Goldman’s biggest lie

By Felix Salmon
April 23, 2010
Abacus for Dummies: a very useful quick overview of the structure of the deal. And in doing so, he helps to reveal Goldman's biggest lie.

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Alea has given us Abacus for Dummies: a very useful quick overview of the structure of the deal. And in doing so, he helps to reveal Goldman’s biggest lie.

Simplifying Alea even further, we have five steps here:

  1. The reference portfolio is put together.
  2. Goldman sells super-senior protection, Paulson buys it.
  3. IKB and ACA sell senior protection, Goldman buys it.
  4. Goldman takes the senior protection that it bought from IKB and ACA, and sells it on to Paulson.
  5. Goldman buys super-senior protection from ACA, through ABN Amro.

From Goldman’s point of view, steps 3 and 4 cancel each other out as a perfect hedge, and it can walk home happily with its fee income. And steps 2 and 5 should do the same thing, but they don’t: in step 2, Goldman sold super-senior protection on the top 50% 55% of the deal, while in step 5 it bought super-senior protection only on the top 45% 50% of the deal. So the hedge was imperfect, Goldman ended up long 5% of the deal, and, in the end, it lost lots of money.

But the fact is that there are two big-picture deals here, not one — and yet they’re very intimately connected.

In the first deal, the super-senior deal, Goldman acts as an intermediary, first selling protection to Paulson, and then buying it from ACA via ABN.

In the second deal, the actual Abacus deal, Goldman creates the Abacus vehicle, which issues securities to IKB and ACA, which are ultimately funded by Paulson taking the other side of the trade.

Now, let’s look at a page from the pitchbook:


The Super Senior tranche here is the one in the first deal; Class A is the notes which were sold to IKB; Classes B, C, and D were sold to ACA; and the First Loss equity tranche at the bottom is the bit of the deal which never existed since, as Alea says, “the deal doesn’t need an equity investor (and doesn’t have one)”. The fact of its nonexistence is conspicuous by its absence: “Not Offered” is by no means the same thing as “Does Not Exist”.

The fact is that the Abacus deal itself didn’t need a super senior investor, either, and didn’t have one. It just needed classes A through D, which were sold to ACA and IKB. The super-senior deal was entirely separate, and had nothing to do with Abacus, although it used the same portfolio of reference securities.

So the question arises: why on earth is the super senior tranche (and the equity tranche, for that matter) even listed in the pitchbook in the first place?

When Goldman refers to ACA as “the overwhelmingly largest investor in the transaction”, it’s clearly referring to the transaction as a whole, including the super-senior deal, rather than just the Abacus part of it. And what’s more, there’s something clean and elegant about the way in which the structure of the deal, as outlined in the pitchbook, goes smoothly all the way from First Loss all the way to 100%.

In theory, as far as I can tell, there’s no reason why the 45-50% tranche — the one that Goldman ended up holding onto and losing $90 million on — should ever have existed either: it, like the equity tranche, could simply never have been offered to anyone. Why didn’t Goldman just move the attachment point for the super senior tranche up from 45% to 50%, so as to match the hedge it bought from ACA via ABN?

After all, Paulson was not buying credit protection on the reference securities as a whole. But that’s how it looks, in the pitchbook. Here’s the pretty picture of the structure, in the same book:


If you’re ACA, looking at this structure, you know that as the deal is being put together, you’re negotiating to insure the Super Senior Amount which exists in this picture as a semi-fictional entity outside the structure and inside a grey dotted box. In other words, while you know it’s not a formal part of the Abacus structure, you also know that it exists.

And in this picture, the First Loss Amount has the same ontological status as the Super Senior Amount: it exists, but only outside the formal confines of the Abacus deal. Since ACA knew full well that the super-senior tranche existed — after all, it was negotiating to insure it — there’s no reason why it should have doubted that the equity tranche existed as well, just like it did in Magnetar trades with which it was familiar.

