ABACUS Spells More Trouble for Ratings Agencies
Good Evening: Having regained most of last Friday’s Goldman-inspired losses, U.S. stocks spent most of Wednesday meandering near the unchanged mark. Investors wrestled with two opposing forces — bullish earnings news from corporate America and evidence that Greece might be slipping back into crisis. Judging by the performance of the main stock indexes, the bout was a draw, but the underlying tension could be seen in rising U.S. bond prices, an advancing U.S. dollar, a firm gold price, and an upward creep in measures of equity volatility. Market participants did their best to put the Goldman Sachs case behind them, but open questions still linger in the minds of many others.
The markets overseas were mixed themselves prior to the open in New York. Asian equities enjoyed gains of between 1% and 2%, but European bourses were flat to down. Various earnings triumphs on this side of the pond, led by none other than Apple, had U.S. stock index futures pointing to a decent start on Wednesday. There was no economic news to speak of, with mortgage applications and crude oil inventories both registering gains that merely offset last week’s declines.
The situation in Greece, however, cast a geopolitical pall over today’s proceedings (see below). While Greece is in talks with the IMF, its unions are set to strike, its debt issues are sinking, and its Credit Default Swaps are soaring. Greece’s fundamental problem of spending far more than it takes in leaves it exposed in a way the U.S., United Kingdom, and Japan are not (at least not yet): It owes staggering sums of money denominated in a currency (the euro) that it is NOT lawfully allowed to print. Expect this situation to get worse again before it gets better, and don’t be surprised to see global equities suffer a shake out as the drama in Greece continues to play out.
Against this both bullish and bearish backdrop, investors seemed rightly confused for most of today. Rallies and dips alternated before most of the major averages finished with small gains. The S&P 500′s 0.1% loss trailed the others, while the Russell 2000′s 0.65% gain not only led the way, it set a post-crash high in the process. As previously mentioned, Treasurys were higher despite the promise of record U.S. debt sales next week. Yields fell between 1 and 7 basis points as the curve decidedly flattened. The dollar rose 0.2% and commodities were up a similar amount. Grains bounced back after a thrashing earlier this week, and, along somewhat buoyant precious metals, they enabled the CRB index to post a modest gain of 0.3%.
President Obama’s Chief of Staff, Rahm Emanuel, appeared on the Charlie Rose show this week and denied the White House had any involvement in the SEC’s suit against Goldman Sachs. President Obama himself said much the same this afternoon, so I will take them at their word that the West Wing had no role in the SEC’s decision to pursue Goldman in the way it did. There are other questions, though, and many of them came to me via phone calls and emails on the subject. Rather than attempting to weave them together with standard prose, I’ve decided to pose some of the better ones in a Q & A format.
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.
– Jack McHugh
Most U.S. Stocks Rise on Apple, Morgan Stanley, Boeing Earnings
Greece Aid Talks Begin as IMF Signals Debt Threat
A History of Berkshire Hathaway
Judge Rejects Credit Rating Firms’ Free-Speech Claims — 9/3/09
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April 22nd, 2010 at 7:34 am
Here is a question: Was ACA led to believe that Paulson was actually the equity tranche investor in the CDO? If so, is that a material mis-representation or omission?
April 22nd, 2010 at 10:15 am
It’s very difficult for any outsider to speculate about who told what to whom. Remember, however, that synthetic CDOs are different structures than are traditional CDOs. Even so, why should it matter to ACA who is playing other roles in the transaction? Their role, and they had the final say, was to pick the reference securities upon which the entire strructure’s performance rested. ACA is supposed to say “no mas” to any monkeying with their duties, but even if they somehow lapsed in those duties, then there are two more important failsafes beyond them. 1) The ratings agencies were supposed to tell investors just what a poor bundle of exposures they were receiving, and 2) Investors themselves were supposed to look over the securities themselves before deciding whether to invest.
In short, it shouldn’t matter to ACA or anyone else who provided “equity” or who was short in this transaction. If the agencies and investors had done their jobs, then the ABACUS deal doesn’t get done.
April 22nd, 2010 at 10:31 am
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.
And who lobbied congress to get that law passed?
April 22nd, 2010 at 10:46 am
Walt, you have a fair point, but the ratings system in place today was set up many, many years before the credit bubble inflated. It was not the result of recent lobbying or Congressional payola.
One thing I left out of both my Q&A and response to Hurricanes was that EVERY synthetic CDO has a long and a short embedded in it. Unlike traditional CDOs, synthetic CDOs cannot get off the ground without parties on both sides of the trade. The long investors knew this fact going in, as did all the players in that market.
April 22nd, 2010 at 12:05 pm
What if there is testimony that emerges indicating the Goldman (along with the rest of the financial industry) colluded with the ratings agencies in a ratings payola scheme? Such a scheme operates along the following lines:
If you don’t give me a (specific) rating on this junk debt, I’ll take my business elsewhere, ALL of my business.
Play this card across the three ratings agencies, and one (or more) of them is likely to accede.
All it takes is for Goldman to commit to the its-all-the-ratings-agencies’-fault defense strategy, then have the SEC counter with emails or testimony indicating the above point. Such testimony appears to be present, if I correctly recall from reading Barry Ritholtz’s book (I don’t have it at hand to verify that recollection).
That would chain Goldman and the ratings agencies together in this matter. The specification of a “specific rating” is the key here.
However, IANAL.
April 22nd, 2010 at 1:38 pm
Jack,
That is what the case will come down to – IMO all the rest is obfuscation. Was ACA mis-led? If so, was it material?
Like you say, it is very difficult (I’d say impossible) for outsiders to know who knew what and when. For the sake of discussion though, it’s interesting to assume ACA was mis-led (though mis-representation or omission) and to discuss whether the mis-representation or omission is material.
Again, like you say – at the end of the day, it was ACA’s decision to choose the underlying portfolio. I’m not familiar with the process, but I wonder if it was standard industry practice for the equity tranche investor to have significant say over the portfolio selection? Also, I suspect that investors/insurers with exposure to the super senior tranches were probably less concerned with the individual reference securities in the portfolio and more concerned with potential correlation amongst those securities. As such, it may have seemed perfectly reasonable to allow Paulson’s team to choose the specific securities, so long as the overall portfolio fit a particular profile. All of this is to say that yeah, ACA was useless, but they might not have done the deal if they had known Paulson’s true role.
I’d also like to point out that just because the CDO was synthetic doesn’t mean long investors should have necessarily assumed there was a speculative short investor on the other side of the bet. As Steve Waldman has pointed out, the CDS that went into the makeup of the CDO could easily have been made up of protection contracts sold to parties hedging exposure to the mortgage market. Actually, this explanation was probably more likely. The fact that the CDO was instead the idea of a single hedge fund seeking net short exposure to the mortgage market likely would have been material information to the long investors in the transaction.
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