounts. 

At the same time, they ceased to count as core capital under new rules known as Basel III. So banks have encouraged investors to convert preference shares into either common stock or mandatory convertible notes, which pay a high initial yield before later converting into stock.... 

While deposit-for-equity swaps have boosted capital ratios, they also mean new risks. If customers face big losses, it could hit confidence. 

Note, customers have already incurred big losses as the securities they are holding are trading at deep discounts!

Given an estimated one million retail investors bought preference shares and mandatory convertibles, maintaining confidence is now a systemic concern. 

So Spanish bank equity may not be truly loss-absorbing....

A big uncertainty is whether customers will stick around. Banks are taking no chances ... And the government has ruled out direct equity injections, saying if new capital is needed it will take the form of contingent convertibles. That would postpone dilution.

Score one for the Spanish banks.

In theory, by converting depositors to equity holders, they procured hostages that will prevent the government from adopting the Swedish model and requiring banks to absorb all the losses hidden on and off their balance sheets today.

In theory, the government will continue implementing policies under the Japanese model to protect the level of bank book capital.  An example of this would be ruling out direct equity injections and promising to only use contingent convertibles to supply needed capital.

In reality, the depositors who converted to equity securities have already experience significant losses.  The depositors know that these losses are directly related to the existence of losses hidden on and off the bank balance sheets.

The depositors who converted to equity securities also know that under the Swedish model the value of their securities might not be wiped out.

The banks can be given the opportunity to rebuild their book capital after recognizing the losses.  So long as the securities are in a bank with a franchise that is able to generate future earnings, there is no need for capital from the government.

Japan illustrates what happens from protecting bank book equity levels

In his Bloomberg column, William Pesek summarizes what happens to countries that pursue the Japanese model for handling a bank solvency led financial crisis.

Under the Japanese model, policies are adopted with the goal of protecting the level of  bank book capital. As a result, losses on the excesses in the financial system are not recognized today.  Rather, they are recognized over time as banks generate earnings in excess of banker bonuses, dividends and modest capital retention.

While the losses are slowly being realized, prices are distorted in the real economy.  Banks continue to fund zombie borrowers rather than recognizing the losses on these loans.  As a result, asset prices are artificially propped up.  This in turn creates a drag on the real economy.

To overcome this drag on the real economy, central banks resort to zero interest rate policies in an effort to boost demand.  Unfortunately, these monetary policies create their own headwind as savers realize they need to save even more to make up for the loss in earnings on their savings.

As Mr. Pesek observed

Japan (JGDPAGDP)’s problem isn’t really the size of its debt. It’s that there has been no real growth since the 1980s-era asset bubble burst. At the start of 2012, Japan’s inflation-adjusted gross domestic product was smaller than it was in 1992....

Here is overwhelming empirical evidence that pursuing the Japanese model and its related policies for handling a bank solvency led financial crisis is a bad idea.

[Japan's prime minister] should work with the Bank of Japan to devise ways to get banks to lend. Wave after wave of central-bank liquidity isn’t resulting in the credit creation Japan needs to jump-start growth .... Why not force bankers to do their jobs?

Wave after wave of central-bank liquidity isn't resulting in the needed credit creation in the US, UK or Eurozone either.

That central bank liquidity would not result in the needed credit creation was completely predictable.  Banks are senior secured lenders.  Bankers know that asset prices are being artificially propped up.  In deciding how much to lend, banks have to determine what the real value of the collateral would be if prices stopped being artificially propped up.

As a result, borrowers have to cover the gap between the real value and the artificially propped up price of the collateral.  It is the need to come up with this additional equity that is the barrier to credit creation.

The key to handling a banking crisis is to keep confidence of depositors

Ultimately, in a bank solvency led financial crisis, the key issue is maintaining depositor confidence.  This is important because if depositors lose confidence, it triggers a downward economic spiral.

As shown by Ireland, Greece and Spain, lending to and growth in the real economy declines as a result of a run on the deposits of the banking system.

The question is how to maintain depositor confidence.

The Japanese and Swedish models for handling a bank solvency led financial crisis offer different answers.

Under the Japanese model, depositor confidence is equated to the level of bank book capital on the theory that if bank book capital declines so too will depositor confidence.  As a result, policies like government capital injections have to be pursued that protect the level of bank book capital.

