Interesting Times

By Jack McHugh, The Big Picture, 4-21-10

Q: Why did Paulson & Company get to pick the securities to be referenced in ABACUS?

A: Sorry, but this misconception is a common one. Paulson’s firm may have wanted poor securities backing this synthetic CDO, and they might have even made this desire known to the issuer, Goldman Sachs. But the primary — and final — determination on security selection was the responsibility of the CDO manager. The manager was ACA, not Paulson & Co.

Q: Wouldn’t ABACUS investors wanted to have known that Mr. Paulson was on the other side of their synthetic CDO?

A: Of course, but they already knew who their counterparty was in this transaction — it was Goldman Sachs. Similarly, GS was the counterparty to Paulson & Co. on the other side of the trade. Putting long investors and short investors together in trades and transactions and collecting a fee is the very definition of what a broker does. Believe it or not, an ethical broker will customarily refuse to disclose the name of parties on the other side of trades. Clients want and expect confidentiality in their dealings.

Q: But wasn’t the legendary Mr. Paulson’s involvement on the other side of their trade a “material fact” investors should have been apprised of prior to the closing of the ABACUS deal?

A: The SEC thinks so, but to say so now smacks of revisionist history. As 2007 dawned, few had ever heard of Paulson and Company (some even confused it with a Portland-based publicly traded firm called Paulson Investment Company). With just more than $10 billion under management, Mr. Paulson ran a large hedge fund but was not yet a legend. That sobriquet was earned only after the housing market collapsed and Mr. Paulson’s hugely successful subprime shorts attracted media attention.

Q: Are you saying Mr. Paulson’s reputation is only obvious now, with the benefit of hindsight?

A: Yes, try to imagine it another way. Should the SEC now go after Warren Buffett for buying up the shares of textile maker Berkshire Hathaway in 1962/63 on the grounds that the sellers (including the founding Stanton family — see below) didn’t know they were selling to an investing genius who would turn the company into a multi-hundred billion dollar empire? Should Mr. Buffett have been required to disclose to the Stantons and other selling shareholders of his grand designs for Berkshire? Of course not, and the Oracle of Omaha is a legend only with the benefit of hindsight.

Q: Speaking of Oracles, if Alan Greenspan, Ben Bernanke, Hank Paulson, and the 95% of folks on Wall Street who called the first cracks in subprime mortgages “contained” had been right and housing had recovered later in 2007, wouldn’t have Mr. Paulson’s firm lost a ton of money?

A: Yes, and he wouldn’t have been entitled to know just which sharpies on the other side of his trade had managed to fleece him, either. Furthermore, the SEC wouldn’t have lifted a finger had ABACUS gone against Mr. Paulson. It seems the government and the media just love to hate the shorts.

Q: Did Goldman disclose its potential conflicts as issuer of ABACUS?

A: Yes, under Risk Factors — if investors bothered to read the documents

Q: If there were so many risks enumerated to investors, why did any of them buy ABACUS at all?

A: Probably because the investors were relying too heavily on the ratings the deal received from the likes of S&P, Moody’s, and Fitch. Investors during the credit bubble often took due diligence shortcuts by relying on the creditworthiness implied by the ratings.

Q: But didn’t Goldman Sachs pay the agencies to rate the deal, potentially corrupting the ratings process for ABACUS?

A: Yes, the issuer (in this case, GS) pays the agencies to rate the deals, and its a hopelessly conflicted process that is mandated by law. Any buyer with a brain would have hired an independent ratings group like Egan-Jones to verify and then validate what the oligopolists (Moody’s, S&P, Fitch) came up with in terms of ratings.

Q: Isn’t it foolish to have the issuer pay, since issuers will want to direct ratings business to those agencies willing to juice up their ratings to win the fee?

A: Yes, this absurd ratings process encourages higher ratings than the paper deserves

Q: So who set up such a dumb system for rating securities?

A: Congress, that’s who. Only Moody’s, S&P, and Fitch have the legal authority to issue officially recognized securities ratings, and Congress thought issuers should pay in order to (theoretically) lower the costs for buyers.

Q: How do the agencies defend themselves when their conflicted ratings end up leading so many investors astray?

A: Historically, they’ve claimed their ratings are protected by the First Amendment to the Constitution.

Q: What? They claim their pay-to-play ratings are covered under free speech?

A: Yes. Though this defense is starting to weaken (see below). Let’s all hope the courts start to recognize that bought and paid-for ratings are actually commerce, not speech. Unfortunately, what the agencies have always claimed as speech has turned out to be anything but free. To this day, and around the world, investors are still paying a frightfully high cost for our ludicrous system of rating securities.