L’affaire Goldman in price/information terms

I have found it helpful to pull away from the details of the Goldman/Paulson/ABACUS deal and think through the issues abstractly. In the unlikely event that others will find it helpful, I present the tale below…

Let’s suppose there is a trader, whom we’ll call “Trader X”. Trader X wishes to take a very large position on a bunch of related and correlated financial instruments. But Trader X has a problem. The size of the trade he wants to make is large relative to ordinary turnover in the asset. The market would almost surely move against him before he executed more than a fraction of his trades. Market-makers are very sensitive to the balance of order flow. If Trader X starts calling dealers and executing trades, they would observe one-sided flow and quickly adjust the price until trades on the other side were attracted and the flow returned to balance. This “adverse price action” would significantly reduce the profitability and increase the risk of X’s trade. It would also reveal his information or belief about future price movement to the market, enhancing market efficiency perhaps, but reducing his edge.

Trader X’s problem is well-known: sporadic large trades are known as “block trades”, and naively executed block trades are inefficient and expensive. If Trader X was buying and selling stock, he could make use of various tools that have been developed to circumvent this problem, “dark pools” that try to match big buyers and sellers without revealing strategic information about either party, to one another or to the market at large. Unfortunately, block trading platforms haven’t yet evolved for what Trader X wants to buy. The instruments he wants are similar and correlated, but not quite as standard as stocks, and “block trades” like his are sufficiently rare that even if the infrastructure existed, he’d be unlikely to find a counterparty quickly. Trader X could try to trade strategically and build a position over time, but given the thinness of the market that would take too long, the opportunity will disappear. Trader X is in a bind.

So, he goes to Investment Bank Y and explains the situation. Bank Y has many connections in the investing community, and could “shop the deal”, looking for a large investor to take the other side of the trade. But other investors are like market makers: they view strong demand to as an indicator of a counterparty’s information, and fear getting ripped off. Bank Y can find investors to trade with Trader X, but they would demand a large price premium over current quoted prices in order to take a position opposite a trader who acts like he knows something (whether he does in fact or not). If Trader X could persuade counterparties that he had no information — if it were clear his motivation was to hedge a risk, rather than gamble on a price change — then other investors might be willing to take the trade, and maybe he could find competitive bidders and get a decent price. Unfortunately, that just isn’t the case. Trader X is widely known to be a speculator, and by revealing the trade he wishes to make and the money he is willing to throw at it, he would reveal both his beliefs and his strong commitment to those beliefs. Other investors without special information would be wary of trading against such a certain counterparty, and would not offer favorable terms.

Bank Y asks Trader X what the ideal solution to his problem would be. Trader X thinks for a moment and says, “Ideally a counterparty would naturally appear who happens to want the opposite side of my trade. If they were buying while I was selling, order flow would be balanced, and we could transact at current market prices.”

Bank Y considers for a moment, and comes up with an idea. “Suppose we start a little investment company up, something like a mutual fund devoted to the kind of positions you want to trade. Since you want to take a ‘short’ position, we’ll find a manager enthusiastic about the prospects of the ‘long’ side and help him start this little fund. There are lots of reputable money managers in the world, with a wide variety of views, so we can find somebody excited and capable of running this fund. We have lots of connections among investors, and we are in the business of drumming up interest in new investment vehicles, so there’s a reasonable chance we’ll find people to fund the strategy at a scale large enough to match your trade. Once we do, there will be a natural buyer of what you want to sell, and you can enter the market without impacting prices. In fact, since both you and this fund will use us as market makers, we’ll just cross the trades internally at prevailing prices, and neither you nor the fund will have to worry about adverse price action.”

“Hooray!”, says Trader X, “You guys are fabulous.” And it all worked out just exactly as Bank Y described.

Let’s suppose that this has all just happened, and asset prices have not moved at all. There has been no collapse of some gobbledygooky RMBS/CDS/CDO market. Today, everybody is happy. No harm, no foul, right? Was this little strategy okay?

Trader X has profited compared to all of his feasible alternatives. He acquired a position he desired very efficiently. Bank Y has earned a fee. But let’s consider the situation of the investors in the new fund, whom we’ll refer to as “the Investors”.

The Investors, as of this writing, hold a position they are pleased to hold at prevailing market prices. However, the Investors would not have taken the position at all had it not been for the intervention of Bank Y.

Let’s call the difference between the prevailing market price and the price Trader X would have had to pay a direct counterparty to take the other side of his trade “the Premium”. If Bank Y had simply shopped X’s trade to the Investors, they would have demanded the Premium. (If they would not have, why go to the trouble of starting the investment fund?) So, the net effect of taking the indirect route was a transfer of the Premium relative to the other feasible opportunity. Under the “full disclosure” scenario, the premium would have gone to the Investors. Under the “little investment company scenario”, Trader X keeps the Premium. The Premium is the value of the information not revealed, conditional on the trade getting done. (It is a maximum bound on that value if the trade would not get done at all under full disclosure.)

Note that this redistribution of wealth does not depend at all on how the investments ultimately perform. It doesn’t matter whether, in the future, Trader X is vindicated and the Investors go broke, or the Investors make a killing and Trader X moves back in with his mom. The Investors suffered an opportunity cost (and Trader X enjoyed a benefit) at the time the trade occurred, based on how the transaction was architected. Trader X might be an idiot or a genius. The Investors might have been duped, or they may have invested only after extensive due diligence (which revealed everything except the confidential involvement of Trader X). Whatever. We want to consider the only the events leading up to the trade, before market fluctuations confuse the issue. Did Bank Y behave ethically when, by withholding information, it got a deal done and caused a transfer of wealth to X?