Under the Swedish model, depositor confidence is equated to the perceived strength of the deposit guarantee on the theory that depositors don't care if a bank has a positive or negative book capital position so long as their deposit is safe.  As a result, policies are pursued that protect the real economy from the losses on the excesses in the financial system and, by doing so, the creditworthiness of the government deposit guarantee.

Henry Blodget knows SEC's job is ensuring disclosure and not preventing stupid investment decisions

In his Business Insider column, Henry Blodget takes on Andrew Ross-Sorkin's NY Times Dealbook column on the JOBS Act and its repeal of disclosure requirements.

The essence of Ross-Sorkin's argument is that in the absence of disclosure, market participants are no longer investing, but blindly gambling. [A point that your humble blogger has been making about structured finance securities since before the financial crisis began.]

So Mr. Obama may want to weigh the fate of Groupon’s investors as he sits down on Thursday to put his signature on the Jumpstart Our Business Startups Act....

The measure, known as the JOBS Act, is a well-intentioned bill with bipartisan support aimed at making it easier for small businesses to find investors early and to continue to grow in the public markets by lowering some of the bureaucratic barriers.... 

the legislation, in the name of creating jobs, dismantles some of the most basic protections for the most susceptible investors apt to be drawn into get-rich-quick scams and too-good-to-be-true investment “opportunities.”...

But it is awful for the investors, who rely on the transparency of the process.... 

Steve Case, the co-founder of AOL, was one of the biggest behind-the-scenes proponents of the JOBS Act ... As for criticism that the law goes too far in loosening disclosure rules, he said, “It’s not perfect,” but he added, “I’m confident we’ll strike the right balance.” 

Mr. Case also made the argument, correctly, that all regulation can’t protect everybody.... 

More important, however, he made a profound, perhaps inadvertent, remark about the business people’s state of mind on investing, suggesting that it still may be analogous to a casino. 

“I don’t want to sound flip about this, but you don’t have to be an accredited gambler to go to Las Vegas,” he said. “Anyone can walk into a casino and lose an unlimited amount of money.” He added, “I’d rather they invest that money.” 

Mr. Case is right: there are few built-in protections for gamblers. 

But investing is supposed to be different. 

Mr. Blodget focuses on the investment results experienced by the Groupon IPO investors and argues that repealing disclosure requirements is okay as the definition of a market is that for every trade there is a winner and a loser.

What just happened to Groupon investors?

Well, those who bought Groupon the IPO price or immediately after the IPO--and held onto it--have gotten demolished. 

So, we should tighten IPO regulations, not weaken them, right? 

Absolutely not. 

The reason investors lost money on Groupon, as well as Demand Media,Pandora, and other flame-out IPOs, is not that regulation failed. It's that the investors paid too much for the stocks.

The SEC gave Groupon a proctology exam before it went public. That didn't stop the stock from cratering. And it cratered long before the embarrassing earnings restatement Groupon announced last Friday. 

And it's not as though there wasn't a healthy diversity of opinion about Groupon's prospects before and after the IPO. 

Many analysts, including Jim Cramer and yours truly, were screaming from the rooftops that Groupon was overvalued--a crash waiting to happen.... 

Investors who bought Groupon on the IPO chose to ignore these warnings. Importantly, these Groupon bulls might have been right. That's what makes a market, after all. One investor on each side of the trade, one of whom is right, the other of whom is wrong.

Mr. Blodget knows that it is not the SEC's job to make investment recommendations or prevent investors from making what turn out to be stupid investment decisions.  It is the SEC's job to ensure that for each investment all the useful, relevant information is made available to market participants in an appropriate, timely manner.

The act of investing involves using this information in assessing the risk of and valuing an investment.

Without access to all the useful, relevant information, investors are not investing, but rather blindly gambling.

Doubtful loans at Spanish banks skyrocketing

In his Telegraph column, Mats Persson, the Director of independent think-tank Open Europe, looks at how much capital Spanish banks have and how much they actually need.

Since the start of the euro crisis, as living standards have fallen, [the] share [of “doubtful” loans, i.e. loans that are at serious risk of default, currently held by Spanish banks] has skyrocketed and now stands at 7.6% (€136bn in total or around 13% of Spanish GDP) of all loans on banks’ books.

