The lover’s spat between Goldman Sachs, Paulson and “sophisticated investors” is not the real problem!

The beauty of the action of the SEC against Goldman Sachs is that it allows us to understand with a real and public example a lot of what happened all over the market. Let us see it here from the perspective of IKB the German Bank who invested $150 million in ABACUS 2007-AC1.

In paragraph 58 we read that IKB bought $50 million of the A1 tranche paying Libor plus 85 basis points, and $100 million of the A-2 tranche paying Libor plus 110 basis points. The average return comes to about 102 basis points.

Since these $150 million were rated Aaa by Moody’s and AAA by S&P when purchased, that meant that IKB’s investment, for bank capital requirement purposes, would be weighted at only 20% signifying only $30 million for which 8% capital requirements had to be held. IKB would therefore need $2.4 million of their own capital to back the operation, a leverage of 62.5 to 1.

$150 million at 102 basis points and $ 2.4 million in capital signifies then an expected gross return of 63.75% on IKB’s capital.

In order for IKB to make a comparable return when lending to their traditional client base of small and medium sized businesses, most certainly unrated, and who therefore are risk weighted at 100%, IKB would have to lend them the funds at Libor plus 510 basis points.

And here we have it, the way the current capital requirements for banks are based on the risks perceived by the credit rating agencies, provide huge incentives for the banks to enter into the virtual world and invest in these “synthetic” operations, instead of lending to the real world... and, that problem is so much larger than a simple lover’s spat between Goldman Sachs, Paulson and “sophisticated investors”.

Do you understand why I beg of you to keep your eyes on the ball? Do you understand why I am upset nothing of this is even discussed in the current proposals for financial regulatory reform?