If Bank Y had plainly represented itself as an agent of Trader X, perhaps there would have been no problem. Bank Y acted very effectively in Trader X’s interest, but in a manner that can fairly be described as adversarial with respect to the Investors. But if Bank Y had disclosed the relationship, the Investors might have inferred Trader X’s intentions and demanded the Premium (unless Bank Y actively misled them, which I’ll presume is bad). So was it okay for Bank Y to be a secret agent of Trader X while engaging in its conventional business of marketing a new investment fund?

In the story as I’ve told it, the undisclosed information was clearly material — the Investors would have received the Premium or would have preferred not to do the deal had the circumstances of the trade been plainly presented. When an investment bank is acting as an agent, to what degree can it withhold material information from other parties in order to benefit its client? And what is the relationship of an investment bank to those to whom it is marketing a new investment product? Clearly it is something less than fiduciary. Potential investors seem something less than “clients” as well. Are they simply adversarial “counterparties”? Perhaps they are “customers”? In any case, what duties are owed them?

I think I’ll just let these questions dangle. What do you think?

This exercise came from thinking through the excellent comments to the previous post, especially those of JKH. Thanks always to interfluidity‘s exceptional readers.


53 Responses to “L’affaire Goldman in price/information terms”

  1. […] needs to “reform or die.”  (Interfluidity, ibid also Felix […]

  2. rootless_e writes:

    Reading the flipchart presentation has convinced me that IKB was clearly presented with the fact that the entire deal was based on a bet by Goldman or a Goldman client that the reference securities would tank. The obvious question that IKB and ACA never asked is “why would someone give us money for nothing”? And the obvious reason that they never asked is that, like many victims of confidence games, they were convinced that the counterparty was the sucker and they did not want to spook him.

  3. rootless_e writes:

    “In the story as I’ve told it, the undisclosed information was clearly material — the Investors would have received the Premium or would have preferred not to do the deal had the circumstances of the trade been plainly presented.”

    But, of course, that is not how it actually worked in the market. The sellers of CDS protection considered the purchasers to be idiots.

  4. Rogue writes:

    Everyone on the structuring table should have had a good idea of the nature of the beast that they were creating – that it was a leveraged bet rather than just a portfolio of securities. ACA likely knew what it was getting into (if it had numerous communications with Paulson himself during the structuring process), and had the confidence of the correctness of its position. But its representation as a portfolio manager made it seem to other parties not party to the structuring that what they created was a portfolio that ACA would manage. Why did ACA allow itself to be called a ‘portfolio manager’ if it was clear to them that they were essentially putting on a countervailing position to Paulson’s short?

  5. Kid Dynamite writes:

    excellent writeup. but I have a quibble or two.

    remember: counterparty information matters many orders of magnitude more for TRADERS than for INVESTORS… Investors are supposed to evaluate the ACTUAL ASSETS THEY ARE INVESTING IN! (sorry for shouting).

    Thus, the INVESTORS here should be concerned moreso with the quality of the INVESTMENTS (see how that works ?!!?!?) and much less so with the circumstances of their counterparty.

    this is,unfortunately, the CRUX of the issue… the disclosure SHOULDN’T matter for the investors!

    here’s a little tangent: this is how i view this trade: there is a bag with a lot of little pieces of paper in them. each piece of paper has written on it, in tiny letters, which you’ll have to actually spend time looking at to find, the value. i bring you this bag of paper, and tell you “don’t sweat it, Steve, Moody’s said they’re all worth $100. how much will you give me for this bag of 1000 $100 pieces of paper?”

    now, you, if you are doing your job, will not put your faith in the fact that Moody’s says they’re all worth $100 each, or that I told you this bag was found in my grandma’s attic, or that some hedge fund was trying to unload this bag. See, you, since you’re smart and thorough, will simply look inside the bag and find the value of each piece of paper inside. It doesn’t really matter who brought it to you, where it came from, how it smells, etc. The value is THE VALUE – and it doesn’t change.

    of course, the value of the actual RMBS may be harder to determine in the real world, but the process is the same.

  6. Byrne writes:

    I maintain that this is pretty embarrassing for ACA. They’re basically saying that despite their expertise in mortgages, they would have demanded a completely different price had they known that some merger arb guy was on the other side of the trades.

    I mean, look at the date on the pitch book: February 2007. People who knew Paulson did not know him as the subprime-shorting genius, because he hadn’t finished shorting and hadn’t made his 600%.

    Can we take this to one more layer of abstraction? What if ACA knew that Paulson was super-bearish, and that he was bearish on securities with the same characteristics as the ones in Abacus–but Paulson himself didn’t short Abacus. Let’s just imagine that he’d taken the position he wanted by then. Now, we have the same securities, the same information (Paulson is bearish!), but I seriously doubt that the SEC would call foul because Goldman let ACA take a position that one of their other investors would not take. It’s Paulson’s presence at the scene that makes the SEC think they can call this a crime–and the alleged crime could happen even if Paulson wasn’t there!

  7. Indy writes:

    I think Kid Dynamite is on to something. Referencing the completely empirical and objective standards of my under-informed moral intuition, I find that I have a sliding scale for measuring the moral turpitude involved in Goldman’s actions. If they were acting as advisers and brokers for some old Granny who desperately needs a rock-solid fixed-income and essentially treated their client as a chump and sold her a portfolio of things they knew were junk in pursuit of fees and their own contrary interests while claiming to warrant their quality, well, then people should be going to jail.

    But as Granny becomes increasingly educated, professional, resourced, sophisticated independent financial-institution-like, and as the distance goes from intimate to arm’s length to caveat-emptor / presumptively adversarial, and as the disclosure goes from zero to 100%+ (with the opportunity to intelligently investigate and ask questions) – then I care less and less until it becomes debatable, and past that point, I find I can’t care much at all.

