In the wake of SEC/Goldman, the must-read Appendix

April 19, 2010

As luck would have it, I’m way late in writing my review of Yves Smith’s new book “Econned.” The book, which primarily describes how flawed economic thinking culminated in the financial crisis, is more important than ever in the wake of the SEC’s allegations against Goldman Sachs. In it, Smith reports extensively about synthetic CDOs. Goldman, of course, now stands accused of committing fraud in the structuring and marketing of one particular synthetic CDO, Fabulous Fab’s Abacus 2007 AC-1.

The most valuable part of her book may be the second appendix. In it she breaks down in minute detail the strategy that a hedge fund might employ to short subprime in large quantities via CDS. It’s a veritable roadmap to understanding other, similar malfeasance that may have happened in this market. The appendix, along with the the lengthy discussion of Magnetar in Chapter 9, together make a powerful argument that Goldman may not be the only firm that should face charges for securities fraud.

It seems to me that it shouldn’t matter whether Paulson & Co. took down the equity tranche of the Abacus deal. The securities fraud occurred when the CDO investors (ACA and IKB) were misled into believing that their interests were aligned with Paulson’s. But even if Paulson HAD taken down the $90 million equity tranche in order to get the deal done, his interests would still have conflicted with investors’ by virtue of the billion-dollar CDS insurance policy he took out on the deal.

Goldman not only knew about Paulson’s CDS position, it sold it to him. It then misled ACA into believing that Paulson’s interests were aligned with its own. By extension, it misled IKB into believing that ACA was an “independent collateral manager” when in fact Paulson gave ACA the bonds to put into the deal. Remember, Paulson as the perceived equity investor basically had the power to determine which bonds were included. Yet its undisclosed CDS position meant it wanted the most toxic bonds possible.*

Essentially, Paulson was insuring for full value a house deliberately designed to collapse. One he’d paid nothing to build. Goldman should have had the integrity not to do the deal in the first place. At the very least, investors should have been made aware.

Those trying to understand why other firms may face similar liability as Goldman should read Smith’s reporting on Magnetar, and her Appendix. Going long the equity tranche could actually be a brilliant trade for subprime shorts, as Magnetar’s stupendous returns appear to confirm.

Being long the equity tranche not only gave shorts the power to select the bonds in the CDO deal (the more toxic the better), it also gave them a cash flow stream to more than pay the cost of carrying the short position. That’s why Magnetar’s particular short trade is considered so brilliant in retrospect by the CDO cognoscenti: it more than paid for itself. “Positive carry” in the parlance. Smith’s appendix has the details.

It’s hard to imagine how other banks structuring similar deals for subprime shorts weren’t intimately aware of their true economic interest to see deals collapse. (Yes, the equity tranche might end up worthless, but CDS payouts after the whole deal pancaked would pay back a multiple of what was lost on the equity.) Michael Lewis’s book offers powerful reporting that the banks knew exactly what was going on.

Did they deliberately mislead investors about the independence of collateral managers? Did they mislead the managers themselves about the true economic incentives of the suprime shorts sponsoring the equity in their deals? If so, the banks should be brought up on the same charges now facing Goldman and the Fab.

UPDATE: After Khuzami said on Friday that the SEC would look to investigate similar deals, WSJ is reporting that they are indeed doing so. While it’s not clear what other firms/deals may be the target of investigations, WSJ mentions the usual suspects: Magnetar and Tricadia. The banks who helped structure their deals, Merrill and UBS, are already the subject of investor lawsuits.


*A particularly damning piece of the SEC’s complaint: “34. On February 5,2007, an internal ACA email asked, “Attached is the revised portfolio that Paulson would like us to commit to – all names are at the Baa2level. The final portfolio will have between 80 and these 92 names. Are ‘we’ ok to say yes on this portfolio?” The response was, “Looks good to me. Did [Paulson] give a reason why they kicked out all the Wells [Fargo] deals?” Wells Fargo was generally perceived as one of the higher-quality subprime loan originators.”


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Nobody has more proof than the SEC and they only found ONE problem. ONE.

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Heh. What that tells me, is what the historical lasseiz-faire attitude of the SEC for the last 15 years has missed. This problem was actually so big they managed to catch it…so what have they REALLY missed?


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The SEC isn’t finished with their (our) indictments. They indicted GS to give notice. There are many more civil and eventually, criminal, indictments to follow. Stay tuned!

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