In the various blogosphere efforts to dissect the Goldman Abacus transaction now in the SEC’s crosshairs, some commentators have characterized it as unusual, a “bespoke” CDO“, or “a very complicated deal…a supersynthetic CDO.” Effectively, the view is that Abacus is a multi-tranche variant on the single tranche CDO structure that was developed with corporate CDS, well before CDS on asset backed securities existed.
I was puzzled by these descriptions, because based on my reading of the prospectus, the notorious flipbook, and the SEC’s claim, I didn’t see anything terribly unusual, save that ACA was the manager and guarantor and some of the long exposures never were placed, meaning Goldman wound up stuck with them. Moreover, it seems likely that the Goldman suit is a test case for the SEC, and if it succeeds here, it may well launch other actions. Hence it would not serve the SEC to target an unusual deal. But I have thought a lot about hybrid CDOs (where some tranches are funded, some partially funded), not much about synthetics, so I could easily be wrong. I wanted to getting a reading from someone who actually puts these deals together, and an expert obligingly weighted in:
You’re right, any CDO could rightfully be called a “bespoke”… the underlying portfolios are all different. But the nomenclature “bespoke” implies something quite different when it is used in the structured product community. “Bespoke” deals are much more complicated and the term is much more often used in the CSO market. The typical “bespoke” deal is an n-th to default basket. An investor comes to a correlation desk and says: “in a basket of 100 IG corporate CDS, I want to take exposure on the 9%-15% slice.” The underwriter/arranger will take and (try to) hedge the risk on the remainder of the basket (i.e., 0-8 and 16-100).
This was not ABACUS. ABACUS was a normal CDO… just in unfunded form.
I think people are confused by the fact ABN’s name has been thrown into the mix. For their most part, their involvement is irrelevant to the CDO itself. One of ACA’s business lines was bond insurance. In this particular CDO, instead of funding the super senior tranche (i.e., creating a note and placing the proceeds from that sale in escrow, earning LIBOR, held there in case losses on the underlying portfolio required a payment to the protection buyer on the underlying portfolio of CDS), ACA essentially wrote protection on it to Goldman. Its the same flow of moving parts as a normal monoline policy… its just the note itself on which the policy was written was never sold/funded.
Goldman refused to take the credit risk of ACA so they did a back-to-back swap with ABN… where for a few basis points ABN agreed to take the credit risk of ACA not being able to pay on the policy and became the counterparty facing Goldman. I hope this makes sense… what it does is essentially make ABN the owner of the super senior tranche, with the benefit of a monoline insurance policy written by ACA.
The funded tranches of a deal like ABACUS — the bonds sold to IKB, the bonds sold into other CDOs, and the bonds Goldman was stuck with — act like the upfront margin in a standard CDS contract. Think of it this way…
I’m a hedge fund and I write protection on a Baa3 rated subprime bond currently trading at $100-00. The price implies the market’s current expectation that the bond will take $0 of loss… BUT, I’m a hedge fund selling protection on something rated Baa3 so my counterparty is still going to require me to post some upfront margin/collateral. That same idea applies to the funded notes in a synthetic CDO. The proceeds from the sale of the funded notes is placed in escrow (on a side note, the “escrow” accounts I’m referring to blew up as well… AIG/FSA did this business and took the money and invested it in subprime securities) and used as collateral against potential losses on the underlying CDS portfolio.
Nevertheless, ABACUS was a “plain vanilla” synthetic CDO and the ONLY reason Goldman was stuck with any long exposure was because it was a failed underwriting. They would have placed the bonds if they could but no one would buy them at the price at which they were offered.
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This is very helpful but what about the questions at the heart of the SEC suit:
1) was Paulson’s role in the portfolio selection process normal in these deals?
2) would IKB have cared that Paulson intended to go short?
Steve,
Recall that the SEC’s contention is misrepresentation, that Paulson was shorting the deal while ACA was given the impression that he was the equity investor.
The Paulson role on this deal is bizarre. My understanding is that the sponsor, who either invests in the equity tranche or otherwise “funds” it (as in a pure synthetic deal would presumably fund at least part of his equity exposure) can and typically does influence the parameters of the deal. The idea is that the equity investor, who is presumably out to protect himself from losses, is also protecting all the other long investors. Plus the equity tranche was normally very hard to place, so that was another reason to give the equity investor influence, as an inducement.
