How ACA was misled by Goldman in Abacus deal

[Cees Binkhorst]

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Een typisch voorbeeld hoe Goldman klanten aan beide kanten belazerde.

Groet / Cees

How ACA was misled
Apr 17, 2010 16:07 EDT
banking

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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Comments
14 comments so far | Comments RSS
Apr 17, 2010
4:28 pm EDT

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.

Anal_yst
http://www.stonestreetadvisors.com
Posted by Anal_yst | Report as abusive

Apr 17, 2010
4:30 pm EDT

that should be “disingenuous” btw, damn spell check!
Posted by Anal_yst | Report as abusive

Apr 17, 2010
5:08 pm EDT

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

Apr 17, 2010
5:19 pm EDT

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

Apr 17, 2010
6:30 pm EDT

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

Apr 17, 2010
7:24 pm EDT

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

Apr 17, 2010
8:40 pm EDT

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

Apr 17, 2010
9:26 pm EDT

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

Apr 17, 2010
11:35 pm EDT

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

Apr 18, 2010
4:06 pm EDT

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

Apr 18, 2010
5:37 pm EDT

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

Apr 18, 2010
7:57 pm EDT

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

Apr 18, 2010
8:14 pm EDT

DanHess, is your real name Ben Stein?

Of course not, you’re just channeling the bad Ben.
Posted by HBC | Report as abusive

Apr 19, 2010
10:11 am EDT

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

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