Wednesday, April 21, 2010

Paolo Pellegrini's Testimony Could Undercut SEC Charge Against Goldman

CNBC's Steve Liesman reports: The SEC has testimony from Paolo Pellegrini, who negotiated the deal with ACA, that could contradict SEC's claims against Goldman Sachs. Paolo Pellegrini, ex right hand of Paulson, told ACA that he chose the portfolio of CDOs based on the low FICA score and high debt-to-value ratio. His intent to short the portfolio was clear and hard to miss.

Watch Steve Liesman discussing the case

Pellegrini is the Rome-born analyst who helped hedge fund operator John Paulson to make a ton of money on the subprime crash in 2007 and 2008. Pellegrini and his colleagues crunched tons of U.S. mortgage data, concluded that housing prices were due for a collapse, and invested accordingly. Paulson made over $3.5 billion on the trade. Pellegrini, is now investing his personal money via his firm PSQR Capital.
Paulson Protege Pellegrini on Bernanke's Fed: "Sheer Lunacy" Posted by: Peter Carbonara on November 16, 2009

Paulson's investors are concerned

by Gregory Zuckerman and Jenny Strasburg

John Paulson hasn't been accused of any wrongdoing. But the hedge-fund billionaire has gone on the offensive to reassure investors that his huge firm will emerge unscathed from a case that has drawn him into a political and legal vortex.

The steps, including a conference call with about 100 investors late Monday, come amid indications from some clients that they might withdraw money from his firm after a lawsuit brought by the government against Goldman Sachs Group Inc. related to an investment created at his firm's request.

[paulson] Bloomberg News

John Paulson

Investors have indicated they are concerned that scrutiny over the firm's deals may spread, including to overseas regulators. They said they wanted to protect themselves in case new information emerges that could damage the hedge fund, they say. Another issue, they say: The legal case could simply prove a distraction for Mr. Paulson.

"Some of the callers asked pointed questions, almost like a court inquisition, but most people were supportive," said Brad Alford, who runs Alpha Capital Management. "I felt reassured that he did nothing wrong."

WSJ Professional

"It's not a rush for the doors," said another investor in Paulson & Co. who has communicated with larger Paulson investors since Friday, when the government unveiled its Goldman case.

Mr. Paulson sent a letter to investors Tuesday night saying that in 2007 his firm wasn't seen as an experienced mortgage investor, and that "many of the most sophisticated investors in the world" were "more than willing to bet against us."

Mr. Paulson's firm focuses on largely liquid investments, or those that are relatively easy to sell without pushing prices much lower. Even if a number of investors ask out, the firm likely will be able to sell investments without crippling their holdings, investors say.

Some traders have been examining Mr. Paulson's top holdings and positions in which filings indicate he has been a substantial holder since the news, they say. When the news of the lawsuit broke on Friday, some of these stocks, including Conseco Inc., Cheniere Energy Inc. and AngloGold Ashanti Ltd., fell sharply.

The case has delayed the planned initial public offering of a Canadian investment fund, Propel Multi-Strategy Fund, which was formed to give individual investors exposure to two funds advised by Paulson, according to people familiar with the offering. Propel didn't respond to requests for comment.

On the Monday night conference call, some investors asked if Mr. Paulson or anyone at the firm had received a government notice of potential civil charges, called a Wells notice, according to people familiar with the call.

Mr. Paulson said no. Mr. Paulson said the case wasn't a distraction that was affecting the firm's investments, and that he was confident the public glare would abate.

On the conference call, Mr. Paulson calmly explained the trade with Goldman, which involved a "short" bet on mortgage bonds. He said that the very nature of the transaction required both a "long" and "short" investor, suggesting that investors knew that a bearish investor had bet against the deal.

Mr. Paulson suggested to clients that the large investors who purchased the Goldman deal and others relied on rating firms, and didn't do enough of their homework, investors say.

The hedge-fund firm has a deadline next Friday for investors who want to withdraw money on June 30. Paulson allows most investors to pull out four times a year, but they need to give at least 60 days notice. Investors can cancel redemptions before the end of June.

Magnetar Capital LLC, another hedge-fund firm that, like Paulson, was heavily invested in collateralized debt obligations in 2007 also has been working to reassure investors that it believes its mortgage-linked investment strategy was sound and can withstand regulatory scrutiny.

Investors in Magnetar, which oversees some $7 billion in assets, also have a deadline next week to request June withdrawals of money. The Evanston, Ill.-based firm sent an 11-page letter to investors Monday saying that it didn't control which individual assets went into CDO deals in which it invested.

It isn't clear whether ongoing scrutiny of Magnetar will rattle its investors, who have known some details of the firm's strategy for several years. An article earlier this month in news outlet ProPublica was the latest to assert that Magnetar designed deals built to fail that caused cascading losses for investors on the other side of the trades. The hedge fund's strategy was also the subject of a January 2008 Wall Street Journal article. Magnetar told investors this week that it based its mortgage-CDO strategy on statistical models, not a fundamental belief that the housing market would slide.

A Magnetar spokesman said, "Our communications with investors have been very positive and supportive."

(from WSJ, April 21, 2010)

Tuesday, April 20, 2010

Carmignac Second Only to Gross After Epiphany Yields 42.6%

By Anne-Sylvaine Chassany

On Sunday March 8, 2009, fund manager Edouard Carmignac was wandering in a paddy field near Chiang Mai, Thailand as equity markets were tumbling to their lowest point in 13 years when he decided to bet on stocks again.

