Randomly Noted

The SEC alleges Goldman's work on a CDO enabled something else

It’s hard to say that the structured financing transaction at the heart of latest Wall Street scandal was what ultimately led to the credit crisis. But this transaction did involve a number of banks with financial ties to the deal that ultimately had to be bailed out.

This latest Wall Street drama has also dragged into it two of the biggest players on both sides of the financial markets – Goldman Sachs and hedge fund Paulson & Co.

The Securities and Exchange Commission today charged Goldman with fraud because it said the firm and an employee knowingly created a deception that allowed Paulson to make a billion dollars. The story involves some other favorite bad guys – subprime mortgages and complicated structured financial instruments. Paulson wasn’t charged.

The question is what this case might ultimately mean for both Goldman and Paulson.

At the center of this case is something called a synthetic collateralized debt obligation (CDO). Typically, a CDO is a bond that has bundled together other debt securities, often securities themselves that are the result of another bundling. A synthetic CDO doesn’t own any of these securities – instead, it holds credit default swaps that are designed to mimic real securities that are owned by someone else.

So, when this synthetic CDO (called ABACUS) was created, Paulson had a big say in what securities it would follow. And they were mostly subprime mortgage-backed securities that through research, Paulson had concluded were garbage. Now, it is apparently not unusual in the CDO world for a hedge fund to have a say in the portfolio when it is willing to buy equity ownership of the CDO (think of these things as almost being set up like a company – different layers of debt and a slice of equity). But what is unusual is for a hedge fund to pick the CDO portfolio and have no equity stake. And what is extremely unusual is for that same hedge fund to then have entered into credit default swaps that allow it to profit if the CDO performs really badly. That’s what Paulson did and Goldman not only knew Paulson did it, but fraudulently let investors believe that Paulson owned the equity – something that the SEC says convinced some to invest in the CDO.

Like IKB Industriebank of Dusseldorf. It bought $150 million of the CDO in April 2007. A few months later, the portions of the CDO it bought were worthless. IKB that summer received the first of its two government bailouts because of heavy losses from its huge U.S. subprime exposure. Enter ACA Capital – it agreed to insure or take on the credit risk of more than $900 million of the senior tranch of this CDO. Now, bring in ABN Amro. It agreed to take on the credit risk, through a series of transactions, if ACA Capital couldn’t meet its obligations. Kind of like insurance and reinsurance.

By January 2008, 99% of the CDO was downgraded and investors lost $1 billion. Because of the CDS it held, that meant Paulson picked up $1 billion.

At the end of 2007, ACA Capital began to experience financial difficulties because of its subprime exposure. It had to unwind billions of dollars of transactions and is, as the SEC says, being operated as a run-off financial guaranty insurance company. In other words, it will be wound down to nothing.

In late 2007, ABN Amro was faltering and was sold to a consortium of banks that included Royal Bank of Scotland. In august 2008, Royal Bank of Scotland unwound those ABN Amro positions in the CDO. It coughed up $840 million that it paid Goldman, and Goldman subsequently handed the money over to Paulson.

Royal Bank of Scotland later was bailed out by the U.K. government.

For the SEC complaint, click here.