    The more I learn about this deal, the farther away from Granny I get, and the closer to the Kid’s position I move. Questions of actual legal liabilities and ideal ethical considerations aside, my subjective sympathy engine for those that actually made the decision to buy is starting to sputter out.

  8. David Pearson writes:

    Those that argue this isn’t fraud because IKB should have known better misunderstand, I think, the nature of a CDO.

    1. CDO’s add value purely through diversification; if a CDO investor knew that underlying reference securities were not “diversified”, he would pay less for or shun the issue.

    2. By letting Paulson pick the reference securities, ACA effectively canceled the value created through diversification.

    3. GS sold a non-diversified CDO to investors while representing it as diversified, even though they knew, given the portfolio selection process was skewed in favor of the counterparty’s interest.


    A commenter asked if one would buy a mutual fund if he/she knew the portfolio was constructed by someone short the underlying securities. Of course. Some of the mutual fund’s benefits come from diversification, and some come from “alpha” — divergence in views over potential fair value for the INDIVIDUAL securities.

    In contrast, I would argue that ALL of a CDO’s value arises from diversification, none from potential mis-pricing of individual reference securities. Therefore a CDO investor is COUNTING on buying a diversified portfolio constructed almost “blindly” with regards to price arbitrage potential. The seller of this portfolio — effectively Paulson — jammed the portfolio with securities it felt had the potential for significant price arbitrage. One can conclude from that, fairly easily, that the portfolio was not diversified, at least not in a way that the CDO investor could fairly expect. Goldman, in order to market this security, HAD to refrain from stating that fact, otherwise the deal was DOA.

    Was Goldman’s failure to disclose the CDO’s lack of diversification a violation of securities law? No idea. In fact, I don’t think anyone really knows, because the blanks in securities law are filled in by the courts, and we cannot know how the court will fill in this one.

    Lastly, I would point out that those who argue IKB should have known it was “playing with the big boys” misunderstand, I think, the nature of a CDO. If Paulson felt housing was going down the tubes and IKB was blind to that fact, that view holds true — it takes two views to make a market, and IKB had the losing one. If IKB was WILLING to take the risk of a housing implosion ONLY in exchange for diversification, then IKB, even while playing with the “big boys”, was defrauded.

    It is one thing to know your counterparty has an opposing view; quite another to know you are paying for a CDO and getting something quite different.

  9. M writes:

    “The Investors would not have taken the position at all had it not been for the intervention of Bank Y.”
    Truth is, the investors were always looking for the highest yield possible in safe investments. All deals they would have done would have been brokered by a trader with a goal to get a deal done. In this case to help someone with a bearish view “to express that view”, in a lot of other (earlier) cases to take the risk of the balance sheet of the originators, etcetera. Each investment opportunity is caused by an underlying need of someone else. What the trader did here is not different from what traders do every day.
    Question maybe more important is: did Goldman at the time send out messages that the RMBS market was about to fall apart (as apparently they thought internally) or did they send out messages that everything was honky dory and the only way is up. Through there communications to there clients. Did they share their view with their clients or did they keep that to themselves to make a killing at the cost of others.

  10. David Pearson writes:

    BTW, those that take issue with ACA’s role may be missing something.

    If I set up a mutual fund with twenty lousy energy stocks and it tanks with the oil price, good luck suing me for negligence.

    If a registered rep markets that mutual fund as diversified, it is fairly easy to sue him under securities laws.

    The SEC is going after Goldman because the law on the marketing of securities is much tighter than the law on managing them.

  11. rootless_e writes:

    David Pearson: Isn’t the core of the financial collapse the fact that investors did not understand that buying the same garbage originated using the same processes from multiple sources is not diversification? The flipchart spells out exactly the kind of diversification that IBK got. The problem for IBK was not that Goldman lied about the assets but that the S&P rating meant zero and the ACA model was junk.

    I think Goldman is still screwed for three reasons (a) they encouraged ACA to deceive itself about Paulson’s position (b) they forgot to make the Wells notice public and (c) even someone like me who thinks the real culpability is at IKB would vote to convict Goldman on general principles.
    My belief is that they have never bothered to analyze what leverage NYState now has over them and when Cuomo hits them, they will collapse.

  12. RK writes:

    To Kid Dynamite’s point, this is a custom product and NOT some vanilla run of the mill retail security. Only *sophisticated* investors are allowed in by law. So the hue and cry of this issue is that the *sophisticated* investors felt taken because they trusted Goldman instead of looking carefully at this custom thing they were buying. Would they have sued Goldman if they had come out ahead?

  13. Kid Dynamite writes:

    David Pearson – ACA picked the securities. It doesn’t matter if they picked them from Goldman Sachs’s recommended list, at random, based on their own criteria, or from Paulson’s larger list. THEY had the final say. i literally have no idea how you can categorize them as victims. by the way, i’m not arguing that GS isn’t guilty of fraud – I am not a lawyer – I’m saying that it doesn’t really matter, and that ACA/IKB are using it as a poor excuse after the fact, when in reality, they got hosed by their own failure to do their work.

    also, as an aside on one of your other points: i think the whole point of the CDO market’s collapse is that the diversification you speak of was a total pipe dream. ALL the correlations and diversification assumptions were completely wrong.