In the days after, his firm, Carmignac Gestion, bought more than 5 billion euros ($6.7 billion) of stocks and indexes, the maximum it could invest. A week later, he purchased U.S. banking stocks, including JPMorgan Chase & Co. and Wells Fargo & Co.

“Markets were in absolute despair,” Carmignac, 62, said in an interview in his office overlooking the Place Vendome in Paris, between jewellers Van Cleef & Arpels and Boucheron. “The weekend newspapers were predicting the end of stocks. It was too good to be true.”

The firm captured the market rebound, which started that very Monday, and more. Carmignac Investissement, his all-equity, 6.9 billion-euro fund, posted a 42.6 percent return at the end of the year compared with 27.4 percent for the MSCI AC World Index. The firm’s biggest fund, the 19.8 billion-euro Carmignac Patrimoine, which mixes stocks and bonds, ended up 17.6 percent, after avoiding a loss in 2008, the worst year for financial markets since 1937.

That performance helped Patrimoine to collect more money last year from investors than any fund except Bill Gross’s PIMCO Total Return, according to New York-based Strategic Insight Mutual Fund Research & Consulting LLC. The firm has tripled its assets under management since December 2008 to 40 billion euros and expects to reach 50 billion euros this year.

“Edouard Carmignac is not only experienced, he’s very talented,” said Thomas Lancereau, an analyst at Chicago-based mutual fund analyst Morningstar Inc., which in February named him European manager of the year for international stocks. Morningstar rates Carmignac’s Patrimoine and Investissement funds “elite,” its highest rating.

The French fund manager was there at the right time with the right products, as investors went back to basics and turned to independent managers after suffering big losses with larger asset managers in 2008, Strategic Insight consultant Daniel Enskat said.

“Carmignac is the Cinderella story of the fund management industry,” Enskat said. “He’d remained relatively small for 15 years, but with the credit crisis, everything came together and there has been a massive snowball effect.”

The French fund manager is now buying emerging markets stocks and commodities, which make up 52 percent of the firm’s holdings and will drive growth this year, he said. The rest is mostly invested in U.S. stocks, which should benefit from the country’s recovery, he said. Europe accounts for 10 percent of the firm’s portfolio.

Carmignac’s preferred stock is U.S. gold mining company Freeport McMoran Copper & Gold Inc., which doubled in the past 12 months. He has boosted his stakes in China Construction Bank Corp., All America Latina Logistica SA, Brazil’s biggest railroad operator, and MasterCard Inc. He sold Barclays Plc because growth in Europe will trail both the U.S. and emerging markets, he said. Wells Fargo and JPMorgan, the two banks he bought, rose 98 percent and 55 percent in the last year.

In principle, the decision to buy stocks that day in March 2009, when he was finishing a two-week Asian trip visiting companies, didn’t surprise Carmignac’s 148 employees. The magnitude did.

“An average manager would have taken a gradual approach,” said Rose Ouahba, head of bonds at Carmignac and who co-manages Patrimoine with Carmignac. “Edouard doesn’t do things half- heartedly.”

“It takes balls and brains to be good at this job,” Carmignac said.

In the week leading to the decision, the dozen indicators the firm was monitoring such as Korean exports and copper stocks started recovering, said Frederic Leroux, fund manager in charge of risk management at Carmignac.

“I had urged Edouard to gradually increase our exposure to stocks, but he would say, ‘Not yet, not yet,’” Leroux said.

The weekend newspapers’ headlines convinced Carmignac markets had reached the bottom.

Carmignac, who as a child was educated in a British school in Peru, has stuck to the same top-down approach of focusing on broad investment themes and making big, concentrated bets he developed when he started his firm in 1989. His stock-picking takes its roots in the same trend he spotted 21 years ago: emerging markets will drive growth and commodities prices up.

“The world has always been my natural playground,” said Carmignac, who has a master’s of business administration from Columbia University in New York. “Of course, if we don’t understand, we stay away. But unlike Warren Buffett, we try to do more than razors and Coke.”

Patrimoine has climbed 32.4 percent in the three years through March, beating the 5.3 percent gain in its benchmark, a combination of the MSCI AC World and Citigroup WGBI indexes, according to Morningstar. The fund is up 60.2 percent over five years, against 21 percent for the benchmark.

Carmignac says his other key strategy is to use derivatives to hedge his holdings in difficult times and change gears quickly in rebounds. The instruments, which Leroux oversees for Carmignac, have been critical to protect clients’ money during the past two recessions.

The firm started using them after the Sept. 11 terrorist attacks in the U.S. led to a 26 percent loss for Investissement and a 3.6 percent loss for Patrimoine in 2001, Eric Le Coz, head of strategy, said.

In 2002, Investissement posted a 3.7 percent gain, compared with a 32.6 percent loss for the MSCI AC World. Patrimoine ended up 5 percent while its comparable index lost 15.6 percent. The following year, the firm more than doubled its assets under management to 1.8 billion euros.

“Not losing money during downturns is priceless for clients,” Le Coz said.

Leroux set up hedges for Patrimoine, including short sales of the S&P 500 and EuroStoxx indexes, after the fund lost money in September 2008, when Lehman Brothers Holdings Inc. filed for bankruptcy. The hedges generated a 20 percent gain, offsetting a 20 percent loss on the portfolio, which the firm had also redirected to defensive stocks, Leroux said.

