Wednesday, October 26, 2011

Thinking about the Abacus sign

The widely distributed - nay viral - picture of a young woman carrying a sign referring to Abacus - the much litigated Goldman Sachs/Paulson/IKB deal got me thinking.

Here is the sign for the small number of you that have not seen the picture:

It says that "It's wrong to create a mortgage-backed security filled with loans that you know are going to fail so that you can sell it to a client who isn't aware that you sabotaged it by intentionally picking the misleadingly rated loans most likely to be defaulted on".

I can't help but agree except this is not what happened in the Abacus case. The Abacus security was an entirely synthetic security. It was not filled with loans that were intentionally picked, it was loaded with derivatives that someone thought were most likely to be defaulted on.

That is an important distinction. If Goldman had created a security filled with bad loans and sold them there is no way that the client would be able to work out that someone was betting against the loans.

But that is not what happened. It was filled with derivatives where it was obvious that a financially sophisticated counter-party was taking the other side. Indeed what the security was was the reverse side of a bundle of bets against mortgage securities bound up by Goldman Sachs and the simplest understanding of it revealed that fact. Sure the buyer did not know it was Paulson taking the other side of the bet. (Indeed, given Paulson's latest run the fact that was Paulson neither adds nor subtracts from the case for buying or not buying the Abacus bundle.)

I think Goldman Sachs was done here unfairly (although it is hard to imagine it happening to more deserving people). Anyone who was financially sophisticated (and IKB certainly portrayed themselves as sophisticated) should have realized there was an opposite side to that bet and that someone had deliberately taken the opposite side with respect to every derivative in the bundle.

Now contrast this with what happens when I make a short sale. I borrow a security from a broker which is identical to any other security with the same cusip number. I sell it in the market. The person on the other side purchased a security and they have no idea whether they purchased it from a long or a short.

People who buy securities from me in the regular securities market are at a disadvantage to IKB. IKB knew there was someone making the opposite bet. When we make money short selling (and we have made plenty) the people who lose have no way of knowing that Bronte/John Hempton was on the other side of the bet.

I am (in part) a short-seller. I regularly try to stuff the market with securities that are "intentionally picked" as "most likely to be defaulted on".

Where is my sign?



Sprizouse said...

Well... Goldman didn't tell IKB that the counterparty to the derivatives deal had actually structured the deal. That's not what anyone signs up for when purchasing Goldman-created securities.

Goldman is free to create as many derivative securities as it wants and then sell off both sides of the deal. That's what they're supposed to do. And in that role, Goldman might have internal estimates that say one side or the other is "bad" but, like a Sportsbook, they probably don't want one side or the other to be catastrophically bad (and certainly not obviously bad).

If they structure a bunch of one-sided securities then they'll probably have trouble selling the "bad" side, and if they can't sell the bad side of a trade, they'll get stuck with it. Which is, generally, what should be legally expected when dealing with an investment bank.

But to have one of the counterparties STRUCTURE the deal so that one side is catastrophically bad? That's not right. And there is no freakin' way that Goldman was "done unfairly" after they pulled this crap. They had to be complicit in pushing the "bad" side because they didn't want to get stuck with it either.

Anonymous said...


I think the obvious difference here is that when you (short) sell a security, the buyer is not paying you for the expert skills you used in procuring a suitable security for them.


Tim Bassett said...

Suspect it depends on what the client was told about the buyers of protection in the synthetic. If it was implied that they were longs just looking to diversify their portfolios and reinvest in other assets (the way similar things were always pitched judging by the material I saw) or whether they were told the seller was a short. Don't forget this stuff trades by appointment rather than on an exchange where one has no (or at least much less) reason to believe that the information available to buyers and sellers is overwhelmingly asymmetrical. That said the people who bought into these things must have been thick as planks.

John said...


Sorry, I don't follow your logic.

If I buy a house insurance, there is a counterparty (the insurer) betting that the disaster won't happen in the next 12 months. But no insurance clients expect the salesmen explain the contracts that way. How is this different from the Abacus case?

Damian said...

Here's your sign -

Highgamma said...

This is a hard one for me. My first reaction was Blankfein's reaction. Who did Goldman have duty to? That is, if I do a lot of research and discover a stock that I know is going to fail, am I obligated to go out and talk to the buy before I sell the stock short to them? Absolutely not. In fact, if the other side is being advised by someone, I'd be getting in the way of the advisory relationship. Also, if I told my broker that I wanted to make sure that the other side of my trade understood the research I had done, he'd put me away. I don't have duty to the other side of that trade and my broker doesn't either.