  14. JKH writes:


    I would argue that much of the required information you claim is missing due to the absence of counter party identification is in fact present due to the disclosure of the size of the deal – e.g. $ 2 billion. That gives the investor ample information on the supply of new shorts coming into the synthetic CDO market. The size of the short supply is arguably more important than knowing the identity of the short originator(s) or the motivation for that supply as between “hedging” and “speculation”. For that reason I would question whether the “premium” you’ve constructed has actually been paid by the investor in this case – i.e., whether a $ 2 billion intermediated deal is really more expensive for the investor than an alternative $ 2 billion non-intermediated series of smaller deals. Don’t forget that the CDO structure does transform the referenced cash flows, and that there would be considerable operating costs associated with an alternative non-intermediated serial transaction structure – whatever that would look like in implementation. Because of the required cash flow transformation, this type of deal really is the equivalent of a block trade for a comparable standard homogeneous product.

    Suppose I am Z, a CDO investor, meeting up with Y the dealer directly and X the trader indirectly.

    What are the parameters I want to consider in order to make my CDO investment decision?

    Again, one of the things I want to know about this CDO is its size. I want to know if it’s $ 200 million or $ 2 billion. And I know that up front. This to me is the information I require in my decision making to manoeuvre in and around the set of issues you’ve described as the “premium” outlay in buying such a CDO. If such a premium exists, I would lean toward classifying it as a liquidity premium of sorts, whereas you might lean toward “deception premium”. But I doubt that it exists, simply due to the disclosure of the total size of the deal. Lesser importance should be attributed to the composition and origin of that total new short position coming into the market. It’s there for everybody to see, regardless of where it came from.

    And I want to know whether the CDO opportunity is cash or synthetic. Why? Because a synthetic CDO opens up far more possibilities on who may be on the short side, which is interesting to me.

    With a cash CDO, I know that there is actual mortgage content in the CDO itself. So I know that the mortgage origination business was at the start of the cash pipeline that supplied this risk to the CDO. In that sense, the ultimate short for the CDO is the mortgage business itself, and the borrowers who are the end users of the money. As per your discussion of shorts and longs, I don’t mind classifying this source generally as a short position. But as an investor, at least I feel I’ve got more of handle on the nature of the risk I’m assuming as a result, even if that perception is illusory – it’s a general sense of touchy feely “legitimate” hedgy – notwithstanding any dubious particulars in the underwriting risk involved in mortgage origination.

    With a synthetic CDO, I have no such general sense of such a “hedging” anchor. I’m naturally curious about where the short side might be coming from. How do I think about those shorts in the sense of hedging or speculation? Maybe banks, hedge funds, or portfolio managers somewhere are hedging their risk on new or existing mortgage assets, rather than selling their mortgage assets via securitization into cash CDOs. Maybe a hedge fund is making a bet. Are people hedging or are they speculating? Absent disclosure about where those shorts are coming from, I just don’t know.

    But the question then becomes how valuable is such information to me? Why would I be concerned about the distinction between knowledge of speculation and knowledge of hedging? Why should knowledge of an incremental eruption of hedging via a synthetic CDO be less concerning than the same information regarding speculation?

    Moreover, who is to decide just how much knowledge I should have? If I believe it is my right to know that John Paulson is speculating on mortgage risk via a synthetic CDO, then surely it follows that it is my right to know what else is on John Paulson’s balance sheet on a real time basis – because if I don’t know that, I really can’t be sure of my assumptions regarding the full motivation and content of his alleged speculation.

    It seems to me that such a “right” to know what the other side of a trade becomes a slippery slope.

    And then there’s all the other stuff involved in executing due diligence on the actual content of the deal. Again, the content is what it is, regardless of its origin.

    I see nothing inherently wrong with the concept of CDO cash flow transformation. What went wrong was a mass delusion / failure of imagination in an industry of “risk management experts” who worshipped at the altar of historical standard deviation and correlation (going back to LTCM), and in this case leveraging on the mortgage origination industry fraud that created the supply of cash product initially feeding such a transformation exercise (before synthetics took over).

    Excellent posts as usual. Interfluidity tends to be the gold standard for making it interesting.

  15. So far, things look okay. But as far as I can tell, that’s just because we haven’t gotten into the details of the conversation between the Bank and the Investors.

    I imagine that the Investors at some point ask this question: “What’s the guiding principle of this investment vehicle? Why is the stuff that’s in it, in it?” And if the Bank says, “It’s a bunch of stuff that Trader X wants to bet against” that probably wouldn’t get the Investors very excited. If the Bank says, “It’s a mortgage product carefully designed to achieve investment goals A, B, and C” that sounds better. But in this case, that would be false, because that’s not actually the guiding principle of the investment vehicle.

    Suppose you’re a S&P index investor, and it comes out tomorrow that S&P adds and deletions are actually done for the convenience of Trader X, so he can move in and out of big positions. I think you should be quite annoyed with the S&P or whoever was misleading you into thinking it was done on more neutral criteria. The Premium isn’t even the issue here. It’s that people shouldn’t lie to you when you ask them why the thing you’re investing in is structured the way it is.

  16. David Pearson writes:

    Kid Dynamite,

    I’m not sympathizing with ACA or IKB. Of course they made a stupid investment. That is not the point. Securities laws do not protect investors from their own stupidity: they protect them from fraud and misrepresentation.

    IKB must have imagined that diversification in CDO’s would present a measure of safety against a housing crash. Back in 2007 most CDO investors believed that a housing correction in certain geographies would not affect the “safer” tranches of a subprime CDO. Such a portfolio-impacting event was thought to be, in fact, a virtually impossible “six sigma” occurrence. Was that analysis spectacularly foolish and mistaken? Of course! But correlation analysis of diversified portfolios — whether crude or sophisticated — is what IKB and dozens of other institutions relied on at the time. I find it amusing that Goldman defenders argue IKB should have “done their homework” and “gone over the individual holdings with a fine tooth comb”. Again, the essence of a CDO is that you DIDN’T have to go over it on a micro basis, assuming some base level of diversification, a “macro” (correlation) analysis told you what you needed to know. Goldman knew this, and it knew the portfolio was not diversified, and it marketed it as a “normal” CDO.

