How ACA was misled

By Felix Salmon
April 17, 2010
Steve Waldman has the single best explanation of what was going on in the Abacus deal and why Goldman is so culpable. He makes a lot of really good points, and it's well worth reading the whole thing. But it's especially worth pointing to this bit:

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Steve Waldman has the single best explanation of what was going on in the Abacus deal and why Goldman is so culpable. He makes a lot of really good points, and it’s well worth reading the whole thing. But it’s especially worth pointing to this bit:

Most of a CDO’s structure was AAA debt, generally viewed as a means of earning low-risk yield, not as a vehicle for speculation. Synthetic CDOs were composed of CDS positions backed by many unrelated counterparties, not one speculative seller. Goldman’s claim that “market makers do not disclose the identities of a buyer to a seller” is laughable and disingenuous. A CDO, synthetic or otherwise, is a newly formed investment company. Typically there is no identifiable “seller”. The investment company takes positions with an intermediary, which then hedges its exposure in transactions with a variety of counterparties. The fact that there was a “seller” in this case, and his role in “sponsoring” the deal, are precisely what ought to have been disclosed. Investors would have been surprised by the information, and shocked to learn that this speculative short had helped determine the composition of the structure’s assets. That information would not only have been material, it would have been fatal to the deal, because the CDO’s investors did not view themselves as speculators.

Steve makes a strong case that there was no reason whatsoever for ACA or IKB to believe that there was a speculative short on the other side of their trade. Quite the opposite: they thought that they were the financial sophisticates providing a supply of derivatives to meet a natural demand. Hundreds of billions of dollars’ worth of subprime residential mortgages were written during the course of the housing boom, and those mortgages had owners, and those owners had every natural reason to want to hedge their exposure or insure against its default. If Goldman could find such owners and put them together with people like ACA and IKB, then Goldman would have been doing exactly what investment banks are meant to do: putting natural sellers of risk together with investors who have cash and want to put it to work.

Steve concludes, rightly:

Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO. They no more thought they were trading “against” short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio. Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors. That’s inexcusable.

The point here is not just that IKB thought that ACA had carefully selected the portfolio with an eye to optimizing its performance on the long side; it’s also that ACA thought that Paulson had carefully selected its longlist of potential components for the portfolio with exactly the same view to making money by selling insurance to people wanting to hedge their mortgage exposure. Goldman, by failing to disabuse its client ACA of this notion, behaved unethically. Of course ACA knew of Paulson’s involvement: that’s exactly what makes the whole scheme so evil. They knew that Paulson was involved, but they were carefully kept in the dark as to why Paulson was involved, and were encouraged to believe — quite naturally, given Paulson’s role as sponsor of the deal — that their interests were aligned.

Investment banking is all about trust: if you can’t trust your investment banker, you shouldn’t be doing business with him. (And if he refers to himself as “fabulous Fab”, probably it’s a good idea not to trust him.) Fabrice Tourre is not a trustworthy banker, and Goldman should be firing him. Instead of mounting a vigorous and forthright defense of his actions.


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Eh, I get it, but perhaps Occam’s Razor provides a less ingenious explanation. ACA/IKB were bullish (or whatever) on the RMBS they voluntarily entered into long exposure to, while Paulson was bearish; remember, also, that at that time (late ’06) Paulson was not the Paulson we know him as today. Who can say in retrospect whether knowing he was taking the opposite view would have changed ACA or IKB’s outlook?

Each side had their own reasons for their views, independently of each other. I acknowledge what you and Steve are saying, but to me, its much more simple than that.


Posted by Anal_yst | Report as abusive

that should be “disingenuous” btw, damn spell check!

Posted by Anal_yst | Report as abusive

Well, that’s all very nice, but what is it that ACA was supposed to have done for the fee it was paid? Just accept Paulson’s selections? Were they not supposed to be you know actually evaluating the structure and underlying assets?

When a firm gets millions of dollars to validate an investment, doesn’t it have some obligation to do some research?

Posted by rootless | Report as abusive

And what were IKB’s highly paid bankers supposed to be doing for a living?

