According to the SEC's complaint, filed in U.S. District Court for the Southern District of New York, the marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. The SEC alleges that undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.These are our financial geniuses at work on a straight con. The CDO lost 83 percent of its value in the first six months. Nice.
The SEC's complaint alleges that after participating in the portfolio selection, Paulson & Co. effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure. Given that financial short interest, Paulson & Co. had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson & Co.'s short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors.
James Kwak at Baseline has a helpful exegesis on the "type of transaction involved — in which a hedge fund makes a CDO as toxic as possible in order to then short it." He notes:
It seems like the key will be proving that Paulson influenced the selection of securities enough that it should have been in the marketing documents. Paragraphs 25-35 include quotations from emails showing that Paulson was effectively negotiating with ACA over the composition of the CDO, so it’s pretty clear he had influence. The defense will presumably be that ACA had final signoff on the securities, and Paulson was just providing advice, so Paulson’s role did not need to be disclosed. (I don’t know what kind of standard will be applied here.)Kwak adds, "no doubt to the annoyance of many, I don’t blame Paulson. It’s Goldman that had the duty to its investors, not Paulson."
Michael Lewis is more explicit about all this in an interview that Kwak quotes elsewhere:
all of the people you mentioned all swallowed a general view of Wall Street, which was that it was a useful and worthy master class, that these people basically knew what they were doing and should be left to do whatever they wanted to do. And they were totally wrong about that. Not only did they not know what they were doing, but the consequences of not knowing what they were doing were catastrophic for the rest of us. It was not just not useful; it was destructive. We live in a society where the people who have squandered the most wealth have been paying themselves the most, and failure has been rewarded in the most spectacular ways, and instead of saying we really should just wipe out the system and start fresh in some way, there is a sort of instinct to just tinker with what exists and not fiddle with the structure.Lewis also hits this blog's humble theme, the intellectual limits of the mass middle class that continues to prevent it from overcoming its humiliating defeat by financial forces it never bothers to understand:
The question is how does Washington move away from those institutions and make decisions that are in the public interest without regard for the welfare of these institutions. It’s a hard question because . . . this is the problem. Essentially the public and their representatives have been buffaloed into thinking that this subject — financial regulation, structure of Wall Street — is too complicated for amateurs. That the only people who are qualified to pronounce on this are people who are in it. And there are very very few people who aren’t in it in some way who have the nerve to stand up and fight it. . . .
The reporter as much on this beat as anyone in the U.S. Gretchen Morgenson, discusses why John A. Paulson who set this up was not indicted. Paulson's firm released a statement that said in part,
There’s no question we made money in these transactions. However, all our dealings were through arm’s-length transactions with experienced counterparties who had opposing views based on all available information at the time. We were straightforward in our dislike of these securities, but the vast majority of people in the market thought we were dead wrong and openly and aggressively purchased the securities we were selling.Morgenson (and Louise Story) continue:
After analyzing risky mortgages made on homes in Arizona, California, Florida and Nevada, where the housing markets had overheated, Mr. Paulson went to Goldman to talk about how he could bet against those loans. He focused his analysis on adjustable-rate loans taken out by borrowers with relatively low credit scores and turned up more than 100 loan pools that he considered vulnerable, the S.E.C. said.In a video clip, Story points out that the case seems to be proof that Goldman does bet against instruments it markets to its own clients, contrary to its repeated denials. In another clip, the SEC's Robert Khuzami answers questions about the compliant.
Mr. Paulson then asked Goldman to put together a portfolio of these pools, or others like them that he could wager against. He paid $15 million to Goldman for creating and marketing the Abacus deal, the complaint says.
One of a small cohort of money managers who saw the mortgage market in late 2006 as a bubble waiting to burst, Mr. Paulson capitalized on the opacity of mortgage-related securities that Wall Street cobbled together and sold to its clients.
The complaints are finally getting under way.