“When Lehman happens, nothing makes sense anymore,” Carmignac said. “There’s no good or bad investment theme. You’ve got to admit to it and set up hedges.”

The challenge for Carmignac in the coming years will be to maintain its historic performance, while assets under management balloon, said Strategic Insight’s Enskat.

“Today’s blockbusters could be tomorrow’s blow-ups, there have been examples in the past and Carmignac knows it,” Enskat said.

The fund manager’s investment philosophy is naturally going to be tested because he has to move more assets, Geoffrey Bobroff, president of Rhode Island-based Bobroff Consulting Inc., which follows the mutual fund industry, said.

“It’s going to be more difficult to find the diamonds in the rough,” Bobroff said.

The firm has proven in the past it could manage big bursts of growth, Morningstar’s Lancereau said. “They should do OK, as most of their holdings are companies with large, hence liquid, market capitalizations,” Paris-based Lancereau said.

The French fund manager, who also collects contemporary art and participates in the Queen’s Cup polo tournament in the U.K. every year, said that “we’re not asset gatherers” and “what interests us is absolute performance.” Yet, growth has its advantages, like being better served by brokers and getting access to top management of big companies, he said.

Morningstar says Carmignac’s expense ratio is above the median. He dismisses it, saying he wants his firm to be “the Hermes of the fund management business.” The minimum investment for individuals is 300,000 euros.

Carmignac, who owns about 70 percent of his firm’s shares and who has “almost all” his liquid assets invested in Investissement, said he wants to emulate Boston-based Fidelity Investments, the world’s largest mutual-fund company with $1.5 trillion under management, which has remained closely held. That’s why his daughter Maxime, 30, joined the firm this year as fund manager after an experience at New York-based hedge fund Visium Asset Management LLC, he said.

Artwork by Roy Lichtenstein or Keith Haring pushes Carmignac to think out of the box, he said. The paintings, which hang on almost every wall, including Jean-Michel Basquiat’s Falling Angel, also help him and the firm’s 20 fund managers and analysts stay grounded.

“Lenin and Mao are here to remind me,” Carmignac said, looking at the giant portraits of the Soviet and Chinese leaders by Andy Warhol hanging on both sides of his desk. “Never take anything for granted.”

(from Bloomberg, April 21, 2010)

Andrew Maguire recently blew the whistle on gold and silver price manipulation orchestrated by JP Morgan

Gold and the Coming Short Squeeze9.51023

Greg Canavan is the editor of Sound Money. Sound Investments, a weekly report on the best value investment ideas in the Australia share market, with a commentary on the global economy and economics.

A few weeks ago a momentous event occurred in the precious metals market. As we detailed in a report to paying subscribers, a London metals trader by the name of Andrew Maguire recently blew the whistle on gold and silver price manipulation orchestrated by JP Morgan.

He provided exact details of the fraudulent trading to officials at the Commodity Futures and Trading Commission (CFTC) before and during the manipulation episodes. Unbelievably, the CFTC ignored these claims. Even further, they did not allow him to give evidence at the recently held CFTC hearings into position limits in the commodities markets.

(The hearing was in part designed to investigate whether allowing market players to hold large positions would lead to price distortions or manipulations).

So Mr Maguire went public and told his story to Gold Anti-Trust Action Committee (GATA) member Adrian Douglas. GATA have been claiming for years that the precious metals prices are manipulated in order to boost confidence in fiat currencies. Without the manipulation, gold prices would be much, much higher.

There are many who dispute this claim. But to be honest their reasons are flimsy. It's far easier to reject something out of hand than to be labelled a 'conspiracy theorist', as GATA and their supporters are. But if you take the time to actually think about the claims and study a bit of history, you'll see that government manipulation of the gold price is nothing new.

Let's take just a few examples.

Roosevelt's Attempts to Manage Gold

Soon after Franklin Roosevelt's inauguration in 1933, he set about the highly controversial policy of 'inflationism'. Funnily enough, the same policy is accepted wisdom today.

His first step was to 'temporarily' - which actually meant permanently - end the export and hoarding of gold. The next step was to announce that the US was off the gold standard.

The impetus for this was, as always, political. Roosevelt's primary motivation was to appease the farmers, who were groaning under the size of their mortgage debt and were demanding higher prices for their product. His aim was therefore to raise the price level for commodities, agricultural commodities in particular.

He became wedded to the theories of a Professor Warren from Cornell University. Warren believed that if the price of gold was increased, commodity prices would follow. Even the inflationist Keynes thought the theory was 'rubbish'.

But it didn't stop Roosevelt. He arranged for the Reconstruction Finance Corporation (RFC) to purchase gold on the US Treasury's behalf. Each day for weeks on end, the RFC would announce the price it was willing to pay for gold, a price that was always higher than the prevailing free-market price.

Needless to say the plan did not work, commodity prices did not benefit but the policy was causing grief in other parts of the economy. And faith in the value of the US dollar was at rock bottom.

Roosevelt convened a meeting to halt the experiment. With some of his advisers fearful of the effect of a weak dollar, Roosevelt said: '...if at any time the dollar should get too weak, the RFC could always reverse itself and sell some gold to the world markets'.*

And a few days later, that's just what they did. But it wasn't long before the period known as the 'gold standard on the booze' came to an end. In January 1934, Roosevelt announced the return of the US to gold at the prevailing market rate of $35 an ounce. In nine months the US dollar had lost 40% of it value against gold.