However, Goldman structured this product and, implicitly or explicitly, put the "Goldman seal of approval" on the deal. I'm sure their documents said otherwise, but most clients would think that Goldman was at least making sure the product was "neutral" and had not been stacked by someone. Does this mean that Goldman had some form of duty here? Also, there were clearly contradictory statements made by Fabulous Fab.
Like I said, I'm torn.

John Hempton said...

To the accounting postgrad who made that sign. Thanks.

To the person who thinks that the comparison of the person selling insurance is the right one - well - there are a few problems. First contractual terms (see utmost good faith), second the asymmetry, third - well this was a triple A - someone was betting against a triple A - which should generally say something.

Goldman sold securities off their own balance sheet - securities that later defaulted - to their clients (whom they call "counterparties"). They should have been done for that... but Abacus? not so much.


yoyodyne said...

'We have no responsibility to tell our counterparties they're wrong because we ALWAYS think they're wrong.'
~Seth Klarman.

There is a difference btw having a fiduciary duty to a client, and merely being a trading counterparty.

If you don't know which one you are, ask your salesman. If Big Bad Bank broaches that duty, then sue them, otherwise quit whining and act like the sophisticated investor you represented yourself as.

Anonymous said...

To all the people complaining about who picked the portfolio, I have to wonder why you think the buyer couldn't look at the portfolio? Who cares who "picked" it? It's there in the trade docs for you to evaluate as the buyer.

If Paulson's bet had gone against him and this deal matured at par, would you all now be complaining that Goldman sold Paulson worthless insurance?

And to John: I don't even understand what's supposed to be the material difference between you short-selling and selling from a long inventory. In either case you are selling. Whether you have started the day with a position of +X instead of 0 or for that matter -X is not particularly interesting, and doesn't change the information you are conveying to the buyer, which is: you wanted the cash more than the security.

fr said...

If there was a moral wrong committed here, it was whoever bought those trashy securities. They were acting like yield pigs, hungry for a bonus for beating their benchmark, rather than acting like fiduciaries.

Anonymous said...

If Abacus was truly designed to hedge I would accept that Goldman has done nothing wrong. It wasn't designed to hedge - it was designed to extract profit through deceit.

newguy said...

I thought there was a difference between shorting a stock and shorting a stock with insider information.

Goldman's settlement suggests that they learned it the hard way.

Richard said...

I love the attitude that the sign expresses, but I can’t agree with the substance.

Collectively, Wall Street didn’t do anything wrong. I acknowledge that there were frequent instances of where people were miss-lead and money was stolen, but these did not cause the GFC. (Such things probably happen all the time, but only get noticed in a down turn.)

As an external observer from a jurisdiction that did things differently, I am certain that the GFC was caused by a massive failure in public policy and regulation. In the US:
• Repeal of Glass-Stegal
• Absence (due to legislation) of derivatives regulation
• Poor implementation of Basel II
• Loose monetary policy
• The invisibility of the regulators (How many people know that the OCC is responsible for the prudential regulation of Banks in the US?)
• An Executive and Legislature that actively promoted and protected the interests of Wall Street

Through its lobbying, Wall Street played a major role in the perpetuation of these failings. But lobbying is not illegal. The fact that a single interest group could command such influence indicated a failure in the political process. I don’t think you can “fix” Wall Street until you “fix” Washington.

By comparison, in Australia:
• Commercial banks had very limited investment banking activity (mostly by choice).
• APRA exercised a significant drag on the use and proliferation of credit derivatives in Australia
• Basel II was implemented with reasonable rigour. (This was made easier by Australian banks not fighting it, as was the case in the US and Europe.)
• The RBA has been relatively heavy handed in its management of interest rates.
• Following the collapse of HIH in 2000, there was a heavy handed regulatory presence in the Australian banking system.
• Australian banks are historically unpopular with the general public. Australian politicians are more inclined to “bash” banks to score cheap political points and never want to be seen supporting them. When in government, both sides let the regulators do their job.

Some analysts might suggest that selling dirt to the Chinese is the main reason Australia has avoided the worst of the GFC. But having a solvent banking system has helped.

I suspect that the Occupy Wall Street people are occupying in the wrong street. They might get closer to the source of the problem if they got themselves down to Washington and parked themselves in the street outside the Capital.

James B. Shearer said...

If Paulson's bet had gone against him and this deal matured at par, would you all now be complaining that Goldman sold Paulson worthless insurance?

Not if the whole thing was Paulson's idea.