Unsurprisingly, most of these loans are to the most vulnerable part of the Spanish economy – its real estate and construction sectors. 

One in five loans in these sectors – mostly mortgages – are now considered toxic and at serious risk of never being repaid. If this wasn’t concerning enough, two further factors are worth considering. 

First, Spanish banks only have €50bn in capital to cover against potential losses – even the simplest calculation shows this is far from enough. 

Clearly, the Spanish banking industry is insolvent as the market value of its assets is less than the book value of its liabilities.

Within the industry, there may be individual banking organizations that are solvent --- the market value of their assets exceed the book value of their liabilities.

Secondly, the Spanish housing market and construction sectors have yet to reach rock bottom. House prices have dropped rapidly over recent months but, considering the adjustment needed to compensate for the over-investment in this sector, could potentially fall by another 35%, similar to where Ireland is today following its major real estate bust.... 

If no action is taken, the insolvency problem is going to get worse.

Compounding the insolvency problem is the fact that 

Spanish banks are currently the chief buyers of Spanish government debt, meaning that if these banks suffer, it could also cause Spanish government funding to dry up. The chances of a self-fulfilling bond run on Spanish debt would thereby increase massively....

Which raises the question of what to do?

Regular readers know the choice is between the Japanese model and the Swedish model for handling a bank solvency led financial crisis.

And as today's budget shows, Spain simply doesn't have the cash for a major bank bailout operation ... if the situation is allowed to spiral ... the eurozone’s permanent bailout fund, the ESM, could be forced to step in, transferring the risk to eurozone taxpayers....  

In order to avoid prophecy becoming reality, Spanish banks should be required to at least double their provisions against souring loans... 

As ever, Spain is too big to be bailed out.

If eurozone policymakers repeat their habit of failing to take the right decisions early, the risk is that Spain and the eurozone will pay a very high price indeed.

Actually, Spain and the eurozone policymakers could choose the Swedish model.  Under the Swedish model, Spanish banks would recognize the losses on the excesses in the financial system today and would rebuild book capital through retention of future earnings.

The ESM would not fund a bank recapitalization, but would instead act as a back-stop to the deposit guarantee offered by the Spanish government.

This has numerous advantages for Spain.  For example, rather than use scarce funds to recapitalize the banking system, it could use these funds to support the various regional governments and expansionary fiscal policies.

Yet another RMBS lawsuit alleging fraud by Wall Street

The Telegraph reports on yet another RMBS lawsuit alleging fraud and misrepresentation in the quality of the underlying mortgages by Wall Street.  This time the lawsuit is between Ambac, a monoline insurer, and JP Morgan.

Regular readers know that requiring residential mortgage-backed securities to provide observable event driven disclosure would eliminate any possibility of the alleged behavior occurring in the future.

Under observable event driven disclosure, every time there is an observable event (for example, a payment, delinquency, default or modification) involving the underlying collateral, it is reported by 7:00 a.m. on the following business day and is easily disseminated for free to all market participants by using a data warehouse.

Observable event driven disclosure assures that all market participants have access to current information on the underlying collateral.  Hence, market participants do not have to rely on representations made about the underlying collateral, but can perform their own independent assessment.

In addition, no market participants have an information advantage based on their ownership of the billing and servicing firms.

Ambac, one of the world’s biggest bond insurers, is suing JP Morgan Chase in an effort to recover money it claims to have lost from insuring mortgage-backed securities sold by Bear Stearns. 

The insurer says that it has received claims of more than $200m (£125m) on a series of mortgage-backed bonds that it insured for Bear Stearns in 2006, according to a New York court filing. 

It is taking legal action because it alleges that Bear Stearns deceived it about the quality of the mortgages included in the securitised bonds, which have since “failed miserably” as homeowners defaulted on their payments. 

The aggressive push by Bear Stearns into the once-booming market for mortgage-backed bonds led to its collapse once US house prices began falling.... 

“Driven by management’s 'Bear don’t care’ mentality, Bear Stearns perpetrated a massive fraud that deceived investors and financial guarantors, such as Ambac, into believing that the mortgage loans backing its securitisations were originated pursuant to established underwriting guidelines and were therefore of good quality,” Ambac said in the filing. 

Ambac’s action is the latest in a spate of lawsuits that have been filed in the last year over losses incurred since the financial crisis.