Here’s Goldman Sachs, in its letter to the SEC:

The fact that ACA may have perceived Paulson to be an equity investor is of no moment. As a threshold matter, the interests of an equity investor would not necessarily be aligned with those of ACA or other noteholders, and holders of equity may also hold other long or short positions that offset or exceed their equity exposure. Indeed, Laura Schwartz of ACA understood this from her work on a transaction that closed in December 2006 in which Magnetar, a hedge fund that bought equity and took short positions in mezzanine-level debt, participated. (See GS MBS-E-007992234 (“Magnetar-like equity investor”).)

This is, I think, inadvertently damning to Goldman’s case. It’s true that in the Magnetar deals the entity which was long the equity tranche was also short the debt. But at the same time, it’s also true that in the Magnetar deals there was no question that the equity tranche existed. So if ACA’s Schwartz was thinking in terms of the Magnetar deal which closed just before the Abacus deal started being negotiated, then it’s quite understandable that she believed in the existence of an equity tranche in this deal, too. And Goldman never did anything to disabuse her of that belief.

The clear message of the pitchbook is that this synthetic CDO was put together to mimic a cash CDO, which has to have all of its tranches spoken and accounted for. You can’t have a cash CDO without an equity tranche. Remember that if the only point of the Abacus deal was to create the Abacus securities, then there wouldn’t have been a super-senior tranche at all, and ACA would not have been the largest investor in the transaction.

Here, then, is arguably Goldman’s biggest lie of omission: it never told ACA that the equity tranche didn’t exist. If it was being a true and honest broker, it should have done. End of story.


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I agree. also, Paulson could have just shorted using the ABX, without having to go through all of the hassle of the Abacus transaction.
The only point of putting the deal together this way was to mislead the investors into thinking this was a real deal.
i still can’t explain the Goldman “unsold” portion – because there is no reason for it to have existed.

Posted by tja3 | Report as abusive

Nice, just 3 points:
a. the pitchbook is a preliminary document, it can change (and it did).
b. this is not a cash CDO, it’s a synthetic.
c. whether there is or not an equity tranche or a super senior tranche has zero relevance for the performance of the Abacus notes.
the equity tranche has to be included in the pitchbook even if not offered, because it is necessary to virtually price this tranche to value/rate the tranches senior to it.

Posted by alea | Report as abusive

Wait, if the equity “first loss” tranche never exsisted then who was taking the first 3% of loss? The A-D tranche exhaust figures only add up to 97%. Forgive my potential ignorance here. I would have assumed the 10% “first loss” equity tranche would over collateralize the deal.

Posted by david3 | Report as abusive

This is mistaken: as shown in both the diagram and the capital structure, the equity tranche is simply unfunded. To say “it does not exist” has no meaning; it is reference credit enhancement (like over/collaterization)

Posted by bionicturtle | Report as abusive

“Goldman sold super-senior protection on the top 50% of the deal, while in step 5 it bought super-senior protection only on the top 45% of the deal”

Shouldn’t it be 55% and 50% respectively?

Posted by mister_x | Report as abusive

Any thoughts about why this isn’t a private action on behalf of ACA or IKB against Goldman? The SEC complaint reads as if ACA and IKB (but especially ACA) suffered from Goldman’s actions, but if that’s the case, I’d expect that ACA/ABN/IKB would be suing Goldman directly rather than the SEC action.

I realize that both could occur, but I haven’t read that ACA or IKB is suing, and if so, I think that’s telling.

Posted by Beer_numbers | Report as abusive

Interesting: this is exactly how Sandrew interpreted the deal. So there was no cash component at all – that would have made it hard to buy protection on the SS. In fact, it may be that GS initially had no intention of finding a counterparty for the 45-100. When they came around to Paulson’s correlation view, they had to scramble to find what protection they could.

It is normal to sell only one side of single-tranche synthetic; you would just sell the tranche and manage the exposure in a correlation book. That’s fine for a reference portfolio based on something like CDX which is pretty liquid and which also trades standardized tranches, which let’s you trim your correlation sensitivity.