I don't know anything about this deal in particular but it is my understanding that these deals in general were exploiting two problems with the way the rating agencies worked. They were very slow to downgrade previously rated securities even if they were obviously going bad. And when rating a synthetic security based on existing issues they didn't revisit the ratings of the components but took them at face value when rating the synthetic security as a whole. As a result it was possible to construct "bets" that were basically sure things. Just stuff the synthetic security with issues that were going bad but hadn't been downgraded and the ratings agencies would give it a totally unjustified good rating.

It as if you were allowed to short stocks based on 6 month old prices. Very hard to lose under those conditions.

Anonymous said...

The Abacas deal is like creating and listing a fraudulent company so you can short it.

The statement in the sales document that ACA was the selection agent was false and misleading. Paulson was at least a co-selection agent.

Anonymous said...

Not if the whole thing was Paulson's idea.

Why does it matter whose "idea" it was? Trades have to originate somehow, why is one direction invalid, and which direction is that? The one that we see, later, went badly?

And why couldn't one equally say that IKB had the idea that they wanted to be long a slightly higher-than-normal yielding AAA instrument exposed to US mortgages? Clearly that is what they wanted. Who are you (and who was Goldman) to second-guess that idea? Because with hindsight we see it wasn't a good idea? But virtually all trades have a 'winner' and a 'loser' side, in hindsight.

As a result it was possible to construct "bets" that were basically sure things. Just stuff the synthetic security with issues that were going bad but hadn't been downgraded and the ratings agencies would give it a totally unjustified good rating.

If this was the case, and if the (short) bet was such a sure thing, then surely the buyer should never have purchased the resulting security. I guess your argument is with them.

It as if you were allowed to short stocks based on 6 month old prices. Very hard to lose under those conditions.

The reason you're not 'allowed' to do that - well actually, surely you are - it's just that you'd have a hard time finding someone willing to take the other side. But in this case, Goldman did find someone to take the other side. By definition, they *wanted* that other side. So, evidently it wasn't so obvious to everyone at the time that the short side was such a sure thing. You now see that it was obvious and that going long was a dumb bet. Okay. I don't see what that proves, other than that the buyer made a dumb investment.

David Merkel said...


There have to be "big boy" markets somewhere, where anyone buying or selling knows that they must be their own best defender. Otherwise financial markets don't work.

The lousy securities were bought by yield hogs that did not do adequate due diligence. Those investors regularly get fleeced, because they were playing with the big boys, and were lazy.

JKH said...

David Merkel is right

IKB wanted the risk and they wanted the yield - and they got what they wanted (and that's exactly what Blankfein said at the hearings)

The due diligence was IKB's responsibility, and the relevant questions that might have been asked about the origin and motivation behind the synthetic creation were obvious; they just didn’t ask them

Goldman wasn't selling to Goldman's mother

the decomposition across long, short, synthetic etc. is not so relevant here; a sale is a sale and the embedded optionality is the same regardless of the long, short, synthetic etc. starting point

Josh said...

The thing that frustrates me the most is that 'shorting' is not inherently bad. For that matter, either is being long.

The bad, evil, criminal, or however you want to label it act is when you take a position and knowingly lie or create a rumor to help move that position in your favor.

In the heyday of the late 90s a stock would be mentioned on CNBC and immediately zoom 5 or 10%. There were more then a few people that talked up their dogs/losers just to sell them right after they got off the air.

Don Juan De Carlos said...

"Collectively, Wall Street didn’t do anything wrong." If they didn't do anything wrong, they aren't that effective or that important. So why are they being paid tens of millions and "the right streets in Washington" being paid so little?

Don Juan De Carlos said...

That is to say financial industry have adopted the nerdish conceits of the computer industry circa mid-90s when everything that ever went wrong was the users fault and they, the producers and manager of the product, never did anything wrong.

Anonymous said...

John - when you sell a stock short the person on the other side knows that whoever the seller is that seller thinks the stock is over-valued.

Richard - you acknowledge people were misled and money was stolen and yet none of those people (except Madoff) are in prison. I agree that the politicians were guilty of leaving the front door unlocked but they were not the ones who then snuck in and stole the family silver.

BTW - the girl in the photo is cute in an intelligent sort of way.

Anonymous said...

To David Merkel - in a "big boy" market if a bank made bad decisions there would be no TARP and no Greenspan put to bail them out, the executives would have to return bonuses that were based on fictitious profits, the auditors who had blessed the fictions would lose their CPA licenses and the executives who misled the CPAs would go to prison. If we had a big boy market the Hamptons would be a ghost town, the marinas would be empty and Richard Fuld would be selling apples in the street.

Wall Street should be thankful we don't have "big boy" markets. Of course, if we truly had "big boy" markets there would be no retail investors because they would refuse to play.

