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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