EU lenders kick troubles down the road

In the absence of ultra transparency and with the adoption of the Japanese model for handling a bank solvency led financial crisis, the Wall Street Journal reports how EU lenders are pursuing strategies to postpone dealing with their troubled exposures.

It is the failure to deal with the troubled exposures that undermines the real economy.  Remember, during the period from 1995 - 2010, Japan pursued the model of letting banks hide their losses on and off their balance sheets and saw its economy contract.

The economy is undermined because hiding the losses artificially distorts the prices of real assets.  For example, real estate prices remain much higher than would be the case if the losses were known.

Even as the European banking crisis shows signs of easing, lenders across the Continent are engaging in a variety of maneuvers to avoid, or at least delay, coming to terms with potential problems lurking on their books. 

Some banks are concocting unorthodox structures designed to improve all-important capital ratios, without raising new capital or moving unwanted assets off their balance sheets.

As discussed previously, it is the ease with which banks can manipulate book capital that renders it meaningless in the absence of ultra transparency.

Others are engaging in complex transactions with struggling customers to help temporarily avoid loan defaults—but possibly exposing the lenders to future problems. 

Banks now have greater flexibility to pursue such tactics because of the roughly €1 trillion ($1.33 trillion) of cheap three-year loans that the European Central Bank recently handed out to at least 800 lenders. ... 

But by granting the new lease on life, the ECB program also has enabled the industry to delay its cleanup process, according to some bankers, investors and other experts. 

"The LTRO has allowed for an extension of the period before which bank reconstruction is embraced, and the damage for the euro area could be material," said Alastair Ryan, a banking analyst with UBS.

Under the Japanese model adopted at the beginning of the solvency crisis, banks have been delaying the cleanup process.

As a practical matter, the banks only recognize losses to the extent that they have earnings that exceed banker bonuses plus dividends plus a modest increase in reported book capital.

The tactics are most prevalent in Spain, where banks are awash in ECB loans but also are buckling under the increasing weight of bad real-estate loans. 

Lenders are making accommodations to small- and medium-size borrowers that take immediate heat off their customers, but possibly only kick problems to a later date.... 

Elsewhere in Europe, banks are getting increasingly creative at finding ways to boost their capital ratios without dumping unwanted assets or selling new shares—two of the methods that most regulators and other experts agree are key to fundamentally strengthening the sector.  

Some banks are parking portfolios of assets, typically commercial real-estate loans, in newly created off-balance-sheet vehicles. The banks then hire outside advisers such as private-equity firms to manage the vehicles. In some cases, the bank agrees to absorb the first wave of losses on the assets, but the losses or profits after that are divvied up between the bank and the vehicle's manager....

In Spain, nearly every lender has looked at creating versions of such structures, according to people involved in the talks. 

But there are potential pitfalls. Regulators at the Bank of Spain are scrutinizing the deals, weighing whether they are appropriate or merely mask risky loans, according to people familiar with the matter. 

"I consider such transactions regulatory arbitrage," said a veteran European investment-banking executive who has turned down opportunities to work on such deals. 

Falcon Group, a Dubai-based trade-finance company, is working with European banks on a similar type of transaction. It involves bundling portfolios of high-quality loans and then selling the riskiest slices of those loans—the portions that will take the earliest losses—to outside investors, according to Falcon Chairman Kamel Alzarka. The structure is intended to reduce the capital requirements associated with good loans and to avoid needing to sell bad loans at a loss. 

Otherwise known as creating structured finance securities where the investors have ultra transparency and can see what is happening with the underlying collateral as observable events occur.

Some big banks are devising intermediate solutions that allow them to claim progress at dealing with unwanted loans without having to suffer losses by actually selling the assets at distressed prices. 

Royal Bank of Scotland Group PLC recently shifted about £1.4 billion ($2.23 billion) of property assets—nursing homes, parking lots and shopping centers—into a fund run by buyout firm Blackstone Group LP. While the deal generated headlines that government-controlled RBS was disposing of the assets, most of these actually remain on the bank's books. RBS is simply paying Blackstone to manage the assets, with the goal of increasing the odds of the British bank eventually finding buyers. 

"This structure is all about getting the expertise of the private-equity fund to get us higher recoveries," said Mark Bailie, co-head of solutions in RBS's noncore division. 

