Tuesday, April 20, 2010

Top Ten Bad Apologies for Goldman

[This post was last revised on April 25, 2010.]

For future reference, linking purposes, and the general edification of the bloggerati, I want to catalog the excuses Goldman is making and why the ones I’ve seen so far seem bogus to me.

1. Big boys don’t cry.

The argument is that IBK and ACA should have inspected the mortgage pools themselves and made their own judgments, whatever Paulson’s role may have been. On this score, IKB and ACA stand in different positions, but not necessarily with different outcomes.

IKB is a foreign investor buying US RMBS. It turned to a gilt-edged investment bank and demanded that a respected, independent bond-picker select the assets and that the CDO be rated AAA. If a foreign investor has to do more than that, then the dollar has no business being the world's currency, because it's too damn risky to hold. I mean, all this boils down to GS saying "You trusted me?"

ACA is in a slightly different position. As the selector of the reference portfolio, it cannot claim to have “relied” on anyone, and, in that role, I think it acted negligently in allowing itself to be fooled about Paulson’s game. IKB, I would think, has a case against ACA (if it or its assets can still be reached!) for simply not doing what it was paid to do.

But ACA’s parent, which was not getting paid to select the portfolio, took the biggest loss in this game, and the fact that it was foolishly separated from its money does not mean that it was not defrauded and does not have a cause of action against GS and/or Paulson if the facts support that position. Yes, as insurer, ACA Holdings had an opportunity to inspect the insured portfolio. (I hate to use insurance words about a contract unsupported by insurable interest, but it saves time.) But insurance is a subtle thing. A good underwriter will take into account perils “known and unknown,” including unquantifiable adverse selection. Paulson’s involvement in the selection process raises a serious issue of adverse selection, and, despite being dumb enough not to dope out Paulson’s role when he rejected the Wells Fargo bonds, ACA can certainly claim that Paulson’s role as insured and portfolio selector, if known, would have posed too great a risk of adverse selection to permit the CDS to be issued.

2. For every long, there’s a short.

IKB and ACA are supposed to know that every sale has a seller who thinks that the assets are worth less than they are, so they should not have been surprised to learn that there was a short on the other side of their deal.

Not every sale is a bet against the buyer. When I buy a car, I am betting that it will run. Is the dealer betting that it won’t? When I buy a Treasury bond, I am betting that the Government will pay it off. Is the Government betting that it won’t? If I buy the bond from a private party, is he betting against me? Maybe, but maybe not. Maybe, he just needs some cash to buy a hot stock. There is no implication that he believes the bond will fall in value on account of something other than a general rise in interest rates. Thus, serious mispricing is not a necessary element to a sale.

IKB’s piece of the synthetic CDO in the Goldman case was nothing more than a loan from IKB to GS on which GS did not have to pay in the highly unlikely (according to the AAA-rating) event that the bonds defaulted. IKB was entitled to believe that GS was doing this transaction for the super-senior opportunity, or to provide a real hedge against securities they or a customer owned and liked, and not because anyone thought the bonds would fail. Indeed, just in case GS might be betting against it (and might, therefore, pick a weak reference portfolio), IKB insisted that ACA be brought in to pick the portfolio. IKB thus tried to assure that, whether or not there was a short, the portfolio was picked by a long.

ACA Holdings, the issuer of the CDS did have reason to assume that someone was shorting the portfolio, but, again, the short could have been hedging a long position or betting on interest rates, and ACA Holdings did not know, and had a right to know if it asked, that the short player had in fact helped to pick the portfolio. Thus, the “for every long there’s a short” argument is simply a non sequitur as to ACA Holdings. ACA knew there was a short, but it did not know about the adverse selection in the pool it was insuring.

3. Investment bankers do not reveal counterparties.

This argument assumes that Paulson was “the other side” of a trade with IKB and/or ACA. As to IKB, that argument has no place. IKB did not have the right to know who, if anyone, was on the other side of the trade. But it did have a right to know who picked the mortgages.

As regards ACA, this confidentiality thing is one of the places where the failure to treat CDSs as insurance contracts turns things upside down. Whereas a broker is expected to maintain the confidentiality of the people on each side of a financial deal, an insurance underwriter must take into account adverse selection and moral hazard, both of which are unique to the identities of the ultimate insured and its actual interest in the risk. ACA needed to know at least that the portfolio was chosen by a short and that the CDS was actually reinsurance of GS’s CDS to that very same short. Those are relevant underwriting facts because ACA’s CDS was not a “derivative security” any more than a horse with feathers glued on is a bird.

Moreover, the law treats an insurance contract as being uberrimae fidei – of the utmost good faith. Because of the asymmetry in knowledge, the buyer is required to disclose all relevant underwriting facts. But a CDS isn’t insurance, right?

4. Any portfolio of Sub-prime mortgages would have cratered, so no harm, no foul.

IKB’s claim against ACA for bad portfolio picking might indeed run into trouble if IKB cannot prove that its portfolio actually underperformed because of how it was selected. But ACA is not the interesting defendant here. That would be GS and maybe Paulson as co-conspirator.

If fraud is proved against GS and/or Paulson, IKB may be entitled to rescission of its deal, whether or not it would have lost money on another pool. Why should the defrauder have the benefit of that doubt?

ACA Holdings should have an easier time getting rescission as a remedy. It can reasonably claim that it would not have issued its CDS had it known the facts, so its damages are whatever it lost. ACAH did not pay GS to find it a portfolio to insure, so it does not make sense to me that ACAH’s remedy should be measured by reference to some other portfolio it might have insured. ACAH should be entitled to rescission of the contract.


I know. That’s not 10. But the night is young..

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