Details on Abacus, Synthetic CDOs at the Heart of the Goldman Sachs Fraud Case

Now the world is awash in Goldman Sachs stories. If you have no idea what they are talking about. Credit Slips explains an Abacus CDO in English (semi):

A CDO is more or less a hedge fund. It's an actively managed, unregulated investment fund. The assets can be anything. In the case of the Abacus 2007-ACA deal, the assets were a portfolio of credit default swaps (CDS). The Abacus CDO was the securitization of a bunch of CDS positions (if it has cash flow, it can be securitized).

The Abacus CDO was selling CDS protection on a bunch of dodgy mortgage-backed securities. As long as there was not a credit event (however defined) with the MBS, the protection buyer (John Paulson) would pay protection premiums to the CDO. If a credit event occurred, however, the payment flow would reverse, and the CDO would pay Paulson. Presumably in this deal, Paulson did not own the MBS; he was using the CDS to take a short position on the MBS, with the CDO (and ultimately its investors) taking the long position.

Goldman, the SEC alleges, constructed the CDO as a bespoke deal for Paulson, so there would be someone taking the long position against his short. Goldman took a nice fee for this and is alleged to also have taken a short position (I'm not clear at this point if it was short on the MBS or if it bought CDS protection on the Abacus CDO, thereby taking a short position on the CDO, which is a derivative bet on Paulson's short).

Bloomberg, who is going full tilt boogie on the Goldman Sachs fraud investigation, has a good article explaining what an Abacus is and how it was front loaded like bad dice in a craps game.

Abacus deals were filled with default swaps that offered payouts to Goldman Sachs if certain mortgage bonds didn’t pay as promised, in return for regular premiums from the bank.

If you believe that Goldman Sachs, or other financial institutions, say JP Morgan Chase for example, just made up one and only one of these synthetic/hybrid CDO time bombs, think again.

In 2006 and 2007, the distinction between synthetic mortgage-bond CDOs and “cash” ones, or those made only of actual debt, broke down as “hybrid” deals, filled with both securities and credit swaps, began to dominate the market, meaning that almost every major bank was underwriting CDOs filled in part with their own bets against homeowners.

Pretty amazing huh, that the great financial innovation was loading up a securitized package of stuff with guaranteed profit payout if the very thing you're peddling to investors goes bust?

Ya think this should be legal? Well, if ya think that, then I believe I should be able to go to Las Vegas and technologically rig the roulette wheel to guarantee the ball comes up on my number too.

Speaking of technology, believe this or not, I have seen very little, in terms of the actual mathematics, structuring, computational complexity, verification, approval end to regulate these financial products. If someone manipulates mathematical models, hides these rigged games so no one can see it, why in God's name are they not banned? Why do they not have to go through a regulation process, similar to the FDA? We don't let people make black tar heroin for sale on the streets, so why are snake oil salesman allowed to put these things together and peddle them in the first place?

It is the products themselves which need to be approved, regulated and investigated before sale. You wouldn't let a car with an engine guaranteed to blow up be sold in the United States, so why ignore the sale of financial time bombs?

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Goldman had the Wrong Buyer

If the FNMA and others with actual exposure had purchased this type protection against default, for loans that they either held or had guaranteed with taxpayer backing, we'd be applauding their foresight. Perhaps now we'd even be thanking Goldman for their innovative work. Too bad.

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