Late last year, Spain's largest bank, Banco Santander SA, agreed to sell a chunk of its U.S. auto-finance business to a group of private-equity firms as well as the unit's chief executive. The sale generated a roughly $1 billion gain for Santander, one of a series of capital-raising initiatives by the company. 

But there is a catch: the deal isn't necessarily permanent. The buyers have the right to sell back their stake to Santander starting in four years.

And this is accounted for when calculating risk weighted assets how?

Absent ultra transparency, China discovers disclosure system no guarantee of protection

Reuters ran an interesting article on how China is looking at how to improve legislation governing its developing disclosure-based securities regulatory framework.

The goal is to increase transparency and improve investor protection.

Regular readers know that disclosure-based financial systems are stable only if investors have access to all the useful, relevant information in an appropriate, timely manner so they can make fully informed investment decisions.

For all financial firms, all the useful, relevant information takes the form of ultra transparency.  Under ultra transparency, financial firms disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details.

Market participants need these details in order to assess the risk of each financial firm.  Then, based on this risk assessment, market participants adjust their exposure to what they can afford to lose given the risk of the financial firm.

Regular readers know that the FDR Framework is the fundamental building block for the stable disclosure-based financial system that China is looking to build.

China’s bourse regulators and the nation’s IPO watchdog, the China Securities Regulatory Commission, have been busy brainstorming improvements to legislation governing the disclosure requirements of listed companies in the PRC. 

Aiming to bring increased transparency and other investor protection merits often associated with a disclosure-based securities regulatory framework, the CSRC is contemplating models from Hong Kong, the United States and other jurisdictions where listed companies are required to publicly disclose corporate and financial statements in a timely manner.

It is ironic that China is studying US disclosure requirements in light of the recently passed JOBS Act that repealed these requirements for firms with less than $1 billion in revenue.

Previously, since the 1930s, the US had been the model for disclosure-based capital markets.

Now, consistent with the financial regulators allowing banks to hide losses on and off their balance sheet as part of implementing the Japanese model for handling a bank solvency led financial crisis, the US is adopting the idea that capital markets work better when investors do not have access to the information they need to make a fully informed investment decision.

Recent fraud allegations involving U.S.-listed Chinese companies have highlighted shortcomings in a disclosure based system, particularly where securities regulators primarily rely on companies and their professional advisors to truthfully and accurately disclose information in filings. 

Although many of the accused companies appeared to comply with disclosure obligations, subsequent investigations produced allegations of material misstatements, omissions and even forgery of regulatory filings....

This is why your humble blogger has urged China to make its financial institutions the global model for disclosure by requiring them to provide ultra transparency.

Disclosing the data from which the financial statements are constructed materially reduces disclosure errors.

Disclosure alone, without regulatory authority to verify the authenticity of documents and hold listed companies responsible for violations of disclosure rules, may therefore be insufficient to protect investors. 

As the guardians of China’s capital markets move towards a disclosure-based system in securities regulation, they may well be looking to such enforcement gaps and considering efficient alternatives to protect investors when companies are accused of lying in disclosure documents.

By requiring disclosure of each financial institution's exposure details, China can instill market discipline in bank financial reporting while efficiently eliminating lying in disclosure documents.

Why are the Fed and SEC keeping Wall Street's secrets?

In his Bloomberg column, William Cohan asks the simple question of 'why are the Fed and the SEC keeping Wall Street's secrets?'

Getting what should be public information about major Wall Street firms can be maddeningly difficult....

Actually, to most market participants its is practically impossible.  Which is a huge problem because our capital markets are based on disclosure!

I was hoping to discover how that whole thing went down at the time, and how Goldman and Morgan Stanley got the Fed’s blessing but Lehman Brothers Holdings Inc. did not. Also I was interested in Goldman’s interactions with the Fed since that fateful moment. 

My hopes were raised further when I heard from people at the firm that Goldman had reviewed the contents of what was being sent to me and that its executives seemed worried about it.

No such luck. On the disk was nothing more than a bunch of obscure -- but publicly available -- Federal Reserve documents about the details of Goldman’s assets and liabilities on a quarterly and annual basis, everything from the kinds of loans the firm had been making to the tenor of its derivatives book to whether the real-estate loans it owns were backed by commercial properties or residential properties. 

