On The SEC’s ABACUS Case Against Goldman Sachs

8 May

Back in Sophomore (maybe Junior) year Finance class, we learn some very basic approaches to investment analysis. Before we ever touch upon analytical methods, we learn high-level stuff, for example, first and foremost you should analyze a potential investment on its merits; extraneous information is, at best, of secondary, tertiary, or just no concern. If I’m considering buying the ABACUS synthetic CDO deal at the heart of the SEC’s case against Goldman, my primary focus is to analyze the RMBS transactions in the reference portfolio selected by ACA (NOT Paulson – ACA could have throw out EVERY/ANY security Paulson suggested if they thought it was a crap bond), the structure of the deal. Once I’ve done the granular analysis of EVERY bond in the reference portfolio – as close to loan-level as possible, especially with the 20+ person diligence team that IKB reportedly employed – and decided everything looked good, then and only then would I get into other considerations. Have we covered all our bases? Are we missing anything? What are other smart people doing with this/similar transactions?

I firmly believe this story pretty cut & dry: IKB/ACA/ABN did their diligence (well, let’s give them the benefit of the doubt they did, at least) and determined they wanted to buy the deal. They had the blessing of the Ratings Agencies (which, with the wisdom of hindsight – key word – we know was not a very bright idea), they had other “smart” people reinforcing their view (long live confirmation bias!), and the financial industry, as a whole, was generally still long housing.

Anyone who claims that the buyers (longs) would have backed-out if they knew some no-name Hedge Fund manager with ZERO mortgage investing experience suggested part of the reference portfolio is material is full of it. The buyers were arrogant, over-confident in their experience and ability to analyze complex structured finance transactions. Hell, if they WERE made explicitly aware of Paulson’s “involvement” they probably would have enjoyed a good, hearty laugh at his expense and quite possibly even bought MORE of the deal when they knew they were up against such a rube, a novice, a guy in WAY over his head.

One person on the other side of this debate says that in order for me to make such a claim I must be either clairvoyant or have worked on IKB’s deal team in 2007. While I think that’s a bit of a non-sequitur, I’ll allow it, and then accuse the SEC of the same apparent psychic abilities. How on Earth do they presume to prove what IKB WOULD have done? How could anyone prove what they WOULD have done in the past? Sure, I WOULD have prepared differently for the GMAT’s if I knew I was going to run out of time on the math section, but I didn’t KNOW that would be the outcome, since I knew the material very well. Similarly, IKB “KNEW” structured finance RMBS investing, they just didn’t know or expect the outcome we know so well with the benefit of hindsight.

That’s it. Everything else is irrelevant. IKB knew the material that was going to be on the test (the composition of the reference portfolio and all other relevant deal information), they had the ability (experienced deal team) to prepare for the test (analyze the deal), they just came to what turned out to be the wrong conclusion, and didn’t do as well as they expected.

Ultimately, whether Paulson’s involvement will be decided in court, and what I have to say is, unfortunately, just words on a page.  I agree there is the possibility that when all of the information is made available (emails, etc), there may have been an intent to deceive, or scienter,but that’s for the courts/lawyers/etc to decide.

Update: Since I published this in haste (my bad), I should have rephrased the bolded text three paragraphs up, to ask “How does the SEC believe they can use the ‘reasonable person’ test in this situation?”  That is, this is a market, which by definition necessarily includes two parties both of whom believe themselves to be reasonable with different, nay, opposing views.   Thanks to @_phlox for the legal edit.

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14 Responses to “On The SEC’s ABACUS Case Against Goldman Sachs”

  1. Morgan_03 May 8, 2010 at 2:32 pm #

    Nice work, unfortunately the damage has been done to GS & banking in general and that French pricks emails dont help. Hopefully GS can settle this and just move on.

  2. Teri Buhl May 8, 2010 at 3:29 pm #

    I agree “IKB knew the material that was going to be on test”. You write that some claim you can’t say that becuase you haven’t talk to IBK or GS in early 07.
    Well I did interview Deutsche Bank CDO managers for a story in The Atlantic, who were the lead people who sold to IBK. They sold similar CDO’s in March 07 and swear IBK did a lot of due dilligence on the collateral in the CDO’s and knew what they were buying and very much wanted to buy these high yield CDO’s. So I think it’s fair to assume that IBK did the same due dilligence with the $GS CDOs.

    The question the courts now have to figure out is what really is material in disclosure rules. I actually don’t think Goldman shouldn’t settle. I think they need to go to court so we can see what other evidence the SEC has. How will we ever know if this was just an abuse of power by the SEC – as Morgan_03 said the reputational damage is already done for Goldman – and even if they are found not guilty they have to cover the cost of rebuilding their customers trust.

    • Anal_yst May 9, 2010 at 8:07 pm #

      Agreed, thank you for being the voice of reason!

  3. David Larsson May 8, 2010 at 4:51 pm #

    Nice post. Your “scienter” hyperlink really got me thinking, and helped me put my finger on what’s really bothering me about Abacus.

