During Sophomore year Finance classes, those of us who actually have degrees in the field are introduced to some basic approaches to investment analysis. Before we ever even touch upon analytical methods
we learn high-level concepts, for example, first and foremost you should analyse a potential investment on its merits.
If I’m considering buying the ABACUS synthetic CDO deal at the heart of the SEC’s case against Goldman, my primary focus is to analyse first, the U.S. residential real estate market. If I was bullish after a thorough macro-analysis, next, I would analyse the RMBS transactions in the reference portfolio selected by ACA. (Note: Critics who claim Paulson, not ACA selected the reference portfolio are simply wrong. ACA had ultimate authority – the only kind that matters – on the portfolio compositions and could have thrown out EVERY/ANY security Paulson suggested if they didn’t like it.
I’ve yet to read anything that suggests that this was not the case.) I’d also analyse the structure of the deal, the terms, the pricing, and other idiosyncratic components of the transaction. Once I’ve done the granular analysis of EVERY bond in the reference portfolio – as close to loan-level as possible, especially with the 20+ person diligence team that IKB reportedly employed – and decided everything looked good, then and only then would I get into other considerations. Have we covered all our bases? Are we missing anything? What are other smart people doing with this/similar transactions? Should we even care what other smart people are doing?
I firmly believe this story pretty cut & dry: IKB/ACA/ABN did their diligence (well, let’s give them the benefit of the doubt they did)and determined they wanted to buy the deal. They had the blessing of the Ratings Agencies (which, with the wisdom of hindsight we know was worthless), they had other “smart” people reinforcing their view (long live confirmation bias!) as the financial industry, as a whole, was generally still long housing.
Securities Lawyers I’ve spoken with indicate that Section 10b-5 of the Securities Act of 1934 is likely the relevant law underpinning the SEC’s case. It states:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
a. To employ any device, scheme, or artifice to defraud,
b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made,in the light of the circumstances under which they were made, not misleading, or
c. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.
The SEC seems to allege that by not explicitly disclosing Paulson’sexact role (paying GS to arrange the deal, suggesting securities for the reference portfolio, etc), Goldman omitted material facts rendering their claim that ACA was the selection agent and other claims, misleading.
Anyone who thinks the buyers (longs) would have backed-out if they knew some no-name Hedge Fund manager with ZERO mortgage investing experience suggested part of the reference portfolio is material is full of it. The buyers were arrogant and over-confident in their experience and ability to analyse complex structured finance transactions. If they WERE made explicitly aware of Paulson’s “involvement” they probably would have enjoyed a good, hearty laugh at his expense and quite possibly even bought MORE of the deal when they learned they were up-against such a rube, a novice, a guy in WAY over his head.
One person on the other side of this debate says that in order for me to make such a claim I must be either clairvoyant or have worked on IKB’s deal team in 2007. While I think that’s a bit of a non-sequitur,I’ll allow it, and then accuse the SEC of the same apparent psychic abilities. How do they plan to prove what IKB, ACA, and ABN WOULD have done? Or, using more legally appropriate terminology: How does the SEC believe they can use the “reasonable person” test in this situation, when a securities transaction (and a market), by definition, necessarily includes two parties who both believe themselves to be reasonable, despite having different, nay, opposing views? Unless the SEC has procured a functional time machine and the ability to change the past at-will without consequence, this is impossible. As in, it cannot be done. Sure, I WOULD have prepared differently for the GMAT’s if I knew I was going to run out of time on the maths section, but I didn’t KNOW or EXPECT that would be the outcome, since I knew the material very well (especially the second time around). Similarly, IKB “KNEW” structured finance RMBS investing,so they EXPECTED a certain (set of) outcome(s); they just didn’t expect the outcome that actually happened.
That’s it. Everything else is irrelevant. IKB knew the material that was going to be on the test (the composition of the reference portfolio, structure of the transaction, etc), they had the ability(experienced deal team) to prepare for the test (analyse the deal),they just came to what turned out to be the wrong conclusion. End.of.story.
Ultimately, whether Paulson’s involvement will be decided in court,and what I have to say is, unfortunately, just words on a page. I agree there is the possibility that when all of the information is made available (emails, etc), there may have been an intent to deceive, or scienter, but that’s for the courts/lawyers/etc to decide.
 Steve Randy Waldman made a good point that IKB may have been violating its mandate if they entered into a speculative trade against a hedge fund. If IKB was in fact limited by mandate to certain counterparties/certain types of investments, the onus was still on THEM to ASK who the counterparties and other deal participants was. Considering the charges filed against IKB and its management, I’m not so convinced they really cared about their mandate; they just wanted yield, like many other greedy, short-sighted investors.