    Every bubble has its analytical handmaiden. Just the other day I read a paper on how “traffic takers” — analysts of railroad traffic — used observed “rules of thumb” during the early days of British railroad penetration to predict traffic in saturated geographies. Time after time these “traffic taker” studies were cited in railroad investment promotions. The projections ended up being, again, spectacularly wrong. Correlation models had the same role in the housing bubble. The analysis itself is not “fraud”, just stupid but pervasive. Beyond correctly representing stupidity lies fraud, and that is the area the SEC is investigation.

  17. Cumudgeon writes:

    My (lay) understanding of Abacus is that GS loaded up the entity with assets that were very likely to fail.

    It’s one thing if bank Y lines up a bet between traders X (short) and Y (long) over the future worth of asset class Z. It’s a very, very different thing if bank Y lines up a short-long bet and allows trader X to cherry pick the worst Z assets available.

    Cherry picking bad assets for an investment vehicle is no different than making a bet over the worth of a building with the inside knowledge that it’s going to have a suspicious fire in the near future.

  18. Panayotis writes:

    The whole point is complexity of the product introduced whose impact has feedback of recovery trade has an entropy of inertia and impresion of information has an entropy of illusion. Inertia and illusion about the product discourages issue party offering operations and rations counterparty investment demand. This can be exploited by intermediaries that share the premium, one of them collecting fees by searching its value and covering its security with its reputation and the other intermediary betting against it by assessing its adversity and monitoring its evasive outcome.

  19. RichL writes:

    It is hard for me to have sympathy with the argument that the Abacus CDO lacked diversification. If anyone cares to take a look at the list of failed banks at the FDIC website, they will see a broadly diversified list of names. Regrettably there was an overall collapse in Real Estate, and the poor result was due to the asset class. Paulson’s name would have been a non-issue in 07; he was a dilettante in mortgages trading vs. a buyer with experience in the business.

    No doubt there were quite chunky yields on the paper. In this instance, as in so many others, the yield hogs lost money.

  20. bkmacd writes:

    One question is how did the security selection for the Abacus deal differ from the security selection for other synthetic CDOs?

    Felix posited that Paulson had control over the CDO because he could determine 55 out of the 90 securities, but that doesn’t answer the question above. Obviously both the short and the long side of the transaction are trying to construct portfolios of RMBS that they think will reach their desired goals but I think the above question matters.

    If the Bearish bet lost money because the Broker constructed a very good CDO that didn’t lose money at the behest of the Bullish counterparty, would the SEC still sue? Would we feel that this was still wrong?

  21. Danny Black writes:

    Cumudgeon, GS didn’t load it up with anything. ACA was the one who “loaded it” up. They got “requests” and “suggestions”, which were probably quite forcefully made but still ACA still had final say as shown by the fact it rejected nearly half of the those “requests”.

    I remember reading a “revelation” that in the mid-80s Bill Gates had suggested to Apple licencing their MAC OS to other PC makers. Because this was the late 90s and because Gates was considered a business genius and because Apple was considered a failure this was some sort of shocking news. Of course at the time Gates was one of many software CEOs and Apple was riding high and it was only with 20-20 hindsight our perception changed.

    It is exactly the same here. I am sure it is no coincidence this deal was picked. You have Paulson, who is solely known for making money shorting the sub-prime market and rightly so given he was a mediocre merger arb guy and the trader who actually made the bet was by all accounts considered a burn-out. You have GS who we all hate anyway right. And we have sup-prime which we all know now was due to soon blow up – except we didn’t know then or didn’t know it would happen soon. I wonder if there would be the same outrage if the whole bubble had carried on inflating for a couple more years. Paulson gets killed for making a short bet, ACA makes a bundle and Fab Fabrice presumably gets thanks…

  22. rootless_e writes:

    Pearson: “Again, the essence of a CDO is that you DIDN’T have to go over it on a micro basis, assuming some base level of diversification, a “macro” (correlation) analysis told you what you needed to know. Goldman knew this, and it knew the portfolio was not diversified, and it marketed it as a “normal” CDO.”

    But both ACA and S&P certified the product to be “diversified” enough to get their blessings. Those were the gold standards of the time and the entire deal, the entire CDO market, rested on the certifications of these “experts”. I’m not shedding any tears for GS, but if this is fraud then anyone who sold a product that was marketed on the basis of e.g. Moodys ratings who had ever had information that Moody’s was full of shit committed fraud. Actually, that seems reasonable.

  23. Here’s post that deals with my concerns:


    “Greg Zuckerman, as pointed out by Wall Street Manna, in his book “The Greatest Trade Ever” describes Paulson’s meetings with Goldman, Bear and Deutsche to “ask if they could create CDOs that Paulson & Co. could essentially bet against. Ironically, it was Bear Stearns that rejected the offer: “[Bear Stearns trader Scott Eichel] worried that Paulson would want especially ugly mortgages for the CDOs, like a bettor asking a football owner to bench a star quarterback to improve the odds of his wager against the team … he felt it would be improper.” Eichel told Zuckerman, ” ‘It didn’t pass our ethics standards; it was a reputation issue, and it didn’t pass our moral compass.”

  24. […] a separate post, Steve mulls a more abstract view of whether Goldman did indeed act as a ’secret agent’ for one client to the […]

  25. fresno dan writes:

    Taking the Kid Dynamite logic, which I think is a good point, we end up at what may be an even more disconcerting conclusion than the fact that GS is evil: Most of the people in finance are simply stupid. Astoundingly stupid.