But here the probable hedge instrument would have been ABX, which is not as nice. tja3, there are two reasons why Paulson would not have just gone short ABX. One is that ABX is pretty thin; you would move the market by trying to short 1.8bn x 55% = 990mm. The second is that Paulson would have had to pay the whole index premium, whereas in this structure he only had to pay a tiny fraction of that to get 990mm exposure in the total-default scenario he envisaged.

GS was probably able to delta-hedge the 45-50 with ABX, because the tranche delta would have been pretty small. But that would have left them with the residual correlation/JTD risk. So I guess they really did lose 90mm. My heart goes out to them in this difficult time.

Posted by Greycap | Report as abusive

Oops, I guess Paulson actually had exposure to a little over 65% of 1.8bn, say 1.18bn. Still way cheaper than the same notional of ABX.

Posted by Greycap | Report as abusive

The traunches are simply the loss intervals on the underlying reference portfolio. To say that 1-10% did not exist is nonsensical. It may be that nobody was betting on or against it, but the equity traunche existed in the exact same way as the others did.
Abacus sold bonds whose yield enhancement came from the proceeds of someone buying protection on these other traunches and that is very well represented in the diagrams.

Posted by Ledbury22 | Report as abusive

All of these alleged adults were investing in artificial securities that were based on loans that were sure to default, and people are discussing who screwed who? Does that happen in Las Vegas? When people lose at blackjack or some other game, and they later realize the odds were with the house, does the government file fraud charges against the casinos?

Goldman was running a casino, and they were the bookie on a bet between two parties with way different perspectives on reality. It would be like if a basketball game was being played between the Lakers and a group of college all-stars, and Paulson was betting on the college team because he looked at the rosters and saw that the Lakers were not the current ones, but guys who last played basketball in 1960. ACA didn’t bother to look at the rosters and assumed an NBA team couldn’t lose (please, no jokes about the current Lakers, I’m still not over last night’s loss). Is it the bookie’s fault one of the gamblers didn’t read all of the available information about the game?

I’m going to keep saying this, Goldman is a parasite, but the real crime is that people gambled other people’s money on incredibly stupid bets that shouldn’t have been considered investments. The fools who took the other side of Paulson’s bets are being portrayed as victims, when they should be viewed as the incompetent, grossly overpaid drunk drivers who squandered trillions of dollars while taking hundreds of billions of dollars in bonuses before their incompetence was exposed.

Getting rid of middle men like Goldman will yield no benefits to society if the operators of the heavy financial machinery are still allowed to run those vehicles in total ignorance of how they work, and with zero accountability for their mistakes.

More re-arranging the deck chairs on the Titanic…

Posted by OnTheTimes | Report as abusive

Abacus included both the notes and the super senior tranche.

The Abacus SPV per se was a component of the total Abacus transaction. The SPV issued the notes as the conduit for the related cash flows as described.

The super senior tranche was part of and not separate from Abacus. It’s performance was a function of the entire $ 2 billion reference portfolio, as was the performance of the notes.

That the equity tranche wasn’t offered is irrelevant to the holders of the actual tranches issued. It makes no difference to the performance of those tranches, based on the reference portfolio as constructed.

Whether such information was or wasn’t conveyed, it in no way qualifies as a lie, because it’s existence or non-existence within the synthetic structure was irrelevant to the performance of the other synthetic tranches.

Posted by JKH | Report as abusive

Mr. Salmon, you get the best comments. Thumbs up @greycap.

Posted by mutant_dog | Report as abusive

Ledbury22 is exactly correct. Any disagreement with that (sorry) just doesn’t understand SCDO

Posted by bionicturtle | Report as abusive

exactly, the equity tranche exits, in this case virtually, because nobody bought it and that was very clear from the pitchbook => no fee, no coupon, not offered, “qualified investors” dealing in CDO and reading prospectuses know what that means.