The London Gold Pool

Fast forwarding a few decades and we come to the second example of blatant government manipulation of the gold price. It concerns the London Gold Pool, established in 1961 to maintain the price of gold at $US35 an ounce. The paragraphs below are taken straight from Wikipedia.

'The London Gold Pool was the pooling of gold reserves by a group of eight central banks in the United States and seven European countries that agreed on 1 November 1961 to cooperate in maintaining the Bretton Woods system of fixed-rate convertible currencies and defending a gold price of US$35 per troy ounce by interventions in the London gold market.

The central banks coordinated concerted methods of gold sales to balance spikes in the market price of gold as determined by the London morning gold fixing while buying gold on price weaknesses. The United States provided 50% of the required gold supply for sale. The price controls were successful for six years when the system became no longer workable because the world's supply of gold was insufficient, runs on gold, the British pound, and the US dollar occurred, and France decided to withdraw from the pool. The pool collapsed in March 1968.'

Once again, this method of controlling the price of gold to maintain faith in the value of paper currencies (or in Roosevelt's case, to placate special interest groups) proved to be useless. A few years after the London Gold Pool collapsed, the US refused to exchange dollars for gold and the dollar price of gold went from US$35 and ounce of over US$800. It took a decade to get there but the gains, even if you participated in some of the move, were sensational.

Today's Gold Market

A similar situation is unfolding today. Andrew Maguire's revelations and subsequent testimony at the CFTC hearing, which basically conceded that 100 times more gold is traded than actually exists, will eventually produce a massive short squeeze in physical gold.

A short squeeze means that players who are 'short', i.e. those that owe gold to someone else but don't actually have any, will be forced to buy gold on the spot market to honour their contracts. Either that or default.

We think there will at some point be a scramble for physical metal and the price will surge higher.

This will happen because gold is like no other asset. The whole reason you own it is to avoid counterparty risk. Gold is a store of wealth and by owning physical gold you are not relying on the solvency of any other party.

So while some might think that $100 of outstanding claims on gold versus $1 of actual gold availability is ok because that's how other markets operate miss the point completely. They say the leverage inherent in the gold market is ok because if short sellers cannot deliver, 'cash' settlement is always available.

But gold is the ultimate form of cash, and those owning physical gold do so because they want to diversify away from paper currencies. Why would they settle for a paper cash settlement?

Up until now, hedge funds have been predominant in the gold futures market and they have been willing to settle for cash. They have simply been playing the theme that increasing monetary disorder will be good for gold. In other words they have participated in the gold bull market without actually owning bullion itself.

But that might be about to change. Recent revelations have highlighted a weakness in the market structure. In financial markets, weaknesses eventually get exploited.

We believe more and more large gold investors will begin to take delivery of their bullion to ensure that they actually possess what they own. The benefits of having 'exposure' to gold (via the futures markets or in unallocated accounts) without the costs of storage, insurance etc will soon be outweighed by the risk of not actually owning gold when its most needed.

This move to take possession or have gold securely stored has already begun on a small scale but it will intensify. Physical gold will slowly diminish in circulation, producing the short squeeze discussed above.

This process is known as Gresham's Law, named after 16th century English financier Sir Thomas Gresham. Its basic premise is that bad money drives out good money. It's happening right now and will continue to do so.

(from The Daily Reckoning, April 19 2010)

the link to the Andrew McGuire and Adrian Douglas ( GATA) interview:

[Abacus] A Goldman blogger round-up

The weekend produced a veritable Eyjafjallajökull ash cloud of blogging and bloviating on the SEC’s filing on Friday against Goldman Sachs and its structured products trader Fabrice Tourre. Here’s the best we’ve read.

Getting shorty in CDOs

First — the key SEC charge is that Tourre allowed John Paulson to pre-select bonds in a proposed CDO and then to short them, without informing its other investors, ACA Capital included.

In a stand-out post, Steve Waldman questions the role of shorting in CDOs overall, arguing that CDOs are more akin to securities than derivatives, in terms of disclosure:

Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO. They no more thought they were trading “against” short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio. Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors. That’s inexcusable. Was it illegal? I don’t know, and I don’t care.

In a separate post, Steve mulls a more abstract view of whether Goldman did indeed act as a ’secret agent’ for one client to the disadvantage of another.

And was that pragmatic, let alone legal?After reading the filing, Bond Girl is cutting:

Seriously, why the hell would anyone want to be a client of Goldman Sachs after reading this?

Why would you work with a firm where employees mock the transactions they are arranging for you to purchase in emails?

Why would you work with a firm that would let someone that it knows is going to have a short position in the investment – because it helped them attain it – help structure that investment for you?

Why would you work with a firm that sees your multi-million-dollar business relationship as nothing more than collateral damage in its ultimate pursuit of fees?

This is not what investment bankers do. This is what backstabbing sociopaths do.


ACA and due diligence

Meanwhile, Henry Blodget and Felix Salmon squared off over whether Paulson’s prior involvement did indeed materially affect ACA’s position — or whether a ’sophisticated investor’ should have known better. Quite the ding-dong, this.

Blodget argues that there is a difference between control and influence:

Paulson did NOT have control over which securities were selected for the CDO.

This is critical. It’s also a fact that is clearly visible in the evidence the SEC provided.

