Goldman’s rebuttal of the SEC lawsuit raises some specific points that deserve further analysis.
“Goldman Sachs Lost Money On The Transaction.”
Whether Goldman made money or not would have been relevant if they were just an investor like IKB. However Goldman is not just an investor, it is a market-maker. Whether a market-maker loses or makes money on a specific trade with a client is irrelevant. The market-maker’s role is to tailor the product desired by the client and hedge out the residual risk with other counterparties in the market. The ultimate loss or profit on one trade is irrelevant unless considered in the context of the exposures of the trading book as a whole.
In this particular case, the residual equity exposure could have been left unhedged because it was a natural hedge to other positions in the book. Else, it could have been dynamically delta-hedged in the market via CDS on the underlying. Or it could have been macro-hedged via a short position on an index. The point is that analysing the profit or loss on an isolated trade in the book of a market-maker is meaningless.
“Extensive Disclosure Was Provided…..These investors also understood that a synthetic CDO transaction necessarily included both a long and short side.”
This is Goldman’s strongest rebuttal as sufficient disclosure on the asset pool was likely provided. Moreover, the argument that Goldman does not have to disclose that Paulson is on the short side is even stronger than most commentators realise. From the perspective of Abacus as a legal entity, the short side is Goldman itself. Paulson is only Goldman’s hedge against their exposure arising from Abacus. This is clear from slide 50 in the Abacus pitchbook which represents Goldman as the “Protection Buyer”.
What is unusual however is that Paulson was short the tranches themselves rather than the underlying bonds. From Paulson’s perspective, this makes sense as it enables him to short only the mezzanine and senior tranches and avoid the equity which would have been the most expensive tranche to go short (Shorting all the underlying bonds is equivalent to shorting all the tranches of the CDO). But nevertheless this is not common in structured products in any asset class. Most structured products involve the market-maker constructing a bespoke product for the client and managing the residual exposure via dynamic hedging. So in this case, Goldman would buy CDS referencing the underlying bonds, sell as many tranches as it can or wants to sell, and manage the residual exposure. In this case, that was the equity exposure and in many other cases as I have analysed before, it was the super-senior tranche. If exact matching hedges had to be found in the market for each product sold to a client, then the business of structured products would not exist. In this respect, Goldman’s assertion that each transaction includes a long and short side is technically accurate but a little bit disingenuous – most synthetic CDOs like most other structured products do not have a market counterparty other than the market-maker who is short exactly the same product. I suspect however that from a legal perspective, this is not relevant.
“ACA, the Largest Investor, Selected The Portfolio.”
The fact that ACA Asset Management was the “Portfolio Selection Agent” is Goldman’s best defense. But the assertion that ACA was the largest investor is true only in the most trivial sense. ACA Asset Management which selected the portfolio had no investment in Abacus. It was its parent company, ACA Capital which in the course of its normal business of insuring super-senior tranches had a $951 million exposure to the transaction. This may seem like an irrelevant distinction but it is not. The usual method of ensuring that the managers’ interests are aligned to those of the transaction would be to have the manager invest in the equity tranche of the transaction as ACA had done in the past. As per slide 31 of the pitchbook, ACA had over $200 million invested in the equity of the CDOs it manages.
All this tells us is that ACA Capital trusted that its asset management subsidiary had done a competent job and was more likely to guarantee against losses on the super-senior given the role of ACA Asset Management. But did this influence the incentives of ACA Asset Management and its asset managers? That seems unlikely given that it was ACA Capital’s prerogative to do its own due diligence even if its asset management subsidiary was the manager of the CDO in question and the decision to invest by ACA Capital was likely separate from, albeit influenced by the decision to manage the CDO.
“Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor”
This is clearly the crux of the case. The SEC seems to assert that it was Goldman’s responsibility to disabuse ACA of the mistaken assumption it made that Paulson was an equity investor. The complaint also quotes an email from Fabrice Tourre to ACA where he explicitly refers to Paulson as the “Transaction Sponsor” (page 14 of the complaint). At best, this description is misleading. It is a stretch to describe a counterparty who is short the exact tranches being marketed to investors as a “Transaction Sponsor”. I suspect much of the case will depend upon whether using the term “Transaction Sponsor” to describe Paulson was an act of deception. In this respect, it is relevant whether there is any precedent of counterparties seeking to short the tranches being referred to in this manner. My suspicion is that Goldman’s definition of “Transaction Sponsor” does not have much precedent. None of this however absolves ACA of its share of blame – it should have obtained written clarification that Paulson was the equity investor failing which it should have refused to do the deal.