    Maybe it wasn’t fraud, or lack of disclosure, or mischaracterization. At the very bottom line, when in my neighborhood crappy, crappy (did I mention crappy???) townhouses reached 350K, and everybody knew something bizarre was happening, people in finance (they must be reincarnated tulip speculators) thought that houses can only go up (gee, didn’t they remember Pets.com???), people got paid grandly who did not know what they were doing.

    The question I always ask: With what is now known, why do people still do business with Moody’s, Fitch’s, or GS? It can be debated if they are criminals (I can’t say I mind if they go to jail) but what can’t be debated is that these people really don’t know what they are doing. BUT PEOPLE STILL TRANSACT WITH THEM! How is that possible in a system of supposed rational actors?

  26. JKH writes:


    “The fact that ACA Asset Management was the “Portfolio Selection Agent” is Goldman’s best defence … none of this … 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.”

    That’s my original view as well, and is why Goldman will escape this.

  27. M writes:

    I think this is a good, clear take down of the case.

    I was with JHK first, but now start to doubt. The law is vague enough in its words to be used against Goldman in this case, and because it is a jury trial the negative image of Goldman Sachs will not help.


  28. David Pearson writes:


    You might find this paper useful. It discusses how cherrypicking the securities underlying a derivative might affect its price, and yet also might be difficult to detect. This essentially supports my thesis that by ACA, by allowing Paulson to materially INFLUENCE portfolio selection, created a large deviation between theoretical and actual value for the CDO. ACA, however, was not actually at fault under relevant securities regulations that govern the marketing of securities. It was Goldman that had knowledge of this material fact, and either failed to disclose or made false claims while marketing the deal.

    Here is a relevant bit from the paper:

    “Note that the lemon issue for derivatives has been examined before. It is well-recognized that
    since a seller is more knowledgeable about the assets he is selling, he may design the derivative
    advantageously for himself by suitable cherry-picking. However since securitization with derivatives
    usually involves tranching (see Section 3 and Appendix A), and the seller retains the junior tranche
    which takes the rst losses, it was felt that this is sucient deterrence against cherry-picking
    (ignoring for now the issue of how the seller can be restrained from later selling the junior tranche). We will show below that this assumption is incorrect in our setting, and even tranching is no safeguard against cherry-picking.”


  29. David Pearson writes:
  30. Jon W writes:

    1. CDO’s add value purely through diversification; if a CDO investor knew that underlying reference securities were not “diversified”, he would pay less for or shun the issue.

    2. By letting Paulson pick the reference securities, ACA effectively canceled the value created through diversification.

    3. GS sold a non-diversified CDO to investors while representing it as diversified, even though they knew, given the portfolio selection process was skewed in favor of the counterparty’s interest.

    While you are right that CDOs benefit from diversification it is a) not necessarily the primary reason they were entered into and b) you fail to establish that a selection process makes it less diversified. Portfolios are never picked at random.

    Assume Paulson were on the long side of the portfolio and picked them in fashion where he felt that the safest securities were in the CDOs. Using your logic, simply as a function of him picking choosing specific securities eliminates the entire benefit of the CDO. That makes no sense.

    Diversification is simply spreading your risk out along multiple securities to lower the risk of any single one. It does not mean that the portfolio constituents cannot be correlated to one another. Many are. Entire industry, country and sector ETFs are based on this. The portfolio was clearly constructed ontop of subprime mortgages.

    One of the primary functions of CDOs is the ability to split the underlying securities into tranches. There by establishing different return profiles based on the various levels of risk associated with being in a particular debt or equity level. Many banks and investors bought / entered into CDOs because they offered higher returns for simliarly ‘modeled’ levels of risk/ratings.

  31. […] Tags: Abacus, Bancos, Goldman Sachs, GS, informacion, market makers, mercados, trades En un post, Interfluidity, describe al actual affaire Goldman Abacus, como un caso hipotético. Una […]

  32. Steve Randy Waldman writes:

    The quality of this comment thread is extraordinary.

    I’ll just add a few points.

    1) Criticizing Goldman’s behavior doesn’t in any way exonerate ACA Management, ACA Capital, IKB, ABN/AMRO etc. I think that the long side of this deal was motivated by a set of institutional incentives that encouraged banks to ignore tail risk and seek highly rated yield. I do think that including the fact that the sponsor intended only to short the structure would have killed the deal, because i) it would have hinted at idiosyncratic risk, when long investors’ strategy was to be “conventional bankers” in Keynes’ sense, that is to go broke only when everyone else goes broke so that they cannot be blamed; and ii) it would have created career risk for the managers signing off, made them look unusually incompetent if things went sour. In other words, I don’t think the “victims” here were innocents. But that doesn’t give Goldman a license to withhold material info.

    2) Contra Kid Dynamite above, I think that investors of any time horizon are and should be interested in understanding the motivations of their counterparties. Fundamental valuation is an inexact art at best, and as David Pearson calls attention to, some assets may be literally immune to valuation, and may be constructed to be that way. I think that the nature of Paulson’s involvement would have been material information to a reasonable investor, and even with the unreasonable investors actually involved, would have scuttled the deal if formally disclosed.

    3) All that said, my purpose in this post was to pull out away from most of the more sordid details of the actual scandal. I intentionally did not use CDOs in the story, only something that could generically go long or short. I left it perfectly open which side of the investment would eventually profit, so we wouldn’t be misled by sore losers. I did not have the short interacting with the investment fund manager. The only questionable act in my story was the investment bank’s selection of a new fund it would promote without disclosing that its motivation for initiating that fund wasn’t the ordinary business conditions that might inspire to to market a fund, but a payment by Trader X who needed the liquidity the new fund would incidentally provide. If the real Goldman had only done what Bank Y is accused of in my story, I am certain no charges would have been filed. The “crime” would have been too abstract. Nevertheless, my view is that would have been enough to create an ethically challenging situation.