The firm that DID have control over which securities were selected, ACA, was a highly sophisticated firm that analyzed securities like this for a living. It had FULL CONTROL over which securities were included in the CDO. We know this because, of the 123 bonds that Paulson proposed for the CDO, ACA only included 55 of them. In other words, ACA dinged more than half of the bonds Paulson wanted in the CDO, presumably because they did not meet ACA’s quality hurdle.

Now, did Paulson influence which securities ACA selected? Yes, he probably did. But any time someone says or does anything with respect to a security, there are lots of things that influence decisions.

Salmon calls this argument ‘pathetically unconvincing’:

Let’s remember here that in the end there were 90 securities in the CDO. Of those 90, it seems that 55 were chosen by Paulson. In other words, more than 60% of the securities in the CDO were picked, essentially, out of a stacked deck. It didn’t matter which securities ACA chose; Paulson had come up with his longlist of 123 securities precisely because all of them were particularly toxic. That’s a material fact which, if ACA had known it, would surely have sufficed to get them to exit the deal entirely.

Paul Kedrosky has the original flipbook for the ill-starred CDO, for reference.

Pivoting from that flipbook, Erik Gerding of The Conglomerate zeroes in on the SEC’s case over disclosure:

My guess is that a reasonable investor would indeed want to know that Paulson was involved in selecting the deck. What’s the support for this beyond the SEC’s Complaint? Look at the “flipbook” for the transaction provided to investors by Goldman…

It goes on at length of why ACA is a good collateral manager for the CDO. On p. 27, it includes a bullet point “Alignment of Economic Interest.” The SEC complaint zooms in on this little nugget (see Complaint Para. 38). (Note to law students: bullet points in “powerpoint” style are not only bad devices to communicate ideas, they have some itty bitty securities law problems when used to market securities. If you can’t formulate something in a complete sentence, try again.) Nowhere does the flipbook mention that the Paulson hedge fund was involved in selecting the collateral for the CDO.

But it’s far from a slam dunk, he notes. Still, Salmon has raised a wider set of questions about the Abacus deal — so this aspect will no doubt run and run as a point of bloggy contention.

(from FT, Apr 19 2010)

Mangling Magnetar

The FT’s John Gapper has copy of the letter dispatched to Magnetar clients in the wake of the ProPublica investigation. In short, the hedge fund (as Gapper put it) has came out fighting against the accusations levelled against it.

The letter contains this chart:

On the subject of which, Magnetar states (emphasis ours):

From the inception of the strategy through to its conclusion, Magnetar believed that its overall portfolio, including macro hedges, would be profitable independent of the direction of the housing and subprime mortgage markets. We clearly explained this fact, and the reasoning behind it, to ProPublica. The graph (above) represents the average portfolio payoff profile over time, and clearly demonstrates that the payoff profile in respect of CDOs in which Magnetar invested was long-biased. Of particular note is the lower, darker line which represents the payoff profile of our long investments in these CDOs plus only those hedges referencing tranches in these same CDOs (that is, excluding the performance of hedges we purchased that related to transactions in which we had no long interest).

Got that?

Thought not.

(from FT, Apr 20 2010)

[Abacus] The experience of Laura Schwartz

by Tracy Alloway

Laura Schwartz is a name that appears in Goldman Sachs’ defence documents — the bank’s counter-arguments against the SEC’s allegations of civil fraud in its Abacus CDO — and the pitch-book for the deal.

From 2004 to 2007 she was head of ACA Capital’s CDO Asset Management business, earning a salary of $275,000 in 2006, according to Bloomberg data. ACA was at the time a monoline insurer and CDO manager — running some 26 deals, worth $17.5bn, by May 2007.

In early 2007 Schwartz began working with Goldman Sachs on the Abacus 2007-AC1 deal, a $2bn synthetic CDO, referencing subprime mortgages. ACA’s role was to act as selection agent for the portfolio of securities the CDO would reference, but it was also an investor in the deal.

Part of the SEC complaint against Goldman alleges that one of the bank’s employees — Fabrice Tourre — misled investors into believing that hedge fund Paulson & Co was buying Abacus’ equity.

The equity tranche is the riskiest portion of a CDO, so being an investor in the tranche might suggest one had some confidence in the deal’s performance. The idea is that by believing that Paulson was going long Abacus, the CDO would be more marketable to the investors; ACA and German bank IKB.

The following is gleaned from Part I of Goldman’s defence documents:

* Laura Schwartz of ACA’s January 8, 2007 e-mail to Gail Kreitman in which she wrote “I have no idea how [the Paulson meeting] went – I wouldn’t say it went poorly, not at all, but I think it didn’t help that we didn’t know exactly how they want to participate in the space. Can you give us some feedback?” (GS MBS-E-003499710);

* Fabrice Tourre’s January 10, 2007 e-mail to Ms. Schwartz containing the “Transaction Summary” in which he stated that the transaction was “sponsored by Paulson” and included the line: “[0] – [9]%: pre-committed first loss,” (GS MBS E-003504901) which the Staff stated described the equity tranche; and

* Ms. Kreitman’s e-mail exchanges with Ms. Schwartz on January 14 and 28, 2007 in which Ms. Kreitman did not correct Ms. Schwartz’s apparent misunderstanding that Paulson was an equity investor (GS MBS-E-007980762; GS MBS-E-007992234).8

Goldman’s defence centres around a few things. For a start, the banks says that, under confidentiality requirements, it could not have disclosed Paulson’s role in the deal even if it wanted to. Furthermore, the bank never intended for ACA to infer that Paulson was investing in the equity tranche.

