[Abacus] A Goldman blogger round-up

by Joseph Cotterill

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

by Paul Murphy

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. More…

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)

An Argument Against Using Government Funds to Help Purchase Structured Credit Securities

Coval of Harvard business school and Jurek of Princeton co-wrote a paper that investigates the current prices of debt: "The Pricing of Investment Grade Credit Risk during the Financial Crisis", Joshua D. Coval, Jakub W. Jurek, and Erik Stafford, March 30, 2009.

The bottom line of the paper:

Policymakers are rapidly moving towards using TARP money to purchase toxic assets – primarily tranches of collateralized debt obligations (CDOs) – from banks, with the aim of supporting secondary markets and increasing bank lending. The key premise of current policies is that the prices for these assets have become artificially depressed by banks and other investors trying to unload their holdings in an illiquid market, such that they no longer reflect their true hold-to-maturity value. By purchasing or insuring a large quantity of bank assets, the government can restore liquidity to credit markets and solvency to the banking sector.

The analysis in this paper suggests that recent credit market prices are actually highly consistent with fundamentals. A structural framework confirms that bonds and credit derivatives should have experienced a significant repricing in 2008 as the economic outlook darkened and volatility increased. The analysis also confirms that severe mispricing existed in the structured credit tranches prior to the crisis and that a large part of the dramatic rise in spreads has been the elimination of this mispricing.

If prices currently coming out of credit markets are actually correct, and not reflecting fire sales, this has several important implications. First, correct prices in the secondary market for these assets essentially imply that many major US banks are now legitimately insolvent. This insolvency can longer be viewed as an artifact of bank assets being marked to artificially depressed prices coming out of an illiquid market. It means that bank assets are being fairly priced at valuations that sum to less than bank liabilities. In turn, any positive valuation assigned by shareholders to their equity claim arises solely from their anticipation of value transfer from firm debt holders or resource transfers from US taxpayers.

Second, if current market prices are fair, any taxpayer dollars allocated to supporting these markets will simply transfer wealth to the current owners of these securities. To the extent these assets reside in banks that are now insolvent, the owners are essentially the bondholders of these banks. The reason their bonds are currently trading far below par is that the assets backing up their claim are just not worth enough (nor expected to become worth enough when their bonds mature) to repay them. And so while they will be cheered by any government overpayment for the toxic assets backing up their claims, their happiness will be at the taxpayer’s expense since – to the extent that current prices are fair – they will be receiving more than fair value for their investments. Similarly, using government resources to support these markets by insuring assets against further losses amounts to providing insurance at premia that are significantly below what is fair for the risks that the US taxpayer will now bear.

Third, the market for securitized claims is not going to operate the same way it did in the past. Investors in these assets are setting prices in the secondary market that reflect both the high expected losses of the securities and the highly systematic nature of these expected losses. And while the pricing of these securities is dramatically different from the way it was a year or two ago, this is because it was wrong then, not now. Efforts to restart this market are focused on resuming the flawed pricing of the past, when there was no charge for risk and investors relied on the accuracy of ratings. Investors have learned from their mistakes and now seem to be pricing these securities in accordance with their true risks.