Posted by alea | Report as abusive

@mutant_dog, @greycap: Agreed that @greycap’s comment is stellar, and not just for giving me props. The point that GS could have (and probably did) hedge the 45-50 supersenior tranchlet with ABX.HE.BBB.06-2 is insightful.

FYI: My speculative timeline is at

Posted by Sandrew | Report as abusive

…not just insightful, but germane to the ruling in the court of public opinion. If Goldman hedged the 45-50 tranchelet w/ ABX, yet excluded it from their calculation of losses, then they’re being disingenuous in trying to garner sympathy. BTW, if they did hedge, they almost certainly are disingenuously excluding it from the reported $90m loss. It’s hard to lose $90m on a $91m hedged exposure where the only risk you’re exposed to is index-bespoke basis. And as GS notes in their defense letters to the SEC, the ABX sucked just as hard as the abacus reference portfolio.

Posted by Sandrew | Report as abusive

greycap – that was my point. if Paulson made his true intentions know – a $1bn short bid on these assets, it would have cost him much more because few people would have been interested in going long BBB. thus, they had to dress it up in this “CDO” with a “manager” to get someone to go long for that big an amount.

when you say the market was thin that’s what it means: not many people wanted to go long unless you pay them much more than the theoretical spreads the market maker claimed was the going rate for BBB. If all of the shorts were actually going long in the index at BBB instead of in CDOs, where it was disguised as AAA, then BBB pricing on the ABX would have been hundreds of basis points wider.
that was the game.

Posted by tja3 | Report as abusive

I love how Sandrews says the most nonsense things to provoke some of the most educational comments. Agree that to say equity tranche “doesnt exist” has no meaning/relevance…whats important is ACA/IKB doesnt bear that first loss

Posted by CSstar | Report as abusive

Can you explain GSIs role as the collateral put provider?

From the diagram it looks like GSCM bought protection from Abacus, and GSI sold Abacus a put on the collateral. Isn’t that circular?

If the collateral is impaired Abacus puts the impaired collateral to GSI, while GSCM collects on the purchased CDS, net ecposure to consolidate GS = 0.

What am I missing?

Posted by mcnet | Report as abusive

tja3 – BBB on ABX index did not exist when Abacus structure was being created…

Posted by TinyOne | Report as abusive

Many people above have covered the gap, but allow me to (over)simplify as usual:

It’s not that the First Loss and Super Senior tranches weren’t available–it’s that no one was willing to buy them at a price for which GS was willing to sell them. (Remember, =synthetic= CDO.)

By May of 2007, most of the world knew that the MBS market was for shite, and that the worst was both Yet to Come and Just Around the Corner. (The traders, if not the reporters, knew that it wasn’t just subprime that was dead.)

The pricing for the toxic waste and “cherce” pieces wasn’t at a level where there was a market. (Whether it was at a reasonable level for the work involved, especially in the latter case, during the entirety of 2002-2007 is left as an exercise to the reader; suffice to say, car companies weren’t the only place where profits came primarily from one area of the business.)

Posted by klhoughton | Report as abusive

@CSstar: Why the ad hominem attack? The reason I stated that the first-loss tranches “never existed” was to clarify the misconception that Paulson had managed to purchase protection on the entire (0-100) hypothetical capital structure, when in reality he only shorted the higher-rated tranches. We can debate what words are appropriate to describe a tranche of a synthetic CDO in which no one takes a position. “Nonexistent” seemed appropriate to me at the time, but if you have another suggestion, I’m open to hear it. (My rhetoric worked, by the way.) But in any event, I think we can both agree that a semantic debate over how best to describe the subordination level is miles from relevant.

Oh, and I do understand that (and why, and how) the subordination level on single-tranche swaps are a critical term.