At a minimum the equity investor would normally demand a target yield (which could be set high, which would the force the party picking the collateral to choose very spready, meaning risky, bonds). My understanding is that the equity investor could also reject bonds. On Magnetar deals, even though Magnetar denies it, there are reports of Magentar presenting lists of bonds it wanted in on deals it sponsored.
I’m not sure how unusual this degree of influence by a sponsor WOULD be; it certainly seems much more aggressive than the norm but not outside the pale. What is bizarre and awfully deceptive is Paulson being presented as the equity when he did not play ANY role on the long side (per Greg Zuckerman’s book on subprime shorts, Paulson did sponsor some synthetic CDOs in which he took down the entire short side). WTF is he doing negotiating with ACA? I know other monolines (who normally were not told who the equity investor was, the banks insisted that was proprietary; the only reason ACA was told was that it was also the manager) when they learned Magnetar had been the equity investor, they did everything in their power to avoid being on any future deals with them.
So why/how was Paulson presented as the equity investor when he wasn’t? This is a very big misrepresentation, separate from the issue of his being on the short side. Maybe Paulson welched on his long commitment partway through, but that seems odd too.
I have no idea re IKB, but I think any investor would care to learn that a short investor had effectively picked the collateral. It’s a pretty sure bet they’d testify to that effect. The question will be whether there are any communications within IKB or between IKB and Goldman that would muddy the waters.
A 10b5 action like that of the SEC requires several elements to be established:
1) a misrepresentation
2) that is material
3) that the investor relied on in making their decision
4) that caused the loss suffered by the investor
The alleged misrepresentation is Paulson’s role – yet it is clearly in dispute whether his role was understood as a long or short. Let’s assume Goldman fooled IKB into thinking he was long not short.
Would IKB have viewed knowing whether he was long or short important? Perhaps on the face of it it would. But IKB had access to the mortgages underlying the reference portfolio and could do their own analysis. In fact, the Offering Circular GS provided them advised them to do just that. They actually wanted ACA involved for that reason and seemed willing to rely on them. Since Paulson’s role or not had nothing to do with the eventual performance of those mortgages and thus their long position why would they have cared whether Paulson was involved or long or short? Keep in mind they had their shady deal going selling CP to unsophisticated investors funded by their investment in Abacus. Should we shed any tears on their behalf?
That raises a question of course about the third element. Even if Paulson was portrayed as going long and the fact that he was short might have made IKB re-think the investment, did they rely on this deception in making their decision? It seems as if they knew there was a need for an ACA to be involved and that that was good enough for them. (One open question: was ACA a selection agent on other Abacus deals or did IKB want them in on just this deal – if the latter it suggests they knew Paulson was short and they wanted someone in their to do battle with Paulson over the selection process.)
Finally, causation – did the deception cause the loss suffered by IKB? If Goldman’s failure to reveal Paulson’s role would have caused IKB to overestimate the value of the investment, perhaps. But IKB knew there was a short on the other side of the deal – i.e., GS! So would the fact that another short namely Paulson would step into GS’s shoes at some point through a swap have altered their assessment of the value of the deal? It seems unlikely.
Oh, I forgot scienter – the requirement that the Government prove GS acted with intent. I have yet to see how they can establish that GS acted with intent to deceive IKB. Yes they earned a fee for the deal, but they ended up long themselves and lost money overall. They could as easily be accused by Paulson of fooling him because he did not know that a big sophisticated German bank was going long on the deal.
Now, all of this is subject to full evidentiary discovery and testimony and so I could be wrong in my assessment. And I will also make one other concession: I have read the risk factors prepared in the offering circular provided to IKB. There are several pages of risks in single space text describing the deteriorating condition of the housing market. However, there is a generic quality to the risk factors and there does not seem to be anything in them that raises a red flag that would alert IKB to the fact that while other Abacus deals were ok, this one might have some dead fish hidden in the reference portfolio. It is possible – but only remotely imho – that had GS told IKB about Paulson’s role they might have sat up and taken notice and said, wait a minute, let’s dig into this a little further.
That’s a stretch, however, and at first glance when the risk factors actually told IKB that there was deterioration underway in the RMBS market. It spoke specifically of the “serious economic difficulties” facing several originators and a “declining market” for loans. In other words, it was clear that IKB was trying to catch a falling knife.