A case like Jeb Bush shepherding Florida pension funds into Lehman’s garbage barge is much easier, for me, to label as fraud. In this case, the job of the IKB bankers was to be able to evaluate this crap and the job of ACA was to be diligent. They’re not supposed to make decisions based on a “I heard so and so who is smart thinks X”.

Posted by rootless | Report as abusive

I see the fraud at the macro level rather than at the micro level. The most appropriate metaphor to me is a pyramid scheme. The expansion of the potential home buyer market was a pyramid where the prime mortgages provided the cash to fund the sub primes until eventually the universe was exhausted and the chain letter collapsed. Chain letters and pyramid schemes are fraud. The creators of the game anticipated and planned for the collapse. With the approval of the legislative regulators they created the CDO and Credit Default Swaps with the plan that the investors would be protected by the taxpayers. So did Paulson participate in creating this scheme or just bet against it?

Posted by jsrogers | Report as abusive

What I don’t understand is this: 1) why didn’t ABN Ambro and IKB conduct due diligence on these assets before investing in them, such as contacting directly the portfolio selection agent, ACA, to inquire exactly how it arrived at its decision to recommend the assets in question. Can someone please tell me if ABN Ambro and IKB were to have contacted ACA, would it have been incumbent upon ACA management to disclose to these potential investors at the time that ACA approved the portfolio in partnership with Paulson or at least mention his involvement? 2) According to court documents, how could ACA Capital, the parent company of ACA Management, LLC, not know of Paulson’s close involvement in the selection of the assets in the portfolio? Is it not also incumbent on the part of ACA Capital to do their own due diligence on what its subsidiary is doing and how it is arriving at it recommendations. In my opinion, the information of Paulson’s involvement was out there, at least available to ACA Capital (and possibly to IKB and ABN Ambro as well) but no one bothered to ask for it or search it out. There are a lot of unanswered questions here and many parties are to blame for not doing what “sophisticated investors” are suppose to do before shelling out millions of dollars. Although I think Fabrice was indeed a distrustful investment banker, I also think Goldman was right in arguing that investors had to the opportunity to analyze the assets on their own or at least contract another third-party bond agent to give its unbiased opinion on the portfolio before investing in it. My fear is that other banks will likely be entangled in this mess with allegations of similar wrongdoing, which does not bode well for financials in the short-term because the SEC’s vague comments and the general sense of uncertainty are still strong.

Posted by Justaninvestor | Report as abusive

Here’s from the sales deck. Spells out that GS is betting on fail. A prudent investor would ask why GS thought it would get money from this deal.


Goldman Sachs will enter into a CDS with the Issuer to buy protection on Reference Portfolio losses
related to the Class A through Class D Notes.

The Collateral Securities and/or Eligible Investments will be available to make payments to
Goldman Sachs in the case of writedowns or other Credit Events occurring on the Reference
Portfolio, which in each case incur writedowns on the Class A through Class D Notes

Posted by rootless | Report as abusive

I’m still at a loss to understand why sellers of credit protection would have changed their mind if they knew the buyer of the protection structured the transaction.

Do ABN/IKB assume all market participants are lazy and gullible as they are? Popeye the Sailor could have selected the collateral but it was incumbent on ABN and IKB to perform their own due diligence on the underlying assets.

Paulson/GS also had no inside or non-public information that these bonds would default. They structured the CDO based on their view that the bonds were likely to default. This information was also available to ACA, ABN, IKB.

Paulson/GS certainly didn’t force the homeowners to default on their payments or cause the bond trustee to declare the bonds in default.

Posted by longandshort | Report as abusive

Unfortunately for you Felix, I fear folks that hand out journalism awards don’t pay that much attention to bloggers, because you and others are working hard and doing good work on this story.

One of your better points…

“Fabrice Tourre is not a trustworthy banker, and Goldman should be firing him. Instead of mounting a vigorous and forthright defense of his actions.”

Exactly. What on Earth is Goldman thinking? Every other company of Goldman’s stature would immediately announce that this behavior will not be tolerated because whether or not the law was broken this type of treatment of clients is not acceptable.