The documents contained a bunch of detailed numbers (without explanation) about the kinds of risks Goldman was taking at a moment in time, thus prying open ever so slightly the firm’s black box. 

For instance, who knew that at the end of December 2011 Goldman had $44.2 trillion in the notional amount of derivatives contracts on its books, about $1.3 trillion more than it did in 2010? Or that $36 trillion of that amount was for contracts of less than one year in tenor? Or that Goldman had $19 billion in insurance underwriting assets, up nearly 40 percent from the year before? Or that Goldman’s book of commercial and industrial loans was $7 billion at the end of 2011, up dramatically from the $829 million it held at the end of 2010? Or that the firm’s stash of mortgage-backed securities -- now $1.37 billion -- had nearly doubled what it had at the end of 2010?...

All of this information and more would be available if our regulators required banks to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off balance sheet exposure details.

This is the data that market participants need if they are going to be able to assess the risk of each firm.  It is this assessment that ends contagion as market participants adjust the amount of their exposure to what they can afford to lose given the risk of each bank.

Mr. Cohan delivers the punchline for why ultra transparency is needed.

If our government agencies continue to do everything in their considerable power to keep hidden information that belongs in the public realm, all the regulatory reform in the world won’t end the rot on Wall Street.

CDO investor: 'no way of having equal information to Goldman'

A Reuters' article about a CDO-related lawsuit between Goldman and German state-owned Landesbank Baden-Wurtternburg confirms Wall Street's informational advantage.

Confirming that the buy-side knows about Wall Street's informational advantage is important because the buy-side is on strike and won't buy structured finance securities until this informational advantage is eliminated.

The only way to eliminate this informational advantage is to require all structured finance securities to disclose on an observable event basis all activity that occurs with the underlying collateral on the business day after the observable event occurs.

It is only with this reporting, that the buy-side always has current information on the underlying collateral's performance and can know what it owns.

It is one of the few cases to reach the appellate court level in which a sophisticated investor has accused a bank of profiting unjustly by being negligent in marketing and selling the product. 

Landesbank also accused Goldman of betting against its own derivative product that was riddled with risky residential mortgage-backed securities. 

In dismissing the case, U.S. District Judge William Pauley in New York had said the allegations against Goldman and TCW were "sparse and lack particulars" and speculated on events occurring long after Davis Square closed. 

Judges on the 2nd U.S. Circuit Court of Appeals also zeroed in on whether Landesbank should have more carefully scrutinized what it was buying. 

"What does the record show about your client's diligence in the housing market during this period?" Judge Susan Carney asked Landesbank lawyer Arthur Miller. 

Miller responded that there was "no way of having equal information to Goldman," describing the investment bank as the "emperor" of financial institutions. 

Miller told the panel that Goldman knew what information the ratings agencies and the top market regulator, the U.S. Securities and Exchange Commission, had about the quality of the underlying mortgages in the investment pool.

In addition, through its investment in sub-prime mortgage servicers, Goldman had current information that was not available to investors on how similar types of loans were performing.  As a result, it has insights into which RMBS deals were highly likely to lose value.

"They know that representing them as triple-A securities is false," Miller said, referring to the highest debt rating for a security. 

The judges also queried Goldman's lawyer about what it knew at the time about the securities and the risks to its client. 

Goldman lawyer Theodore Edelman told the panel that the firm's disclosures were "extremely clear and specific" and that the SEC website had timely information on loan delinquencies.
"All of this is available by a click of the mouse," Edelman said.

Actually, all of the data on loan delinquencies was out of date, particularly when compared to the data Goldman had access to.

In court papers, Goldman said Landesbank relied on a late 2007 report by Clayton Holdings, a provider of due diligence services to the mortgage industry. The report referred to loans that Clayton examined in 2006 and 2007, but the loans backing Davis Square were originated primarily in 2004 and 2005....

Excuse me, but Clayton Holdings did not look at the loans underlying the securities bought by the German bank.

Goldman had an informational advantage that it could have used (and, at least in the Abacus deal, was suspected by the SEC of having used). It had insight into the current performance of the loans backing the security that was not available to the German bank.

Landesbank accused Goldman of profiting unjustly from Davis Square by charging an excessively high purchase price and fees. It said Goldman also bet against the product by buying billions of dollars in credit default swaps that insured Goldman against the collapse of the mortgage securities collateral it sold to Landesbank.