When it comes to those e-mails, the bank says that it doesn’t know what Tourre meant by “[0] – [9]%: pre-committed first loss,” and “sponsor” doesn’t necessarily mean equity investor. Meanwhile, Kreitman’s communiques were largely irrelevant, Goldman says, as she was simply the bank’s relationship manager for ACA, and did not participate directly in the creation of Abacus.

One of the over-arching themes of Goldman’s defence, however, is that it was not actually materially important for ACA to know that Paulson was or was not the equity investor. Thus it was under no obligation to disclose the position.

And here’s where things get really interesting.

From the defence document:

Similarly, the fact that ACA may have perceived Paulson to be an equity investor is of no moment. As a threshold matter, the interests of an equity investor would not necessarily be aligned with those of ACA or other noteholders, and holders of equity may also hold other long or short positions that offset or exceed their equity exposure. Indeed, Laura Schwartz of ACA understood this from her work on a transaction that closed in December 2006 in which Magnetar, a hedge fund that bought equity and took short positions in mezzanine-level debt, participated. (See GS MBS-E-007992234 (“Magnetar-like equity investor”).) Certainly, ACA could have questioned Paulson about its interests if it that information were significant to it.

Chicago-based hedge fund Magnetar is another name that has been hurled into prominence in recent months.

ProPublica ran a very detailed series about how the hedge fund created subprime CDOs to short in the years before the financial crisis. The Magnetar Trade, according to ProPublica, involved investing in the equity tranche, and then shorting its own position.

ProPublica also said some people have alleged that the hedge fund also helped stuff the CDOs with riskier mortgages — an allegation Magnetar strenuously denies. The hedge fund says it was arbitraging between the different layers of securities and was “net long”, rather than engineering a short.

Magnetar closed at least 26 subprime deals in 2006 and 2007, according to ProPublica.

Schwartz’s work was on ACA Aquarius 2006-1, a $2bn CDO which closed in September 2006.

Her name and biography appear in the prospectus for the deal, and ACA is listed as CDO manager — a similar role to the one it had on Goldman’s Abacus 2007 project.

Thus it looks like, in one sense, Schwartz’s experience on the construction of Abacus could well lie at the heart of a legal battle between Goldman and the SEC. Proving whether ACA was misled into believing Paulson was a long investor in the deal will no doubt involve her perspective.

In another sense, Schwartz’s overall experience as a CDO manager, including her role in Magnetar’s Aquarius CDO, could act as a litmus test for the sophistication of Abacus investors — something Goldman refers to in its defence documents over and over again:

Like other transactions of this type, all participants were highly sophisticated institutions that were knowledgeable about subprime securitization products and had both the resources and the expertise to perform due diligence, demand any information that was important to them, analyze the portfolio, form their own market views and negotiate forcefully at arm‟s length.

As for Schwartz, she appears to have left ACA in late 2007 — shortly before the firm divested itself of its CDO business.

(from FT, Apr 20 2010)

Profile: Fabrice Tourre, Goldman Sachs

David Teather

Goldman Sachs is standing by its man – so far. The investment bank has said an internal inquiry cleared Fabrice Tourre, the 31-year-old at the centre of fraud allegations, of any wrongdoing. He was apparently not at work today, at Goldman's Fleet Street offices, but the bank said it was a "personal decision", adding he has not been suspended.

But if he does return to work, Tourre will find it difficult to live down the moniker of "Fabulous Fab" after describing himself as such in an already infamous e-mail sent to a friend, in which he boasted with a flourish that he would be a "survivor … of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implication of those monstrosities (sic)!!!".

French-born Tourre has a mathematics degree from the Ecole Centrale in Paris, one of the top universities in France, and a master's in operations research from Stanford University.

He joined Goldman in New York in 2001 and quietly worked his way up through the firm, to become a vice-president on the structured product trading desk, where he helped create the Abacus 2007-AC1 CDO, packed with toxic sub-prime mortgages.

He moved to London in late 2008 where he is now an executive director, a title that belies his relatively junior position in the bank.

Little else is known about Tourre. One report described him as "a slight man with a flair for salesmanship". The Daily Mail suggested he lives in a £3,000-a-month apartment, claims to come from a prominent French family, earns £1.5m a year and is something of a party animal.

He did at least have a clear understanding of the perils of the housing boom. In his e-mail of January 2007, he warned the "whole building is about to collapse anytime now", just three months ahead of closing the Abacus deal that is now under the microscope. In fact the New York Times cited a former colleague who said Tourre was "way ahead" of his time and had been predicting a crash as early as 2005.

(from, April 19, 2010)

Leaked Goldman Presentation on Abacus Trade

Yves Smith, creator of Naked Capitalism: "We received a copy of the document via e-mail and assumed this is being leaked broadly (which begs the question of whether this was by happenstance or deliberate. The proximity to the filing of the suit suggests the latter). Richard Smith published it on ScribD:"


Yves Smith: "Several items jump out.

First is the unseemly number of pages devoted to touting ACA’s expertise and deliberate screening process, namely pages 20 to 48 and 57 through 63. ACA presumably provided all the material in this section, which is misleading, but since it was for the most part not incorporated in the offering documents, ACA would appear not to be liable (plus Goldman is still on the hook, since it was making representations re ACA’s process and procedures). The amount of information provided gives further support to the idea that the caliber and independence of the collateral manager was an important consideration for prospective investors in the deal.

