Parsing the new Goldman statement

By Felix Salmon
April 16, 2010
much longer statement on the Abacus affair. It's worth delving into:

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Good news! Goldman has just released a much longer statement on the Abacus affair. It’s worth delving into:

We are disappointed that the SEC would bring this action related to a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact.

Is Goldman really trying to say here that because its “extensive record” is OK, that gives it license to do what it likes on any given “single transaction”? Certainly it’s repeating its ill-advised assertion that “the accusations are unfounded in law and fact”.

We want to emphasize the following four critical points which were missing from the SEC’s complaint.

* Goldman Sachs Lost Money On The Transaction. Goldman Sachs, itself, lost more than $90 million. Our fee was $15 million. We were subject to losses and we did not structure a portfolio that was designed to lose money.

Goldman goes into no detail here about exactly where the losses came from. But I won’t be impressed if it turns out that they just pulled a $90 million number out of thin air as the value of the equity tranche — which they never even attempted to sell — and then declared that they lost $90 million when it turned out that the equity was worth nothing.

In any case, we’re talking about two different things here, which Goldman is conflating. On the one hand there’s the $15 million in direct fee income, much of which went straight into the CDO desk’s bonus pool. Then there’s the profit-and-loss on whatever part of the structure that Goldman decided to retain: that’s trading-and-investment income, and is a different bucket. It’s entirely conceivable, and indeed probable, that the people structuring the deal cared much more about their fees than they did about the ultimate performance of the CDO.

* Extensive Disclosure Was Provided. IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities. The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side.

If the word “Paulson” isn’t included in the section about “extensive disclosure”, then I don’t think the disclosure can be considered to be extensive. The point here is that neither IKB (which really wasn’t that sophisticated) nor ACA was told by Goldman that this synthetic transaction — which, yes, necessarily includes a short side — was actually architected by that short side. Paulson stacked the deck by giving ACA a pool of toxic assets to choose from, without revealing that they were short. Goldman knew what Paulson was doing, and was complicit in the silence. That’s not “extensive disclosure”, chaps.

* ACA, the Largest Investor, Selected The Portfolio. The portfolio of mortgage backed securities in this investment was selected by an independent and experienced portfolio selection agent after a series of discussions, including with Paulson & Co., which were entirely typical of these types of transactions. ACA had the largest exposure to the transaction, investing $951 million. It had an obligation and every incentive to select appropriate securities.

Except ACA didn’t know — because it wasn’t told — that the securities presented to it by Paulson were specifically chosen to be the ones most likely to default. From the complaint:

In late 2006 and early 2007, Paulson performed an analysis of recent-vintage Triple B RMBS and identified over 100 bonds it expected to experience credit events in the near future. Paulson’s selection criteria favored RMBS that included a high percentage of adjustable rate mortgages, relatively low borrower FICO scores, and a high concentration of mortgages in states like Arizona, California, Florida and Nevada that had recently experienced high rates of home price appreciation.

If ACA had known how these securities were chosen, it would never have agreed to this deal. Simple as that.

* Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor. The SEC’s complaint accuses the firm of fraud because it didn’t disclose to one party of the transaction who was on the other side of that transaction. As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor.

This is hair-splitting. Goldman represented to ACA that Paulson was a “sponsor”, and invariably in this world sponsors are equity investors. What’s more, Goldman told ACA about the equity tranche of the deal in the same transaction summary: the clear implication was that Paulson was holding on to that tranche. And Goldman ended up getting exactly what it wanted: ACA walked away convinced that Paulson was long. It was wrong — and it was therefore misled by Goldman.

Goldman then includes a long “Background” section:

In 2006, Paulson & Co. indicated its interest in positioning itself for a decline in housing prices. The firm structured a synthetic CDO through which Paulson benefitted from a decline in the value of the underlying securities. Those on the other side of the transaction, IKB and ACA Capital Management, the portfolio selection agent, would benefit from an increase in the value of the securities. ACA had a long established track record as a CDO manager, having 26 separate transactions before the transaction. Goldman Sachs retained a significant residual long risk position in the transaction.

IKB, ACA and Paulson all provided their input regarding the composition of the underlying securities. ACA ultimately and independently approved the selection of 90 Residential Mortgage Backed Securities, which it stood behind as the portfolio selection agent and the largest investor in the transaction.

The offering documents for the transaction included every underlying mortgage security. The offering documents for each of these RMBS in turn disclosed the various categories of information required by the SEC, including detailed information concerning the mortgages held by the trust that issued the RMBS.

Any investor losses result from the overall negative performance of the entire sector, not because of which particular securities ended in the reference portfolio or how they were selected.

The transaction was not created as a way for Goldman Sachs to short the subprime market. To the contrary, Goldman Sachs`s substantial long position in the transaction lost money for the firm.

The thing to remember here is that the heart of the SEC has nothing to do with investor losses, be they within Goldman or outside it: instead, it has everything to do with transparency and honesty, or the lack thereof. And the SEC isn’t pulling a Ben Stein, complaining that Goldman was short mortgages and saying that there’s something inherently wrong about that. Whether Goldman was long or short this structure is entirely beside the point. The point is that Goldman treated its clients — ACA and IKB — atrociously. At the very least they deserve a grovelling apology; the SEC makes a strong case that they deserve hundreds of millions of dollars on top of that.

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