    I can understand that it offends your sense of craft as a trader for the govt/courts/press/publc to come in after the fact and (i) reward IKB/ACA/ABN for sloppy due diligence and/or losing strategy and (ii) punish Goldman/Fab (Paulson some day?) for a winning strategy. Fair enough. That’s because you’re thinking about it as a matter of contract between two consenting parties (which is how I also tend to think of things, I’m a dirt lawyer). And if the sole result were that IKB/ACA/ABN’s representatives ended up making a bad deal and spending their retirement years eating dogfood, I could live with that. I have two issues:

    1. The foregoing assumes, as you suggest, that the SEC can’t prove that Fab/GS perpetrated fraud upon IKB/ACA/ABN by actively tricking them into thinking that Paulson was long: see SEC complaint 44 – 51. If Fab/GS did perpetrate the fraud, then Fab/GS are toast: it’s hard for me to picture myself as Fab’s lawyer keeping a straight face when I argue “Your Honor, now that the SEC has established that Fab went to great lengths to lie about Paulson’s involvement in the deal, it doesn’t matter, because that’s not a material fact.”

    2. My main problem is that everybody knows it’s not IKB/ACA/ABN’s representatives or GS’s representatives who are going to end up eating dogfood: it’s people who lost 50% of their retirement accounts in 2008 who are eating dog food. Given the stakes involved, these massive derivative plays are not really a simple contract problem between two parties: the deals are so huge, the consequences are so unknown (because the deals are so opaque), and the interconnectedness of this decade are all so great that they become “inherently dangerous activities” (see the Rylands v Fletcher case referenced in your scienter hyperlink) that society has an interest in limiting by imposing strict liability (not just negligence) upon the person causing the activity. “One who keeps a wild thing ‘must keep it at his peril.'”

  4. Danny Black May 8, 2010 at 7:26 pm #

    Teri, IKB were up to their gills in exactly this type of product. They WANTED this exposure and rode the products all the way down to zero because they had convinced themselves these products were a good buy. There had to be a pretty general meltdown in particular section of the subprime markets for IKB to lose so comprehensively and they clearly didn’t expect that. Hence why Paulson’s involvement is not material.

    David, the issue here is that yet again incompetent investors are being bailed out. IKB clearly had extremely poor risk management and a sign they were incompetent was that they rode these babies down to zero. The ilk of IKB is why we had a bubble. You can argue that Americans were borrowing too much but at the end of the day this product existed because there were not enough loans to satisfy investor demand. You can argue the banks helped facilitate these trades but that again is only because demand was there. As long as you fail to deal with why investors regularly get to make poor decisions and then blame someone else we are going to keep getting these bubbles. That is why this case is such a disaster for any decent regulation.

    • Anal_yst May 9, 2010 at 8:03 pm #

      This is perhaps the best comment on anything I’ve ever written. Thank you!

  5. Retail Donkey May 9, 2010 at 1:35 am #

    I am out of my league in these comments but can someone give me a sense of the upside for IKB in this deal? By my understanding their upside was ridiculously small. To be clear, I am not saying this is material in the case, I am just curious.

  6. perrymecium May 9, 2010 at 2:09 am #

    The upside for IKB was their belief that the US housing market would continue to rise. Doing the deal in April 2007 was exquisitely poor timing. Apparently so poor that the SEC is accusing Goldman of fraud rather than congratulating them for escaping the financial crisis.

  7. Retail Donkey May 9, 2010 at 4:49 am #

    Can one be any more material than “US housing market would continue to rise”? Again given that I am talking outside my expertise, it seems as though they took the long side of a synthetic CDO which would necessarily mean they where taking the long side of a group of CDS. Therefore it would seem, in my retail wisdom, that they (i.e. IKB) were in effect taking on a definitive upside of payments on the CDS in the portfolio. Am I way off here?

  8. Thomas May 9, 2010 at 11:02 am #

    I love (LOVE!) the fact that this suit is starting to put focus on the real perpetrators of this crisis: THE BUYERS OF MORTGAGE SECURITIES. The idea that IKB or ACA can call themselves investment advisers after having executed such a piss-poor strategy is beyond comprehension. The fact that no one seems to care about this is wild! I feel like I’m living a world, where everyone walks around saying in low, monotone voices: “It is the fault of the seller. The seller should protect the buyer. The buyer has no responsibility for making a bad decision. It is right to look for scapegoats after the fact.”
    Wake. Up. People.

  9. pcdunham May 11, 2010 at 1:37 pm #

    Awesome! What bothered me most was the focus on the short side, as if there is something inherently wrong with being short. If IKB was basing it’s decision on who was on the other side, they shouldn’t be considered qualified to manage money. WTF happened to personal responsibility? Everyone is looking for someone else to blame. Goldman was just an easy scapegoat. Lets face it, it was great populist theater for congress to put “arrogant bankers” in front of cameras and grill them so the public focuses on GS instead of FNM & FRE.

  10. Retail Donkey May 11, 2010 at 9:00 pm #

    To echo what has already been said with respect to this ABACUS deal: caveat emptor.

    To go further, has anyone read an article printed by the main stream media that makes the housing consumer complicit at all in this mess? Clearly, the politicians blame “Wall Street greed” and “predatory lending” but I think the extent to which “Main Street” was over leveraged in housing has been underplayed drastically.

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