On Materiality, Goldman, Abacus $GS

12 May

As my last post stated, the SEC – absent some sort of damning evidence we’ve yet to see – has its hands full proving Goldman’s lack of disclosure of Paulson & Co’s involvement in the Abacus CDO was material and amounts to fraud. They’re up against some interesting precedents, for example, TSC Industries Inc v. Northway, Inc, in which the judge’s logic went as follows, and found (see http://en.wikipedia.org/wiki/TSC_Industries,_Inc._v._Northway,_Inc.):

“If the test was too stringent, it would cause the dismissal of otherwise meritorious lawsuits; if it were too lenient, corporate officers would be inclined to overwhelm shareholders with such a large volume of information that truly valuable facts might escape them. He formulated the test as follows: an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. In other words, the court must determine whether under all the circumstances, the omitted fact would have assumed actual significance in the decision of the shareholder. Thus, materiality is a mixed question of fact and law.”

As I’ve argued, I don’t buy that full, explicit disclosure of Paulson’s involvement would have changed anything (excepting perhaps, as Steve Randy Waldman said, if IKB decided they’d be violating their mandate, but thats another conversation altogether).

I’ll try to post some more later,

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12 Responses to “On Materiality, Goldman, Abacus $GS”

  1. Byrne May 12, 2010 at 12:23 pm #

    Part of the problem is that our disclosure regime has evolved from a time when the stuff disclosed would be non-fungible hard assets. i.e. “The company owns X miles of track, and Y locomotives, plus Z cash.” When you look at that stuff, it’s easy to get a rough estimate of what’s material and what isn’t.

    But when you’re dealing with complex financial instruments, enumerating all the assets in a portfolio/structure is just overwhelming (it fits the enforceable letter of the law, not the spirit). What you’d want, ideally, is a set of models and formulas that tell you what the assets should be worth under different scenarios, and what assumptions go into that projection.

    A nice midpoint would be to present structured data (which the SEC is apparently asking people to do, see: http://kelloggfinance.wordpress.com/2010/04/08/the-sec-gets-one-right/ ).

    • Anal_yst May 12, 2010 at 1:00 pm #

      Uh, its called scenario-modeling/testing and its hardly anything new, fancy, or secret. As a matter of fact any analysis absent such work would be laughed-at even in an Undergraduate Finance class. Come on, man!

      In order for the Abacus buyers (longs) to get f’d on the deal, their models (and the underlying assumptions driving them) probably indicated an extremely low probability of the confluence of events that happened (correlations -> 1, etc).

      • Byrne May 12, 2010 at 5:41 pm #

        Right, that’s why spending time on the assumptions is important. It would be a lot easier to resolve the whole Abacus thing if there was a line in the prospectus like “All these numbers rely on the assumption that residential real estate will continue to appreciate, liquidity will not vanish, the top five investment banks in the US won’t all either go under, get taken over, or convert to bank holding companies, etc.” Obviously something extreme like that isn’t necessary, but in this case it would have been very easy to say “One of the inputs in this model is property prices. Our worst-case scenario is a real return of 1% with basically no volatility. If things get worse than that, expect really bad returns.”

        The docs I’ve seen for this deal cover things in either a really general way (“ACA is awesome. Here’s why.”) or an ultra-specific way (“Here is the entire reference portfolio. It’s a bunch of indistinguishable BBB-rated securities.”). Good information to have, but it means that IKB can complain that there was just so much data that they couldn’t figure out what was important (except the counterparty. They know that was of crucial importance to whether or not the mortgages that made up those reference securities would default).

        • Anal_yst May 12, 2010 at 5:49 pm #

          What I think you’re missing is that anyone who would potentially buy this deal (or one like it) has the capabilities, expertise, etc such that the offering materials didn’t contain “a bunch of indistinguishable BBB-rated securities.”

          IKB has no leg to stand on if they just didn’t do the diligence and analysis required for such a complex security. Its not as if you or me are sitting at home with our computer and yahoo! Finance; these guys had several (perhaps dozen) seasoned financial professionals on their team and access to data sources and tools that we don’t.

          • Byrne May 12, 2010 at 7:16 pm #

            Sure, IKB completely messed up the trade, and the SEC action is ridiculous.

            But from what I’ve read about Paulson’s trades (and Burry’s, and Lippmann’s), even though they spent a lot of time on individual MBS products, the actual returns just came from generally being short. There was obvious crap and non-obvious crap, but it was all crap in the end.

            In fact, the whole point of the credit/quant/real estate/etc. bubble was that you could boil anything down into a product that could be priced based on some kind of static formula. The Abacus prospectus seems to be based on the idea that IKB could, fundamentally, buy slices of individual loans to Joe and Jane Homeowner, whereas what they were actually buying was a huge exposure to a single variable (home prices) that moved in the wrong direction for them. Basically, they thought they were banking, and the prospectus was for a (complicated, attenuated, sliced-and-diced) banking transaction–but really, it was a macro trade.

  2. CFN May 13, 2010 at 8:03 am #

    I like the logic. I do have a question for you. Besides exposure, what is the purpose of allowing Clusterstock to link your posts. The commentors on that site are simply populists who will not listen to reason. I applaud you for even taking the time to argue with them but at some point do you think it is a waste of time?

    • Anal_yst May 13, 2010 at 11:57 am #

      You hit the nail on the head at the beginning of your second sentence. Every now and then there’s some pretty reasonable comments there and I like hearing what all sorts of people have to say, whether its from some schmuck sitting in his skivies on his Lazy Boy in bumblef*ck, Nowheresville with zero formal financial education or experience or industry pros.

  3. Anal_yst May 13, 2010 at 12:02 pm #

    @byrne

    What you’re saying, in too many words, is that until 2007/2008 everyone (this was taught in classes at Universities) that the U.S. residential real estate market was a fantastic correlation trade, i.e. there was no chance in hell defaults in Nevada would affect RMBS comprised of loans from across the country i.e. home prices were geographically uncorrelated.

    What we’ve learned, is that in a uniform credit bubble, they are highly correlated.

  4. Anal_yst May 13, 2010 at 12:14 pm #

    er that should be “everyone THOUGHT…”

  5. john May 13, 2010 at 6:31 pm #

    wow. good luck growing that brain.

    • Anal_yst May 13, 2010 at 6:34 pm #

      Thanks for the constructive, thoughtful comment! I really appreciate what you’ve brought to the table. Feel free to come back if you ever have any similarly useful commentary, thanks!

  6. Beutty May 18, 2010 at 9:11 am #

    In this case, the disclosure that a small-time hedge fund manager was both short and playing a role in the security selection process almost certainly would not have caused IKB to alter its investment decision. However, whether or not an investor would change his mind based on a given disclosure is not the relevant question here. An omitted fact can be material and still not change an investor’s mind. The real question is whether or not IKB would have considered the disclosure significant or relevant. To me, whether the hedge fund is SAC or it’s two guys working 12-4 in front of a Bloomberg MWF, I would find it relevant to know that the fund playing a role in the security selection process was short, rather than long — even if I still do the deal exactly the same way I would have had such a disclosure not been made. That being said, this case is clearly an example of a witch hunt driven by partisan politics.

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