IKB is no longer KfW (german state) controlled. It was sold to Lone Star if I remember correctly. I guess all litigation is handled/controlled by this firm as german politics wanted this thing buried. They even stopped internal investigations by the auditors much to shareholders dismay.
I guess Lone Star would arrange itself with Goldman for a favour here and there…..
I thought it wasn’t plain vanilla because Paulson bought protection directly on the CDO tranches and not on the reference securities. Didn’t you note this in your first post on the subject?
Also, no equity tranche was issued, which is unusual. This encouraged the tranche protection design.
You picked a good expert to explain! I agree – this was more plain vanilla than not.
As commentary, I agree GS had a failed underwriting and submit the reason is GS forgot who its god is. They should have been praying to the potential noteholders – not to Paulson. Their inherent and non-resolvable (and of course, non-disclosed!) conflict in serving Paulson to the detriment of noteholders is really the heart of the issue. I can attest that the most complicated aspect of negotiating these types of structures is, as an underwriter, getting people comfortable with the structural incentives to and for each party. It really is follow the money, follow the fees, follow the counterparties, follow the disclosure, follow the side letters.
On a different point, the fact that Paulson or anyone else outside of GS has not been named YET by the SEC is semi-irrelevant. These cases, I believe, tend to be built from the ground up, not the top down. The devil is in the details and the guys that built the deals and talked to/negotiated with the parties are obviously the detail. Don’t be so sure no one else is going to get dragged into ABACUS-gate.
“The typical “bespoke” deal is an n-th to default basket. An investor comes to a correlation desk and says: “in a basket of 100 IG corporate CDS, I want to take exposure on the 9%-15% slice.””
If I understand Steve Waldman correctly his view is precisely that Paulson came with a basket of 100 MBS and said I want to take short exposure to the x% – 100% slice.
The only difference between Abacus and standard bespoke CDO is that Goldman chose to package the bespoke CDO as a vanilla synthetic in order to sell off some its risk. (I’m assuming that some negotiation over the underlying is not particularly unusual in bespoke deals.)
csissoko,
In a single tranche CDO, only the tranche desired by an investor is created (and on the LIABILITY SIDE, not the asset side). The prospectus CLEARLY contemplates a full liability side and asset side of a normal CDO.
This isn’t merely a matter of the prospectus; there are hundreds of pages of other legal documents (the trust agreement in particular) that correspond to the offering memo. You can’t modify these things on the fly.
What is getting everyone bent out of shape is that Goldman was the initial protection buyer, then sold customized short positions to Paulson that referenced the CDO. Those are trades separate and apart from the CDO.
“The prospectus CLEARLY contemplates a full liability side and asset side of a normal CDO.”
That’s the point of Waldman’s critique. The prospectus proposes a full liability side — while it’s far from clear that Goldman ever intended to have a full liability side.
See David Harper’s chart here: http://www.bionicturtle.com/learn/article/goldmans_abacus_structure_illustrated/
I’m aware of the chart.
The deal had a full liability side. A single tranche CDO would ONLY contemplate a partial liability structure. The fact that some tranches were not funded does not change the picture. The fact that Goldman was stuck with some unsold tranches also does not change the nature of the transaction.
Yves, I realize that in my previous comment I got the asset and liability side of the CDO wrong. (My brain has yet to adapt to the topsy turvy modern financial world where the sale of insurance is an asset not a liability.) What GS did was claim that it was selling a full portfolio of credit default protection for Abacus (i.e. the asset side of the CDO) when in fact it was only selling the 21% to 100% “tranche” of that protection. Just because standard bespoke CDOs were long, that does not mean that a client-tailored short CDO position does not merit the name “bespoke” CDO.
The candy man says Goldman should go free!
==> Buffett, whose Berkshire company holds $5 billion in Goldman shares, agreed.
“I have no problem with that Abacus transaction,” he said to reporters Sunday. “If there were other things that were hugely troublesome, I haven’t seen them.”
Berkshire vice president Charlie Munger redirected to the conversation toward a “dysfunctional” financial system that tempts…
>>>> Let this be a lesson to all you dumbass bloggers, Warren is not in jail, because he is a sweet old man who is as innocent as Goldman ….. gads, how can people screw up something so simple???? Get a life and help support Warren and Goldman!!!
It’s a war? A good war….
Re: Update 3-May-2010: Yves Smith publishes a note from an anonymous correspondent claiming that ABACUS was just a failed underwriting ….
http://www.interfluidity.com/v2/814.html