Chidem Kurdas
From the Securities and Exchange Commission’s claim, “Goldman Sachs failed to disclose to investors vital information …. in particular the role that a major hedge fund played in the portfolio selection process,” you might think that John Paulson, the manager of the hedge fund in question, was Goldman’s secret partner in the subprime mortgage-based collateralized debt obligation called ABACUS 2007-ACl.
In fact, Goldman introduced Paulson & Co. to the main party in the deal, ACA. Mortgage-backed securities specialist ACA Management picked the underlying securities for the portfolio; its parent, bond insurer ACA Capital, took on the credit risk by insuring the notes.
According to the SEC complaint: “On January 8, 2007, (Goldman employee Fabrice) Tourre attended a meeting with representatives from Paulson and ACA at Paulson’s offices in New York City to discuss the proposed transaction.” The ACA people met the Paulson people—repeatedly. They wanted to know why Paulson was involved in the CDO. You would think they asked this question while they sat in the Paulson office.
The SEC would have us believe that despite all the hobnobbing with Paulson, ACA fell under the misapprehension that Paulson was buying the equity chunk of the CDO—and Tourre caused or prolonged this mistake. “Paulson’s economic interest was unclear to ACA, which sought further clarification from GS & Co.,” says the SEC. But why would ACA seek clarification from Goldman instead of directly asking Paulson?
What is more, the charge that ACA believed Paulson would take an equity stake in the deal is bizarre. Paulson’s bearishness on mortgages was already established by then. As the SEC itself states; “Beginning in 2006, Paulson created two funds, known as the Paulson Credit Opportunity Funds, which took a bearish view on subprime mortgage loans by buying protection through CDS on various debt securities.”
Paulson told investors that he was bearish on subprime mortgages, believed the market would crash shortly and was looking for ways to bet against it. This was widely known. Paulson & Co. could not credibly be a buyer for the equity tranche in a sub-prime synthetic CDO—an investment guaranteed to be wiped out in the market crash Paulson expected. Besides, this CDO had no equity tranche.
The SEC argument implies ACA missed that Paulson was bearish, would not ask the Paulson managers despite repeated conversations with them and also missed that the CDO they were working on had no equity tranche. Yes, people can be incompetent, but it is more plausible that ACA knew Paulson was the other side of the trade. That must have been why they spent time at the hedge fund’s office—the two sides were bargaining.
ACA did not just take Paulson’s suggestions of what mortgages to include. An email from ACA, with the subject line “Paulson Portfolio 1-22-10.xls.” makes this clear: “Of the 123 names that were originally submitted to us for review, we have included only 55.” They proceeded after Paulson agreed to their selection.
ACA Capital then “wrapped” or insured the $909 million super senior tranche of the CDO—for a fee. To do this, ACA got credit from the Dutch bank, ABN AMRO. ACA presumably wanted the business. Therefore it wanted Paulson involved, because without someone taking the other side there can be no synthetic CDO. Goldman was the intermediary, but ACA in effect did the deal with Paulson.
The transaction was certainly not among Goldman’s finest. The German bank, IKE Deutsche Industriebank AG, bought $50 million of notes, but Goldman could not sell all the notes, had to hold a block and made a $100 million loss as a result. The $15 million fee it received for brokering the deal did not come close to making up for the red ink.
The SEC complaint says nothing about Goldman’s loss, probably because this weakens the government’s allegation that the brokerage intentionally created a losing CDO. You can argue that Goldman initially thought it could unload the notes and therefore was not bothered by this being an inherent loser.
But a CDO without an equity tranche is tough to sell—without the equity cushion to take potential losses the debt is too risky. Goldman should have known that it might not sell all the ABACUS paper and end up holding some of it. It did not make sense to take that position if you agreed with Paulson’s prediction.
Truth is, had the property boom continued, the CDO would have made money for ACA, ABN AMRO and IKE, as well as for Goldman. Then the loser would have been the Paulson hedge funds and ultimately Paulson investors. People took different sides to this trade—the only guarantee was that one side would lose and the other would win.
Tags: ACA Capital, John Paulson
HedgeFundSmarts 