Second is the long list of contacts on page 65, including Jonathan Egol (who spearheaded the Abacus program) and Testuya Ishikawa (who has left the industry and wrote the book How I Caused the Credit Crunch). As many have remarked, the singling out of Tourre seems odd.

Goldman released a short statement today on the pending suit and has provided a longer statement in its defense. Its basic arguments are:

1. Goldman lost money on the deal. Hhm, is that because the losses were larger than the guarantee provided by ACA on the super senior tranche? (The statement “ACA was the biggest investor” presumably translates into “ACA insured the super senior tranche” but to the extent the insurance failed, Goldman would be exposed). That would be a failure of risk management (as in GS expected the deal to fail, but its hedge was insufficient).

2. Goldman made adequate disclosure. We’ll see how that contention holds up as more information comes out."

(from Naked Capitalism, April 16, 2010)

Tuesday, April 13, 2010

Bill Gross' Rocking-Horse Winner

There once was a family who lived in a fine house on Main Street USA sometime in the 1980s. It was a handsome house with a big yard and a white picket fence, but something always seemed to be missing. There was never enough of this or that – a fancier car, another TV, it didn’t seem to matter – there was never enough. And so, the house came to be haunted by an unspoken phrase, “there must be more money, there must be more money.” The walls seemed to whisper it in the middle of the night, and even during the day everyone heard it although no one dared say it aloud. The chair spoke, the bedroom armoire, and even five-year-old Billie’s toy rocking horse would eerily demand almost in unison, “there must be more money, there must be more money.”

One day, sensing the family’s distress, little Billie asked his father, “What is it that causes you to have money?” “Well, you go to school, get a good job, and get raises,” his Dad said, “but these days there just doesn’t seem to be enough.” But Billie, being just a little boy didn’t understand and so he went off to ride his rocking horse, searching for the “clue” to “more money.” The horse was a special toy because not only did it whisper like the walls and the living room chair, but it seemed to answer questions if you only rode it fast enough. And so Billie would sit on top of his horse when no one was looking, charging madly up and down, back and forth in a frenzied state to a place where only he and his pony could go. “Take me to where there is money,” he would command his steed.

At first, Billie could not make the horse answer the way it had when he asked about Christmas presents or what kind of ice cream Mom would bring home from the store. Finding money seemed too hard of a question for a toy horse, but it made him try even harder. He would mount it again and again, whipping its head with the leather straps, forcing it faster and faster until it seemed its mouth would foam. “Where is the money, where is the money?” Billie would scream, and at last the horse in full gallop cried out, “borrow the money, borrow the money!”

At just that moment Billie’s Mom came around the corner and into his room and his eyes blazed at her as he fell to the floor. She rushed to his side, but he was unconscious now, yet still whispering the horse’s answer. He continued in that condition for the next 25 years, full grown, and confined comatose to his hospital bed. His family would visit, hoping for his revival, and then miraculously one day in 2008 he awoke with his father and mother at his side. “Did I find the money?” he asked, as if it were still the same afternoon. “Did you borrow it?” “We did,” his Dad answered, “but we borrowed too much.” Billie’s eyes seemed to close at that very instant and he died the next night.

Even as he lay dead, his mother heard his father’s voice saying to her, “My God, we became rich – or what we thought was rich – and we thought that was good, yet now we’re poor and a lost soul of a son to the bad. But poor devil, poor devil, he’s best gone out of a life where he rode to his doom in order to find a rocking horse winner.”

Adapted from a short story by D.H. Lawrence
“The Rocking Horse Winner”

For readers lost in the literative metaphor of another of my lengthy introductions to investment markets, let me connect the dots and suggest that it is symbolic of the perversion of American-style capitalism over the past 30 years – a belief that wealth was a function of printing, lending, and of course borrowing money in order to make more money. Our “horse” required more and more money every year in order to feed asset appreciation, its eventual securitization and the borrowing that both promoted. That horse, like Billie, however, died in 2008 and we face an uncertain and lower growth environment as a result. The uncertainty comes from a number of structural headwinds in PIMCO’s analysis: deleveraging, reregulation, and the forces of deglobalization – most evident now in the markets’ distrust of marginal sovereign credits such as Iceland, Ireland, Greece and a supporting cast of over-borrowed lookalikes. All of them now force bond and capital market vigilantes to make more measured choices when investing long-term monies. Even though the government’s fist has been successful to date in steadying the destabilizing forces of a delevering private market, investors are now questioning the staying power of public monetary and fiscal policies. 2010 promises to be the year of choosing “which government” can most successfully substitute the governments’ fist for Adam Smith’s invisible hand and for how long? Can individual countries escape a debt crisis by creating even more debt and riding another rocking horse winner? Can the global economy?

The answer, from a vigilante’s viewpoint is “yes,” but a conditional “yes.” There are many conditions and they vary from country to country, but basically it comes down to these:

  1. Can a country issue its own currency and is it acceptable in global commerce?

  2. Are a country’s initial conditions (outstanding debt, structural deficit, growth rate, demographic balance) moderate and can it issue future public debt as a substitute for private credit?

  3. Can a country’s central bank be allowed to reflate via low or negative real interest rates without creating a currency crisis?