Anonymous said...

It is psychologically typical and not necessarily consciously "foul play" to argue general statements (in this case, "the game is wrong/rigged") by specific examples.

You can't win that argument by countering said examples, because underlying general statement will produce more and more of that.

However, I'd like to focus on a part glanced over above: how the "Wall Street" in "big" meaning is recently a mess of irresponsibility.
E.g. as someone already said, there is a name, like GS, and it's implied they won't be, like, pardon my French, straight fucking clients up da rear - while actually, errm... they do, and apparently, they are in the right doing so.

Just one of those cases where the implied meaning of things people perceive is not only not what is warranted, but not what is being strived for either. So we've got a-banks that could sell you any unimaginable junk pile the moment you blink (with full knowlege of that being stacked junk pile), rating agencies which rate said junk pile AAA yet in no way answer for that, audit companies with history of monkey business (see no evil) if not outright fraud (many of us still remeber how is was "big 5", right?), consulting companies who's advice can't be relied upon...
And all of'em are apparently responsible for nothing.
Got so used to it, too, that when surprise-slapped with actual fiduciary duty many of'em still fail (see recent scandals of fund's employees pension allocations and stuff like that).

Now just as Highgamma, I'm not "Lawful Stupid" on the case: by design, some people win and some loose. But the system as a whole definitely needs a better overall responsibility and control level: someone along the line of auditors, raters and underwriters should actually end up responsible for a package labeled "top-quality, organic pork" end up containing a pile of putrefied goo - just the same as it would happen with actual products.

Now the question is, where that responsibility should come from: the banks, which make lion's share of profits from it but are gamers themselves, or make-it-look-legit service companies (rating/audit), which are not financially equipped to carry those risks but are the ones who's supposed "neutral pov" enables the whole con?


Andrew S said...

No one has actually read that sign, because the lady holding it is pretty.

That's the first rule of fight club.

Anonymous said...



Well you did ask...

Personally, I don't actually see any real conflict of interest in this: You are open and transparent about your positions.

By contrast Goldman, IIRC, had a pretty obvious conflict of interest between their roles of salesman for the instrument and that of advisor (and the fact that they were being paid for both roles).

One question: how is it easier to determine that a derivative that is likely to fail than a stock? I see derivatives as providing an extra level of obfuscation, not clarity.

Yes, if someone is selling a simple derivative, the nature of their bet is obvious. But once these are combined into complex instruments and used in baskets, they become a "Great Way to Bury Bad News".

Anonymous said...

Good points, maybe the money managers at IKB (and by extension all those who acted in a similar way) should be the ones being named and shamed.
Were they at least fired?

Doug said...

The EU has given you your sign: short selling is now routinely restricted, is about to be subjected to a Directive of its own in which you will be forced to disclose shorts above 0.2% of market cap and you'll soon be faced with a 10bp charge on all your trades.

James B. Shearer said...

If this was the case, and if the (short) bet was such a sure thing, then surely the buyer should never have purchased the resulting security. I guess your argument is with them.

No question the buyer was stupid and/or careless. Fraud victims often are. That doesn't make defrauding them legal.

Incidentally I also have a quarrel with the rating agencies which should have gotten in a lot more trouble than they did for rating obvious garbage triple A.

... But in this case, Goldman did find someone to take the other side. ...

By fraudulently failing to disclose material facts.

... So, evidently it wasn't so obvious to everyone at the time that the short side was such a sure thing. ...

Because the buyer was not in possession of material facts.

pcarroll0813 said...

In my eyes, the biggest question is whether IKB had reason to believe that Goldman constructed this security "independently". Caveat emptor certainly applies to all financial transactions, but if CDOs are "normally" structured by the investment bank, to the point that it's unheard of to have one of the counterparties involved in construction (are there any other examples of this?), then Goldman should have disclosed that a counterparty was involved. The identity of the counterparty is irrelevant, but the fact that one was involved may be important if it's not standard practice.

Definitely a murky situation, though.

WellRed said...

Let's not forget that Paulson was an also-ran in the merger-arb space when he came to Goldman looking for this deal. The fact that Goldman retained exposure to Abacus speaks volumes to how they viewed his involvement.

James B. Shearer said...

Now contrast this with what happens when I make a short sale. I borrow a security from a broker which is identical to any other security with the same cusip number. I sell it in the market. The person on the other side purchased a security and they have no idea whether they purchased it from a long or a short.

The person on the other side is actually the person who lent you the security. They are the ones left holding a synthetic security and they are the ones who eat the loss if you are unable to fulfill your obligations.

