The Goldman and Magnetar letters

By Felix Salmon
April 20, 2010
Goldman's first letter to the SEC:

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Goldman’s letters to the SEC make for fascinating reading, and I’ve learned quite a lot from them, including where Goldman’s $90 million loss came from: tt’s not an unfunded equity tranche at all!

Here’s Goldman’s first letter to the SEC:

Because Goldman Sachs purchased protection from ACA on a portion (50-100%) of the super senior tranche, but wrote protection to Paulson on the entire (45-100%) super senior tranche, it bore the risk that poor performance of the Reference Portfolio would affect the 45-50% portion.

It’s a bit weird, that Goldman would leave itself with the 45-50% tranche of the Abacus deal, but that seems to have been the case.

More generally, the Goldman defense — which is as sophisticated and well-argued as you’d expect from bankers and lawyers of this caliber — seems to be that ACA was an enormous asset manager which neither knew nor cared about a small fund manager like John Paulson. If they thought about his positioning at all, they would probably have come to the conclusion that he was short, and if they came to that conclusion it wouldn’t have stopped them going forwards with the deal, because they considered themselves to be highly sophisticated when it came to putting together CDOs.

It’s a reasonably strong argument, but it fails utterly to answer the question of why on earth, in that case, Paulson’s role wasn’t disclosed much more transparently. The whole deal came out of a reverse enquiry from Paulson to Goldman: why couldn’t Goldman, bringing ACA into the loop, explain the whole concept in the space of a couple of minutes? Why all the studied ambiguity about equity tranches and sponsorships? Why not just come out and say that Paulson wasn’t taking an equity slice, and was going to be short the entire structure?

Here, for instance, is the disclosure from Magnetar’s Auriga deal:

Initial Preferred Securityholder may enter into credit derivative transactions relating to Reference Obligations or Cash Collateral Debt Securities in the Issuer’s portfolio. On or after the Closing Date, the Initial Preferred Securityholder may enter into credit derivative transactions relating to Reference Obligations or Cash Collateral Debt Securities in the Issuer’s portfolio, under which it takes a short position (for example, by buying protection under a credit default swap relating to such obligation or security) or otherwise hedges certain of the risks to which the Issuer is exposed. The Issuer and Noteholders will not receive the benefit of these transactions by the Initial Preferred Securityholder and, as a result of these transactions, the interests of the Initial Preferred Securityholder may not be consistent with those of Noteholders.

That kind of thing would have gone a long way in the Abacus disclosures — and remember that in the Auriga deal, Magnetar really was long the equity tranche. Goldman desperately tries to say that this disclosure wasn’t worth including because it doesn’t identify Magnetar by name — but a disclosure like this would not have needed to identify Paulson by name, either, in order for ACA to know exactly who it was talking about.

Meanwhile, John Gapper has obtained Magnetar’s letter defending itself from ProPublica’s allegations, which is well worth reading, and which is plausible on its face:

Magnetar’s strategy was in essence a capital structure arbitrage. This type of strategy is broadly employed in corporate credit markets, and is based on the relative value between differing components of a company’s capital structure (in our case the different tranches or classes of a CDO), and on the supply‐demand imbalances which can be exhibited in the pricing of rated and non‐rated tranches. From early 2006 to late 2007, there was a systematic relative value mispricing between the equity tranches of Mortgage CDO structures, which offered approximately 20% target yields, and mezzanine debt tranches of Mortgage CDO structures, on which credit protection could be bought for between 1% and 4% (depending upon which tranche and CDO).

If anything, the story of the Abacus deal makes the Magnetar letter more believable, since if Magnetar really just wanted to go short subprime securities, it could have done so Paulson-style, without taking on the equity tranche at all. ProPublica never really demonstrates that Magnetar was in the business of making Paulson-style directional macro bets, as opposed to clever relative-value plays which paid off very well when correlations unexpectedly went to 1.

That doesn’t mean that the Magnetar Trade was all sweetness and light, however. In trying to maximize the yield on its equity tranche, Magnetar surely influenced the makeup of its CDOs: it had every interest in building structures with high equity yields, and those structures by their nature were likely to be pretty risky. What’s more, Magnetar threw so much money at this trade that it helped to fuel the entire subprime bubble.

But between the disclosures and the long-equity part of the Magnetar Trade, it’s becoming pretty clear that this particular Abacus deal is significantly more egregious than anything Magnetar did. If you take all of the Magnetar deals and put them together, then they become bad by dint of sheer size. But if you’re a lawyer looking to nail a financial market professional for doing something wrong, then you’d do as the SEC did, and pass over both Magnetar and Paulson on your way to Goldman Sachs.

Goldman, after all, has to resort to saying, with a straight face, things like this:

The offering documents contained nothing materially false or misleading about ACA’s role, and no reasonable investor would have needed disclosures describing the participation of Paulson…

The fact that Paulson was unknown to ACA – which, as of May 31, 2007, had 26 CDOs valued at $17.5 billion under management – demonstrates that the fact of Paulson’s involvement would not have been material. Nor is there any evidence that IKB or ABN knew of Paulson at the time or would have changed their investment decisions one iota had they fully understood his involvement…

Similarly, the fact that ACA may have perceived Paulson to be an equity investor is of no moment.

None of this is plausible on its face. Goldman repeatedly says that ACA was a “reasonable investor” in the deal, and ACA clearly needed some disclosures with respect to Paulson’s role. Not because of who he was, but because of his reason for doing the deal in the first place. They thought he was with them, on the long side; instead, he was against them, on the short side. That knowledge, no matter who he was, would surely have greatly affected the back-and-forth between the two sides when they worked out a group of names which was mutually acceptable. Either you’re working with someone, or you’re negotiating against them. The difference is crucial, and Goldman should have made it clear.

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