    4) Both in the real story and my parable, the size of the deal relative to the liquidity of the proposed investments is important, as JKH suggests. It’s worth noting that liquidity covers a lot of ground: Markets with a lot of turnover relative to the proposed deal size would be more liquid than markets that trade little; markets with a lot of hedgers or traders without divergent-from-market-price views are much more liquid than markets dominated by traders likely to be transacting based on information (real or perceived). I think that part of the Paulson story is that liquidity was asymmetric in the RMBS CDS market. Banks would take transient short positions against CDO deals cheaply, because CDO deals were viewed as noninformational traders. There was little “adverse selection risk” (the possibility you’ll get ripped off because the guy you’re trading with knows more than you). But although investors hedging exposure to their own RMBS were noninformational, someone trying to take a large short position in a brief period of time was as an adverse selection risk and charged a premium. If I’m right (I may not be!), then deal size alone wouldn’t have been a very good “tell” to CDO investors that there was speculative interest on the other side. (To a degree this is an empirical question: were the Paulson/Magnetar-catalyzed CDOs unusually large?)

  33. JKH writes:

    To what extent does the interpretation of Trader X’s motivation/role in the deal as “material information” depend on the judgement that Trader X has access to additional critical material information that isn’t available to the financial markets at large?

    Specifically, in this case, what unique material information did Paulson have on the underlying mortgage market that wasn’t available to the financial markets at large? What “inside information” did he have on the underlying mortgage market that the rest couldn’t have accessed or researched or analyzed on their own?

  34. JKH writes:

    On the legal issue in this case, more inquiry into the critical Goldman-ACA nexus:



    I think the legal question becomes whether or not ACA’s responsibility to obtain confirmation in writing of any of its interpretations or assumptions or doubts regarding structure and agent roles within the deal was greater than the obligation of Goldman to read ACA’s mind this regard and provide that confirmation accordingly.

  35. […] S.E.C. case revolves around how much say Mr. Paulson had in building the portfolio that he would eventually short, whether that […]

  36. Greg Taylor writes:

    Regarding JKH’s question on the nature of Trader X’s material information, I can think of a couple of possibilities.

    First, while the data are available to the financial markets, the analysis to reproduce the information that Trader X has is both time consuming and expensive. Now, if each investor has far less at stake than Trader X, it is possible that the costs of the analysis would make the transaction uneconomic to the investors. The only way the transaction makes sense to these smaller investors is to “free-ride” the analysis of a third party – ideally another trusted investor. Trader X and Bank Y understand this – their profits and fees depend on the trusted third party.

    This first situation seems pretty common in the financial world. Look at the many sources of close-to-free financial analysis available to investors. The situation seems ripe for confidence games.

    A second possibility, not only is the analysis time consuming and expensive, but it uncovers material fraud in the underlying securities. Even more motivation for Trader X to bet that they go bad. If he knows the securities are fraudulent and colludes with Bank Y to create the investment vehicle, is he not committing fraud?

  37. Games writes:

    also, as an aside on one of your other points: i think the whole point of the CDO market’s collapse is that the diversification you speak of was a total pipe dream. ALL the correlations and diversification assumptions were completely wrong.

  38. […] follows this up with an analysis of the premium that Goldman extracted from the buy-side investors and transferred to Paulson (in exchange for its […]

  39. Kosta writes:

    Steve Randy Waldman wrote To a degree this is an empirical question: were the Paulson/Magnetar-catalyzed CDOs unusually large?

    Well Yves Smith, quoting her own book, recently :

    Those numbers suggests Magnetar’s entire program was large, although I imagine the individual deals were smaller.

  40. Kosta writes:

    Steve Randy Waldman wrote To a degree this is an empirical question: were the Paulson/Magnetar-catalyzed CDOs unusually large?

    Well Yves Smith, quoting her own book, recently wrote:

    Some other important details about the Magnetar trades that are discussed in ECONNED include:

    • How a seemingly small amount of BBB tranches from subprime bonds used in Magnetar’s CDOs, had a devastating impact on the subprime market. Consistently conservative analyses indicate that in the peak years of 2006 and early 2007, Magnetar’s program drove the demand for roughly 35% of subprime bonds. Industry sources have estimated that the number may be as high as 50% to 75%.

    Those numbers suggests Magnetar’s entire program was large, although I imagine the individual deals were smaller.

    (sorry about the double post)

  41. Rajesh writes:

    The issue revolves around the ability to short securities. Is it fair for Mutual funds to be forced to stay long securities with public money, while hedge funds are allowed to take short leveraged bets using money borrowed from Banks, against them, in the same market ? The two should not be allowed to coexist in the same market, as they are not playing on a level platform.

    In this case, the security did not even exist! The investment bank put up a sham fund and a portfolio manager with no sense of fiduciary duty, loaded it with bad securities ( Feb 2007 was pretty late in the day to represent RMBS as good legitimate long term investments) and then represented the same as legitimate securities to foreign banks. Page 26 & 27 on the flipbook detailing ACA’s abilities and expertise ( “Investment decisions are credit driven and conducted by industry specialists,
    – Every investment is approved by a heavily experienced investment committee, No rated notes in any of ACA’s CDOs have ever been downgraded” ) are simply fraudulent in any moral sense of the word. It does not matter if it was not illegal under current laws.