Charles Krakoff said...

John, Two days ago I posted an article on my blog - - addressing precisely this issue, including the SEC case that Citigroup last week settled for $285 million. Leaving aside disclaimers about not admitting any wrongdoing, no one parts with that kind of scratch (in Goldman's case, $550m) if they are truly convinced they have done nothing wrong. Yes, IKB and Ambac (the CDS issuer that went bankrupt when the Citi portfolio turned to dust) are grown-up investors who perhaps should know better. But Goldman and Citi are not mere arm's-length traders; they also act as advisors to their clients. One more reasons banks should not be allowed to bet their own capital.

o. nate said...

John, I think you're missing the point here. Of course there is a counterparty to every CDS. However, there is a big difference between these two scenarios: (A) Goldman selects a portfolio of loans that they think are undervalued and goes out and sells protection on them in the open market thereby creating a basket of CDS for IKB to invest in, and (B) a noted short-seller selects a portfolio of loans that they think are trash and buys protection from IKB on those names, with Goldman colluding to conceal their involvement from IKB. IKB signed up for (A) but they got (B). That's a major difference.

Anonymous said...

Yea, but she is quite pretty....

Anonymous said...

It would have been easier to say, "Banks used to service their clients, not screw them."

Anonymous said...

These arent two private individuals or two companies whose shareholders will pick up the tab.

These are two TBTFs, both of which (IKB and Goldman) had to be bailed out by the taxpayers of their respective countries.

Ultimately it was German taxpayers who paid for Abacus blowing up.

Philo said...

Your point about the obtuseness of the sign is well-taken. The investment scene is a battleground of contrary opinions; the warm and fuzzy socialistic idea that we should all get together in solidarity appeals only to people who ignore this diversity of opinion.

But I think you are making too much of the distinction between bettors, including derivatives purchasers, who know someone is betting directly against them and ordinary (long) investors. The long investor knows he is buying the security from someone who, at best, no longer finds it an attractive holding, contrary to his own attitude. In buying a share of IBM stock, for example, he knows there are people who are *short IBM*; what difference does it make whether his counterparty *in this particular purchase* is a short or a long (an *ex-long*, that is: someone who is *terminating* a long position)?

Absalon said...

Any time we buy a security we know that most and usually an overwhelming majority of other investors do not hold that security. The implication is that for most securities, most of the time, most investors think the security is over-priced.

Absalon said...

The woman's name is Caitlin Curran. She was a journalist and was fired for the photograph. Interesting since the sign itself is in my opinion pure motherhood. People might disagree about whether the sign reflects what really happened at a certain bank but surely there is no argument that the sign is correct as a statement of principle?

Anonymous said...

There was a time when Goldman was very happy to act as agent and not principal. That was when Goldman had a good reputation. As a client back then I found them the gold standard for brokers.

Somewhere in the early 90s Goldman realized that some of their clients were much much smarter than them and began to hire to compete with those clients. This lead to Goldman doing Prop trading.

There is a big difference between being "long term greedy" in a partnership and being a bonus compensated employee. Same goes for Hedge Funds on 2/20.

I think anyone who buys any issue must do their own due diligence. If you don't you're a fool.

But a broker who will rip a stupid customer's face off is not being long-term greedy. It is short-sighted and bad for society and the markets. It is possible to kill the golden goose if you poison the well too badly.

I have very little use for 95% of brokers these days.

Anonymous said...

The biggest fallacy with this sign is not whether the exposure was cash or synthetic, but the words "you knew they would fail."

That's easy to say in hindsight, but not in 2006 when Abacus and similar deals were created. In those days, CDS on lower-tier BBB-rated subprime RMBS traded at approximately 250 bps. Right now, Spain CDS is at 400 bps and Italy is at 500, which means the market believes there's a greater probability they will fail than subprime RMBS in 2006.

Was not disclosing Paulson's role in shorting the assets a material omission? In my opinion, probably. However, there was also a manager (ACA?) whose role it was to "pick" the assets, so I'm not sure it would have made a difference to IKB and other investors.

Finally, keep in mind that there were plenty of other similar deals in which a manager actually did diligently select the assets, with no hedge fund involved. Not surprisingly, the AA tranches in those deals were more expensive than the Abacus/Magnetar deals. IKB could have bought those but apparently chose the higher-yielding Abacus tranches.

At the end of the day, EVERY deal backed by subprime RMBS blew up, so you perversely argue that IKB actually benefited from investing in Abacus vis-a-vis alternatives because they received a higher coupon for some period of time (not to mention the settlement proceeds!)

Anonymous said...

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.