These three important conditions render an immediate negative answer when viewed from an investor’s lens focused on Greece for instance: 1) Greece can’t issue debt in its own currency, 2) its initial conditions and demographics are abominable, and 3) its central bank – The ECB – believes in positive, not negative, real interest rates. Greece therefore must extend a beggar’s bowl to the European Union or the IMF because the private market vigilantes have simply had enough. Without guarantees or the promise of long-term assistance, Prime Minister Papandreou’s promise of fiscal austerity falls on deaf ears. Similarly, the Southern European PIGS face a difficult future environment as its walls whisper “the house needs more money, the house needs more money.” It will not come easily, and if it does, it will come at increasingly higher cost, either in the form of higher interest rates, fiscal frugality, or both.

Perhaps surprisingly, some of the countries on PIMCO’s “must to avoid” list are decently positioned to escape their individual debt crises. The U.K. comes immediately to mind. PIMCO would answer “yes” to all of the three primary conditions outlined earlier for the U.K. in contrast to Greece. We as a firm, however, remain underweight Gilts. The reason is that the debt the U.K. will increasingly issue in the future should lead to inflationary conditions and a depreciating currency relative to other countries, ultimately lowering the realized return on its bonds. If that view becomes consensus, then at some point the U.K. may fail to attain escape velocity from its debt trap. For now though, “crisis” does not describe their current predicament, yet that bed of nitroglycerine must be delicately handled. Avoid the U.K. – there are more attractive choices.

Could one of them be the United States? Well, yes, almost by default to use a poor, but somewhat ironic phrase, because a U.S. Treasury investor must satisfactorily answer “yes” to my three conditions as well, and the U.S. has more favorable demographics and a stronger growth potential than the U.K. – promising a greater chance at escape velocity. But remember – my three conditions just suggest that a country can get out of a debt crisis by creating more debt – they don’t assert that the bonds will be a good investment. Simply comparing Greek or U.K. debt to U.S. Treasury bonds is not the golden ticket to alpha generation in investment markets. U.S. bonds may simply be a “less poor” choice of alternatives.

The reason is complicated, but at its core very simple. As a November IMF staff position note aptly pointed out, high fiscal deficits and higher outstanding debt lead to higher real interest rates and ultimately higher inflation, both trends which are bond market unfriendly. In the U.S. in addition to the 10% of GDP deficits and a growing stock of outstanding debt, an investor must be concerned with future unfunded entitlement commitments which portfolio managers almost always neglect, viewing them as so far off in the future that they don’t matter. Yet should it concern an investor in 30-year Treasuries that the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt? Of course it should, and that may be a primary reason why 30-year bonds yield 4.6% whereas 2-year debt with the same guarantee yields less than 1%.

The trend promises to get worse, not better. The imminent passage of health care reform represents a continuing litany of entitlement legislation that will add, not subtract, to future deficits and unfunded liabilities. No investment vigilante worth their salt or outrageous annual bonus would dare argue that current legislation is a deficit reducer as asserted by Democrats and in fact the Congressional Budget Office. Common sense alone would suggest that extending health care benefits to 30 million people will cost a lot of money and that it is being “paid for” in the current bill with standard smoke, and all too familiar mirrors that have characterized such entitlement legislation for decades. An article by an ex-CBO director in The New York Times this past Sunday affirms these suspicions. “Fantasy in, fantasy out,” writes Douglas Holtz-Eakin who held the CBO Chair from 2003–2005. Front-end loaded revenues and back-end loaded expenses promote the fiction that a program that will cost $950 billion over the next 10 years actually reduces the deficit by $138 billion. After all the details are analyzed, Mr. Holtz-Eakin’s numbers affirm a vigilante’s suspicion – it will add $562 billion to the deficit over the next decade. Long-term bondholders beware.

So I’m on this rocking horse called PIMCO, a “co”-jockey appropriately named Billie, I suppose, and I’m whipping that horse in a frenzy, “The house needs more money, the house needs more money.” Hopefully my fate is not the same as the one created by D.H. Lawrence, nor is the horse’s answer. Billie’s rocking horse was a toy created in the 1980s and abused for two decades thereafter. Today’s chastened pony cannot cry out “borrow money,” but simply the reverse – “lend prudently.” In today’s marketplace, prudent lending must be directed not only towards sovereigns that can escape a debt trap, but ones that can do so with a minimum of reflationary consequences and currency devaluation – whether it be against other sovereigns or hard assets such as gold. Investment strategies should begin to reflect this preservation of capital principal by positioning bond portfolios on front-ends of selected sovereign yield curves subject to successful reflation (U.S., Brazil) and longer ends of yield curves that can withstand potential debt deflation (Germany, Core Europe). In addition, as increasing debt loads add impetus to higher real interest rates worldwide, a more “unicredit” bond market argues for high quality corporate spread risk as opposed to duration extension. In plain English, that means that a unit of quality credit spread will do better than a unit of duration. Rates face a future bear market as central banks eventually normalize QE policies and 0% yields if global reflation is successful. Spreads in appropriate sovereign and corporate credits are a better bet as long as global contagion is contained. If not, a rush to the safety of Treasury Bills lies ahead.

Above all, however, lend prudently, lend prudently if you want to be a rocking horse winner. And for you would be jockeys: be careful when you put your foot in the stirrups. Riding a thoroughbred can be a thrilling but risky proposition. Just look what happened to Billie – poor devil.

William H. Gross
Managing Director

(from, Investment Outlook, April 2010)