    The fact that these securities were illiquid was a signal, that no one wanted to buy them. By finding someone willing to short the security and matching them off with a buyer, you are creating a false market with temporary liquidity to offload this product. Did the investors have the opportunity to turn around and sell the securities back to Paulson ? Would Goldman have stepped in and allowed them to open a short position once they realised where the market was going ? This is wrong at so many levels that I dont see why we are even arguing about it.

  42. o. nate writes:

    An interesting unanswered question is what, if anything, was revealed to the rating agencies who rated this deal about the involvement of Paulson. Clearly the deal never would have happened without the blessing of the agencies. Did Goldman mention anything to them about Paulson’s involvement?

  43. Wyncher writes:

    Simply put, “caveat emptor”. But, here we are splitting hairs, but because of the size of the transaction, split hairs are wotth millions. Only the polticcal climate determines whether or not this is a problem.

  44. Patrick E. writes:

    1. To me, it’s clearly not okay for Bank Y to be a secret agent of Trader X while engaging in the marketing of a new investment fund. Bank Y is supposed to be an honest broker in these transactions – that means having to reveal all material information. And as to marketing a new investment product, they have to be an honest broker there as well.

    2. Information assymetries are often part of market transactions. However, market participants are often clued into those information assymetries when they encounter each other in adversarial positions. If Trader X had encountered the Investors in the marketplace, due to the size and direction of the trade, the Investors would have sussed out this information assymetry, would have demanded the Premium, and they would have gotten it for the risk they took.

    3. To JKH, that Trader X’s motivation/role is material information does not depend on the judgment that Trader X has access to additional information, merely that it is material because it is information that any reasonable investor would consider important. If Trader X is making such a big bet, relative to the market, opposite from the one I would make, is there something that Trader X knows that I don’t? It is the size and the direction that leads one to question or believe that Trader X has access to additional information, regardless of whether Trader X actually does. Maybe Trader X is crazy, but the size and direction would make one pause before taking the opposite side.

    4. Re: Kid Dynamite’s trade: The problem with that example is that for most market deals, without some obligation to disclose information, the deal you’re really giving me is that the bag of paper contains 1000 $100 pieces of paper, but I can’t look inside until I’ve bought it. Also, value changes because the world changes.

  45. […] read regarding the Goldman […]

  46. SWH writes:

    I think Steve Waldman nails it with this and the last post.
    1. As a buyer of the synthetic CDO, I expect it to be constructed to perform, not constructed to fail. I know there are always “shorts” in the CDSs within the CDO, some are hedgers, some are speculators. I want low, zero or negative correlation among them. The manager has a duty to construct it as an investment vehicle, to be rated as “AAA”. To have a potential shorter of the CDO (not just counterparts in the CDS components within the CDO)to participate in the construction of the CDO is absolutely inconceivable and is definitely a material fact. Whether or how I would act on it is irrelevent. His participation disturbs the correlation of the product and his interest is in constructing the CDO to fail. Again, whether or not it will fail is irrelevant.
    2. I am really curious about this and I would appreciate comments and information on this. Paulson should not be allowed by GS to short the synthetic CDO (again, we are not talking about the CDS within the CDO). At least it would have been a necessary disclosure item. The fact that he participated in constructing the CDO which he is shorting must be a disclosure item when he is shorting the CDO. Wonder who is the counter party to his shorting of the CDO? Why would anybody take the other side knowing that he helps to construct it. This is not the same as the MBS or CDO equity owner getting insurance. This is a side bet, in comparison with his equity stake.

  47. I get confused easily when it comes to information asymmetry, opportunity cost and disclosure. How is the Premium an opportunity cost to the Investors if they do not know it exists (because as you note, if they did, they would either demand it or not perform the trade)? We know it exists, because we are omniscient onlookers of the story. Furthermore, the entire purpose of Trader X’s mission, if I understand correctly, is to pocket the Premium for himself. I’m going to assume that Bank Y also earns the majority of its fees only if it finds Investors to complete the deal.

    What I can’t shake here is that if someone approaches you with a neatly packaged deal with your name on it, of course they have more information about it than you do. There should be no dispute about that. The only question is whether there is a positive net value in taking it, respective to competing deals.

    So, if the Investors could not detect a Premium, who is to say it even exists? And should Bank Y be forthcoming about it, against its own interest (confined to this context of course)? Every day, I probably incur dozens if not hundreds of opportunity costs of varying significance, just as a part of my routine. It is almost certain that somebody out there is aware of one or another, possibly someone I know, possibly someone who has observed me making one of these mistakes. Should I expect them to stop me and point out my foibles? Honestly I wish more would, but I doubt I could guarantee being receptive to them when they do.

    That said, if I asked them about it, I’d expect a straight answer. But that would entail being tipped off in a way that could form a straight question. I think I’ll go back to my original observation, though: If someone comes to you with an offer they clearly put a non-trivial amount of effort into, they must know something about something. What would be interesting to know is who said no to ABACUS and why?

  48. […] Steven Randy Waldman at Interfluidity (via Felix Salmon) argues the same. […]

  49. […] investors in this particular deal.  The best explanation for how this played out can be found here. […]

  50. […] two articles by Steve Randy Waldman clarify the case, even to the layman; Goldman-plated excuses; L’affair Goldman in price/information terms. Waldman blogs at […]

  51. […] L’affaire Goldman in price/information terms […]

  52. […] contribution to “the liquidity and vitality of our financial system“.  In fact as Steve Waldman argues the Abacus CDO — by giving Paulson the opportunity to trade off the public ABX market […]

  53. […] Goldman in price/information terms Hypothetically speaking, Goldman Sachs still come off as douchebags. by Quixote | May 1st, 2010 | Permalink | Printable Version […]