Posted by Sandrew | Report as abusive

mister_x, good catch. Thanks. Fixed.

clarify, tranches on the ABX BBB did not exist yet, sorry if any confusion

Posted by TinyOne | Report as abusive

@TinyOne: Excellent point. So I guess that means Goldman couldn’t have hedged the 45%-50% tranchelet–at least not very well. On closer inspection, Greycap pointed this out by suggesting a delta-hedge and retaining exposure to correlation and JTD. All the more props to you both.

Posted by Sandrew | Report as abusive

Biggest lies, cont.d

A legal final maturity commitment of 2037 runs about thirty years past the designated explosion date.

Posted by HBC | Report as abusive

It is intellectual challenging to analyze the scheme, but at the end this is financial pornography as its best, executed by the brightest smart boys of Wall Street, and thus a total waste of time. For ordinary people it takes hard work to make money and really smart work to keep it. For a large % of Wall Street boys all it takes is to design schemes that few ordinary people really understand and add to them a bit of lies here and there. Let’s be honest, it is not the left wings activists or socialists the ones destroying capitalism and the free enterprise system, it is the insatiable greed of guys in Wall Street and captains of industry and commerce te ones doing it. Therefor financial reforms are not only desirable, they are absolutely necessary.

Posted by ZAMORANO | Report as abusive

ABX was introduced over a year before this Abacus transaction. Perhaps you mean the TABX?
even without TABX, Paulson could have easily shorted BBB on the ABX – except there was no long demand.
he could have easily have shorted A on the ABX – except there was no long demand.
and once the TABX was introduced for tranching of the BBB level, he could have easily have shorted that, except that it collapsed within days of its launch and virtually no one would go anywhere near it.
The pricing of BBB MBS bonds should have reflected this (absence of) long appetite, but it didn’t (yet). the pricing of the Abacus deal should have reflected this pricing, but it didn’t (yet). according to the prospectus felix posted, the classes offered by the prospectus rates between 85 and 110bp over libor – for junior AAA risk.

interestingly – exhibit A of the prospectus has lots of neat details about the referenced collateral (like: current actual amount $12 mn, current notion amount: $22 mn). but there is no mention of the BBB pricing for the bonds – no bond price, purchase price, coupon, etc. were they all bought at par? a premium, a discount? who knows! who cares – it’s synthetic!

Posted by tja3 | Report as abusive

Goldman’s biggest lie!
Goldman’s problem at present, is not explaining that what they did was in their minds legal and they are going to refute all charges by the SEC.
But realizing the SEC is not interested in taking prisoners and hence, Goldman have been chosen for a sacrificial offering.
“i.e., they are bull about to be released into the ring and the SEC has the suit of Lights”

Posted by The1eyedman | Report as abusive

One of the best articles all around, in a long time, good length and graphics.

One thing though, the biggest lie is the media lie that this one range of transactions and one trader and one bank and one country triggered the meltdown.

People all over were fed credit,like bait and couldn’t service it, various financial instruments were short-sold, and investors got caught short, HFT and carry trade.

What looks like good news, is actually bad news.

Posted by Ghandiolfini | Report as abusive

…sure enough, the banks had to bailed out, that domino effect would have been fatal, but

The banks should now bail out customers in distress and come to the party with lifeboat initiatives, they are the quick avenue, Feds and Treasuries have an admin lag of note, worse than fiscal drag.

Maybe the banks will become humane, throwing the fish back into the water with those massive earnings’ reserves.

Posted by Ghandiolfini | Report as abusive

Holy complicated, Batman! The subprime households are the lower box in the corner getting hosed

Posted by STORYBURNcom_0 | Report as abusive

As a non-financial professional, I’m not clear on the point of:”Here, then, is arguably Goldman’s biggest lie of omission: it never told ACA that the equity tranche didn’t exist.”

Is it that “didn’t exist” means “no investor was willing to take on the risk of the equity tranche?” If not, please explain. If so, then why would ACA assume that there was such an investor?

