Goldman’s Super-Senior Moment

Not by Damon Runyan

Johnny the Hedge walks into Goldy’s bookie joint and says "I think the Mets lose big this year. Here’s my bet:

I'll pay you $100 if the Mets win at least 60 games. But if they win fewer than 60 games, you pay me $25 per game under 60. And just to pay you for the trouble, we’ll start with a $15 credit to you."

Goldy says, “I’ll get back to you. I have to see if I can lay the bet off.” She then looks through her rolodex for Mets fans and finds two that interest her.

Ikey B. loves the Mets, always has. Goldy offers Ikey B. a deal:

"I’ll pay you $79 if the Mets win at least 60 games. You pay me $25/game for every game fewer than 60 that the Mets win, up to $150 max."

Ikey B. is sure that the Mets will win at least 60 games, so he takes the bet. But Goldy isn’t done. She has laid off $150 of her risk on Johnny’s bet, but what if the Mets win fewer than 54 games?

So Goldy turns to Al “Citifield Action" (ACA to his friends). Al’s a really well-heeled Mets man. Goldy says to Al:

"I’ll pay you $10 if the Mets win at least 54 games. Otherwise, you pay me $25 per game fewer than 54 that the Mets win."

Goldy offers ACA so little because, well, winning fewer than 54 games? C’mon, no one ever does that. ACA sees a chance to pick up an easy ten-spot, and he jumps at the chance.

So let’s take a look at where Goldy sits:

If the Mets win 60 games or more (the most likely outcome, if history is any guide), she collects $115 from Johnny and pays out $89 to Ikey B. and ACA, netting $26.

If the Mets win 54 games, she pays $10 to ACA, collects $150 from Ikey and pays it to Johnny, less the $15 she gets to keep for her trouble, netting $5.

If the Mets win 50 games, she collects $150 from Ikey, $100 from ACA, and pays $235 to Johnny, netting $15.

If the Mets win 20 games, she collects $150 from Ikey, $850 from ACA, and pays $985 to Johhny, netting $15.

In the quaint patois of Wall Street, Goldy’s bet with ACA is called a super-senior tranche. The concept is very simple. Ikey B.’s bet – that the Mets would win at least 60 games, is rated AAA by the mavens because it is (apparently) risk-free. But, in the strange world of investment banking, some risk-free investments are more equal than others. If a bet that at least 80% of mortgages will pay off is rated AAA, what about a bet that at least 60% will pay off? By breaking its bet with Paulson up into tranches, GS was able to arbitrage the spread between what Paulson was willing to pay to bet against 80% of the pool and what ACA would demand to insure the top 60%. (These numbers are illustrative, not actual.) All that was required was for someone to take the AAA-rated tranche represented by pay-offs in the 60-80% range, and IKB did that.

Thus, the money for GS was not in its deal with IKB. The money was in the arbitrage between what GS was charging Paulson for its bet on the whole pool vs. what it was paying ACA to cover the “super-senior” tranche of the pool. That super-senior opportunity is what drove the synthetic CDO market.