Understanding the Goldman Abacus issue

I have not been able to understand it. The moment I read Goldman structured a deal called Abacus which invested in synthetic CDOs, it was enough to hide for cover. It sounded so similar to Enron which gave fancy names to all its shady investments.

Knowledge @ Wharton issue has a nice primer on the issue. First what is this synthetic CDO??

The case involves four types of securities that played roles in the financial crisis.

The first are residential mortgage-backed securities, or RMBS. These are pools of mortgages converted into bonds that are sold to investors, who then receive income from homeowners’ monthly mortgage payments. Typically, the bonds come in a variety of grades, or tranches. Owners of the safest have first rights to the income from the pool. Owners of the riskiest are last in line, making them the first to suffer losses if homeowners fail to make payments. As compensation, they earn a higher interest rate — and they get a bigger share of the income if homeowners do pay their mortgages.

Next are credit-default swaps (CDS), a kind of insurance policy that pays off if a debtor fails to make its payments. An investor, for example, could buy a CDS that would pay off if a company fails to make interest or principal payments on its bonds. The CDS becomes more valuable as this default risk rises or if the bond’s rating is lowered, since that improves chances of a payoff. The speculator buying a CDS does not have to own the debt security being insured.

Third is the collateralized debt obligation. While there are many types, they are pools created from other securities with shares that are then sold to investors. Many CDOs, for example, were created by assembling portfolios of risky, low-rated tranches of mortgage-backed securities. The CDO is then tranched as well, just as the mortgage securities are.

Finally, there are synthetic CDOs. These are much like ordinary CDOs except that instead of owning real securities, investors own credit-default swaps on real securities. In Goldman’s Abacus deal, the CDOs owned credit-default swaps that would rise or fall depending on the fortunes of a specific list of residential mortgage-backed securities, mainly on subprime loans to homeowners who are considered risky.

Despite the best attempt it is still so complicated. A synthetic CDO involves all three – RMBS, CDS and CDO. And all these three are equally difficult to understand. So what you have is a highly complex security whose value is so difficult to find. So, there is a lot of trust involved and credit rating agencies role becomes critical as well.

The basic issue is like this:

  • In the Abacus deal, completed in April 2007, Hedge Fund Paulson took the short side
  • Two major investors took the long side: IKB, a large German bank, and ACA Capital Management, a New York-based investment firm.
  • Paulson worked with ACA to choose the 90 underlying mortgage-backed securities.
  • But there is dispute about Paulson’s exact role. The SEC claims Goldman led ACA to believe that Paulson was taking the long side — that he would bet the securities would rise in value — when Paulson was actually taking the opposite view. This, according to the SEC, led ACA to believe Paulson thought the securities were safer than they were, and that its interests and Paulson’s were the same.
  • Goldman, however, says it “never represented to ACA that Paulson was going to be a long investor.”

The case raises important questions:

  • Could Goldman’s customers really have evaluated the Abacus risks for themselves, as Goldman claims?
  • Do derivatives like synthetic collateralized debt obligations, or CDOs, serve any useful purpose?
  • Does Goldman’s defense — that it had no obligation to alert investors to especially high risks — undermine its claim to be a “client-centered” firm worthy of customers’ trust?

The Wharton issue discusses this with a number of academics and other practitioners. The broad idea that emerges is Goldman’s act may not be illegal as it played the customers beware card. However, it is unethical and would harm Goldman’s image:

This view could damage Goldman’s franchise, Herring says. “Goldman Sachs has made its reputation as a trusted advisor and superb investment manager. Many people would buy a Goldman Sachs mutual fund simply because they are thought to be among the best investors in the business. If [Goldman] really wants to play the caveat emptor game, however, they are giving up a valuable reputation that was hard won over decades.” According to Allen, “they have this reputation of dealing on both sides and exploiting information…. I think it will hurt them…. Along the way I think we will see a lot of messy revelations. I don’t think Goldman will come out of it very well.”

Nonetheless, says Blume, the SEC’s case is not a slam dunk. The SEC was split 3-2 on whether to file the Goldman case, and  usually does not proceed unless the view is unanimous. It is often hard to define what constitutes material information, he notes.

The note however is silent on the role of credit rating agencies. As said above, these CDOs are highly complex and there is no way a buyer can understand what is going on. So, you need a trusted broker (Goldman) and proper ratings. Both failed in their roles. Krugman points this in his recent article:

Let’s hear it for the Senate’s Permanent Subcommittee on Investigations. Its work on the financial crisis is increasingly looking like the 21st-century version of the Pecora hearings, which helped usher in New Deal-era financial regulation. In the past few days scandalous Wall Street e-mail messages released by the subcommittee have made headlines.