Posted by sklein11 | Report as abusive

by OnTheTimes:

“When people lose at blackjack or some other game, and they later realize the odds were with the house, does the government file fraud charges against the casinos?

Goldman was running a casino, and they were the bookie on a bet between two parties…”

Very good comparison. However you conveniently chose to ignore that one party came to the table with loaded dice and the casino knowingly approved that.

Posted by vlscout | Report as abusive

viscout, it wasn’t a dice game. It was a sports game, and the rosters of both teams were available for both gamblers to see. The losers of the bet never bothered to look at the rosters, they just took the word of some sportswriter (Moodys or S+P) who favored one team heavily.

If Goldman actually cared about their clients as they are falsely rumoured to (like a bookie might do with one of his repeat customers), they would have told the losers that they really didn’t think it was a great idea (assuming that people at Goldman were all in agreement that the bonds were a bad idea, which they weren’t, as they placed bets on both sides). But Goldman doesn’t really care about its clients, as long as they think they can be replaced, which they obviously are able to do, over and over, because their customers, managers of other people’s fortunes and pensions, are completely inept.

Posted by OnTheTimes | Report as abusive

OnTheTimes: ” It was a sports game, and the rosters of both teams were available for both gamblers to see.”

Well, one player was not content with just seeing the teams. He made sure to influence its composition, otherwise he would not have played at all.

Goldman did not disclose this to the other player.

IKB would not have bet if knowing that their team was hand-picked by their opponent in the game, regardless how lazy, greedy for yield and incompetent they are.

You do not need much due diligence to realize that it is wise not to bet in such case.

Posted by vlscout | Report as abusive

viscout, many “investment banks” (if any derision is detected, it is intentional) broker deals without both parties knowing who the other side is. That’s why the buyers and sellers often use a third party, because they WANT to be anonymous. Otherwise, they might as well use ebay. Did IKB ask Goldman who was on the other side of the deal? (if they didn’t, then is it still Goldman’s fault?) And if Goldman refused to tell them who was on the other side, why did they still go ahead with it? If the identity was important to them in their decision to gamble their client’s money, why did they do it without knowing who the seller was?

Also, the creator of the bonds is irrelevant, unless you are somebody who is willing to bet billions of dollars of other people’s money solely on reputations that have no basis in reality. Then I can see why you would want to know who put the bonds together. What you seem to be saying is that IKB has absolutely no responsibility to perform any due diligence, and that their clients should be content paying them their fees just for buying things based on face value (“Goldman sold it to us, and that means it’s a good investment”. Or were they expecting an automatic profit on their investment? Did they not know there was somebody who would lose money if they made money? Or did they think it was all magic, that profits are created out of thin air, with no risk to anyone?

Posted by OnTheTimes | Report as abusive

OnTheTimes, try reading the pitchbook again. There’s a whole section about ACA, its qualifications, and its personnel and their backgrounds and qualifications. Nothing there about any role for Paulson, or even anything to the effect of “The manager may be assisted from time to time by outside specialists.”

So this suggests strongly that asking someone to invest into Abacus (yes, I know there would be more involved than just one pitchbook) was like asking someone to bet on a special exhibition game between the Chicago Cubs and the Boston Red Sox, but without mentioning that the Cubs were not playing their usual roster, but instead one hand-picked by the manager of the St. Louis Cardinals from a pool of all major and minor league baseball players in the U.S.

Posted by SelenesMom | Report as abusive

Good analogy Selenesmom. It was difficult to understand the steaming pile of excrement that was the Abacus deal, but over the past week, I have come to understand it very well, indeed.

My head is shaking now rather then reeling at the high risk/high yield bets on non-entities, being made other people’s money by those entrusted with their life savings and retirement funds.

Words like Investment, banker, broker, client, synthetic, credit, debt, trust, security, ethics and other such words all have a different meaning then I realized, in the ‘sophisticated’ world of finance.

Posted by hsvkitty | Report as abusive

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Posted by sidsahu | Report as abusive