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.