Don't Falsely Blame Goldman & Paulson
In Wall Street's scandal du jour, Goldman Sachs and Paulson & Co. have been vilified, while very little has been said about the culpability of ACA Capital Management and IKB Deutsche Industriebank in the transaction. At best, these institutions made a poor investment decision; at worst, they violated their fiduciary duty on behalf of their clients to thoroughly scrutinize their investment in ABACUS 2007-AC1.
Though the quality of diligence done by ACA and IKB may never be known, the SEC's Formal Complaint and Litigation Release manipulates the facts and avoids key subject matter in order to persecute Goldman Sachs and Paulson & Co., while relieving ACA and IKB of all responsibility for their losses.
The SEC's Litigation Release proclaims "Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played" in the transaction, plus its description of Paulson & Co. as a major hedge fund at the time of the transaction is dishonest. Recall that the transaction closed on April 26, 2007, well before Paulson & Co. became the "major hedge fund" that it is today.
In Gregory Zuckerman's book, The Greatest Trade Ever, which chronicles the subprime mortgage trades of hedge funds such as Paulson's, it is noted that around June 2006 when the Paulson Credit Opportunity Fund was launched, it had only $147 million of capital. While Paulson's fund would subsequently grow to $28 billion by the end of 2007 thanks to gains, it was hardly a recognized name nor did it have significant assets under management until trades such as ABACUS finally paid off. For the SEC to characterize Paulson & Co. as "one of the world's largest hedge funds" at the time of the transaction is clearly misleading and was presumably politically motivated to make it seem as though large hedge funds were profiteering off the mortgage crisis.
The SEC's Complaint claims "Goldman Sachs did not disclose Paulson & Co.'s short position or its role in the collateral selection process" in any of the offering materials. Regardless of whether Goldman was obligated or even legally allowed to disclose Paulson's positions to counterparties in the transaction (a Goldman press release states that "as normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa"), it was ACA and IKB's responsibility to perform adequate due diligence on the investment and make sure the collateral was sound. Since by January of 2008 (9 months after the funds close) 99% of the portfolio had been downgraded, it's clear that diligence efforts fell short.
In addition, while the SEC's Complaint harped extensively on Paulson's role in the selection of RMBS for ABACUS, an understanding of the chronology of events reveals that ACA was well informed as to the collateral in the CDO, and in fact selected the collateral with Paulson. As the SEC's Complaint notes, in January 2007 Goldman approached ACA and proposed that it serve as the ‘Portfolio Selection Agent' for a CDO transaction sponsored by Paulson. ACA previously had constructed and managed numerous CDOs for a fee and as of December 31, 2006, had closed on 22 CDO transactions consisting of $15.7 billion of assets.
On January 9, 2007, Goldman sent to ACA a list of 123 RMBS selected by Paulson. About the selections, an ACA analysis showed that it had previously purchased 62 of the securities on Paulson's list.
On January 22, 2007, ACA sent an email listing 86 sub-prime mortgage positions for the fund. Of the 123 positions that were originally selected by Paulson, ACA rejected all but 55.
On February 2, 2007, ACA emailed Paulson and Goldman a list of 82 RMBS on which Paulson and ACA concurred. Finally, on February 26, 2007, Paulson and ACA came to an agreement on a reference portfolio of 90 RMBS for ABACUS 2007-AC1.
Clearly ACA had the opportunity to review and select all the securities, which indicates that neither Paulson nor Goldman can be blamed for the fact that ACA simply made a bad investment or failed to perform adequate diligence. It is also safe to presume that IKB had a similar opportunity to review the securities it would be exposed to. If IKB had been denied that opportunity, then as fiduciaries of the capital of its investors, it should have declined to participate in the transaction on the grounds that it could not adequately scrutinize or understand the deal.
The SEC's Complaint goes on to state that Goldman "misled ACA into believing that Paulson invested approximately $200 million in the equity of ABACUS 2007-AC1 and that Paulson's interests in the collateral selection process were aligned with ACA's when in reality Paulson's interests were sharply conflicting." This statement makes it appear as though Paulson and Goldman were attempting to deceive ACA and IKB, when in reality, purchasing a slice of the equity would have been an important part of Paulson's trade.
In The Greatest Trade Ever, Zuckerman writes that "Paulson and Pellegrini believed the debt backing the CDOs would blow up. But Pellegrini argued to his boss that they should offer to buy the riskiest slices of these CDOs, the so called equity pieces that would get hit first if problems resulted. These pieces had such high yields that they could help pay the cost of buying protection on the rest of the CDOs, even though the equity slices likely would become worthless over time. And if their analysis proved wrong and the CDOs held up, at least the equity investment would lead to profits" (page 180). Thus, the purchase of equity by Paulson was not a ruse to mislead counterparties, rather it was a prudent part of Paulson's trading strategy.
Both Goldman Sachs and John Paulson entered into this much discussed investment opportunity to maximize value for their respective constituents, which is what participants in a free market capitalist economy should do. In this transaction, Goldman Sachs's duty was to serve as a market maker whose job was to structure and execute a transaction to meet multiple client needs. Goldman did just that.
Paulson & Co.'s role was to act as a responsible fiduciary for its investors and earn a desirable return, which it did. ACA and IKB have a customer mandate to earn an appropriate return as well.
In this case, however, ACA and IKB's investment selections resulted in approximately $1 billion in losses. Whether those losses were the result of poor investment selection or inadequate due diligence, neither Goldman Sachs nor Paulson & Co. is to blame. As such, it's irresponsible and deceptive for the SEC, the media and politicians to hold Goldman and Paulson accountable.