Goldman has a choice:
(1) They can take charge and deal with this immediately themselves, and the guilty employees take the fall that they deserve or
(2) They can fight a fight they are unlikely to win and have the words ‘Goldman Sachs’ and ‘fraud’ appear side by side in headlines every day for the next couple of years.

Door number one is far better for shareholders. That Goldman would even think about choosing door number two means present management is incompetent. This is a Chappaquiddick situation where the failure to take responsibility quickly makes things worse.

Posted by DanHess | Report as abusive

If the whole rigamarole here were to begin and end with “Fabulous Fab” then what Felix is suggesting would make perfect sense and then, y’know, game over, let the big greed olympics continue, et cetera…

But. What’s really at issue here is the flimsy proposition that Goldman did anything other than zoom in on ailing core investments that didn’t stand a snowball’s chance, pad them up with an extra load of tosh to make them into really big balls of slush, then create the aura of possibility that anyone in their right minds would step in as a counter-party with any sort of illusion as to these toxic balls ever coming to anything other than a bad end.

It’s not just one rotten Apple Fabulous, it’s what Fool’s Goldman is made of, through and through.

Goldman only needs shills like ACA to lend a superficial whiff of (fake) viability to the (other people’s and in some cases fictitious) property aka financial vehicles they were insuring. The operative expression being, “Well, SOMEbody’s stupid enough to buy these”. One shill will do, and a few other fools are bound to join in. Goldman then precipitated the vehicles’ (plural, Abacus being one of many) demise and merrily cashed in – on the largely fictional deal, and on (to date, a trillion or two in) fraudulently obtained insurance. Voila.

As blatant as it has been, this crime spree of Goldman’s couldn’t last forever. The time for it to end, once and for all, is now.

Posted by HBC | Report as abusive

DanHess, you seem to consider this case an anomaly, perpetrated without Goldman’s knowledge. If, on the other hand, this was business as usual, then I would expect Goldman to take the actions that they have. After all, if they admit that an employee did this, against company guidelines, they will be on the hook for the billion dollars that the European banks — including one now owned by the British government — lost. I don’t think they want to pony up that money without a fight, especially if it means a slew of follow-on lawsuits from other ABACUS deals, nearly all of whom collapsed. And that might open up the AIG can of worms again. Last thing they want.

As the report from ProPublica on the Magnetar deals makes clear, there were a number of these “sponsors” who had a say in the selection of either the CDO manager, the MBS that went into the CDO, or both. What knowledge the investment bank that put the deals together had is still in question. The evidence ranges from damning, as in this case for Goldman, to J.P. Morgan’s deal with Magnetar in which they lost $880 million.

Posted by bff426 | Report as abusive

Point taken. If Goldman accepts responsibility in this case, there are more like it, here, there and everywhere.

Still, I think Goldman could get through it well if they focus on rebuilding the franchise, wherein the good Goldman roots out the bad Goldman. We must appreciate that there are many good parts of Goldman Sachs including investment banking, much of their market-making and part of their trading.

I-banking should be in open revolt right now, because the some of the traders have been destroying the franchise.

If Merck can get through Vioxx, Goldman can get through this. They will have to scale back trading and reform their culture and probably leave some dirty money on the table, but the world needs the good Goldman and there is a bright future and plenty of up-and-up business for them in a gigantic globalized economy.

Posted by DanHess | Report as abusive

DanHess, is your real name Ben Stein?

Of course not, you’re just channeling the bad Ben.

Posted by HBC | Report as abusive

Goldman Sachs is trading at a trailing earnings multiple and a forward earnings multiple in the range of seven. That is atrocious and reflects what the market thinks of the franchise and its earnings quality. By contrast, Berkshire Hathaway, which like Goldman is a kind of hedge fund, has an earnings multiple three times as high.

When a meaningful share of your revenue pie is fraudulently obtained, it contaminates all of your other revenues.

The board needs to throw out Blankfein, Cohn and Viniar. Investment banking needs to revolt until that happens. They are Goldman’s rotten core. Goldman cannot improve until those at the helm amid these ethical disasters are gone.

Posted by DanHess | Report as abusive