That’s the good news. The bad news is that most of the headlines were about the wrong e-mails. When Goldman Sachs employees bragged about the money they had made by shorting the housing market, it was ugly, but that didn’t amount to wrongdoing.

No, the e-mail messages you should be focusing on are the ones from employees at the credit rating agencies, which bestowed AAA ratings on hundreds of billions of dollars’ worth of dubious assets, nearly all of which have since turned out to be toxic waste. And no, that’s not hyperbole: of AAA-rated subprime-mortgage-backed securities issued in 2006, 93 percent — 93 percent! — have now been downgraded to junk status.

What those e-mails reveal is a deeply corrupt system. And it’s a system that financial reform, as currently proposed, wouldn’t fix.

Krugman also suggests a reform for CRAs which will help resolve the conflict of interest – CRAs are paid by the companies they rate. What mess CRAs have got themselves into. They surely need soul searching. What is ironical is they still call the shots. You keep seeing downgrades of EU countries by some rating agency and markets tank again.

Finally what about usefulness of these CDOs?

As the derivatives trading system is re-evaluated, some critics wonder whether certain derivatives serve any useful purpose or have merely turned Wall Street into a casino. Frey and the Wharton faculty members interviewed say derivatives linked to real assets such as mortgages do serve a purpose. The mortgage-backed security, for example, allows a lender to convert homeowners’ future payments into immediate cash, so the lender can provide money to other home buyers.

Credit-default swaps allow companies and other market players to hedge against risks. A bond owner, for instance, can use a CDS to insure against the danger of not receiving principal and interest payments as promised. The problem, some critics say, is that the CDS buyer does not have to own the security that is being insured. That allows the swaps to be used for pure speculation, as if one took out 10 life insurance policies on a stranger, hoping to profit if the stranger dies — a bet that would be illegal with ordinary insurance. Rampant speculation with credit-default swaps forced the $182 billion government bailout of American International Group. Collateralized debt obligations can serve a useful purpose when they repackage real securities, such as those backed by mortgages, says Smetters. In that case, they help supply money for homeowners.

But synthetic CDOs, like those in the Goldman case, do not pump money to people or companies with real needs, says Frey. Synthetic CDOs, adds Blume, are more like side bets among spectators standing around a craps table in a casino.

While the creation of ordinary CDOs is limited by the availability of underlying assets like mortgage securities, an unlimited volume of synthetic CDOs can be created because they are not tied to asset-based securities but to credit default swaps, which themselves can be created in unlimited numbers. Thus, synthetic CDOs satisfied a hunger early in the 2000s for investments with high ratings. Because the ratings were poorly done, many mortgage-related securities collapsed in value, and synthetic CDOs magnified the losses.

Says Frey: “In looking at securities … I ask one simple question: Is there an economic reason to have this transaction? And if the answer is ‘no,’ what does this transaction do?” Synthetic CDOs don’t pass his test, Frey says. “I don’t really see any need for them. I don’t see that there is a real underlying economic need for that transaction. What does that transaction really accomplish, other than to move money around? Moving money around is not an economically productive event.”

For testing these products, follow this methodology by Robert Litan. He suggests 3 parameters for judging a usefulness of financial innovation: Access, Convenience and Productivity/GDP. Clearly a synthetic CDO does not fit anywhere. Litan also says:

My ultimate verdict is that like Johnson and Kwak, I find that there is a mix between good and bad financial innovations, although on balance I find more good ones than bad ones.  Individually and collectively, these innovations have improved access to credit, made life more convenient, and in some cases probably allowed the economy to grow faster. But some innovations (notably, CDOs and Structured Investment Vehicles, or SIVs) were poorly designed, while others were misused (CDS, adjustable rate mortgages or ARMs, and home equity lines of credit or HELOCs) and contributed to the financial crisis and/or amplified the downturn in the economy when it started.

Along the way, I also address two of the main critiques of financial innovation just cited. The fact that many financial innovations have been and continue to be designed to “get around” financial regulation does not automatically make them bad. Indeed, the opposite is true if the regulations are impeding productive activity. Indeed, I argue that a number of financial innovations of this sort have been socially useful for this reason.

The financial firms have actually dug a hole for themselves. By creating all these products for just short term incentives has led to a lot of problems. These products were bound to fail at some time and is amazing that how their volumes grew. They added nothing to the economy but was just a fancy casino game. The regulators were on their side believing the private sector knows best. With the game over and causing considerable damage, knives are out. What is surprising however is there is no serious will  to reform all this practice. There is just talk and talk. The entire sector needs an overhaul.

7 Responses to “Understanding the Goldman Abacus issue”

  1. Mortgage-backed securities II Says:

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  2. Goldman & Abacus « Rubber Tyres –> Smooth Rides Says:

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