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Fab Tourre's CDO Deal Wasn't Complicated Enough

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If you wanted to short the housing market in 2007 you could just buy protection on mortgage-backed securities via a synthetic CDO, and that's what John Paulson did in the Abacus deal, for which Goldman Sachs and Fab Tourre got in trouble. But the problem with that is that buying protection costs money; just for instance the super-senior protection in Abacus would run you about 50bps, or around $4.5 million a year on the $909mm notional that ACA Capital wrapped.1 And who wants to throw away millions of dollars a year waiting for the housing market to crash?

So another way to short the market is to buy a lot of protection on senior tranches of CDOs (cheap because: what are the odds that the housing market will crash?) while also selling a little protection on junior tranches (expensive because the odds that there'll be some defaults are higher). If you do this, you can have a positive carry (you get paid as more each year on the protection you sold than you pay on the protection you bought), but you can make just about as much money if the housing market craters and there are massive defaults. (The tradeoff is that if performance is mediocre, with some defaults, then you lose money on the junior protection you sold and don't make it back on the senior protection you bought.)

This second trade is a very stylized description of what Magnetar did,2 in another CDO deal for which JPMorgan got in a bit of trouble. Less than Goldman, though! And no one at JPMorgan was sued individually; the sacrificial individual on that trade, who worked at collateral manager GSC Capital (an analogue of ACA in the Abacus case), ended up getting off when the SEC realized it didn't really have a case against him. Whereas Fab's on trial this week.

Are those deals the same? Meh, for what purpose? Here I drew you a picture:

So: if there are not a lot of defaults these are very different beasts. If the housing market craters they are basically twins. Which one you're expecting determines whether you think they're the same thing or different things. A stylized fact3 is that John Paulson and Magnetar both expected the housing market to crater and so their strategies were, for their purposes, very similar bets. Also that it did, so they were.

You can think about whether they're the same with that graph, and you can quantify how the same they are in various ways - you can compare their long vs. short notional, their carry, their delta, their gamma, etc. You can do scenario analyses and figure out how they look in various cases and how likely you think those cases are, and get a general sense of how similar those trades are.

The lawyers and witnesses at the Fab trial are discouraged from using technical Wall Street jargon like "long," "short," and "trading desk."

Anyway I was thinking about all this today because yesterday Fab's lawyers questioned Laura Schwartz, the hapless ACA employee whom Fab maybe hoodwinked into thinking that Paulson was long Abacus when actually he was short. DealBook's headline is "Witness in Tourre Case Describes Difficulty in Knowing Deal’s Friends From Foes" but that's not the half of it. This trade could easily have been structured - economically similar trades were so structured - in such a way that Paulson bought a slug of the equity but was nonetheless a, I guess, "foe" of the deal. Short I mean. "Betting that it would fail" seems to be the preferred locution. Short. In a short delta-equivalent position. Whatever. That chart.4

As it is there is much wrangling over things like: did Fab, or someone else, tell ACA that Paulson was planning to be long Abacus equity? When Fab referred to Paulson as the "transaction sponsor," is that a term that implies "long equity investor," or does it just mean, like, "guy who made the transaction happen"?5 And: why would it matter? From DealBook:

Ms. Schwartz testified that she assumed Paulson & Company was wagering the trade would succeed and that she did not know who was on its other side.

[Fab's lawyer Sean] Coffey was also quick to zero in on how ACA carefully analyzed each component that went into the Abacus trade, so it should not have mattered if the portfolio had been picked by Paulson & Company or by Joe, a court clerk for Judge Forrest.

“How about if you had found it on the floor?” he asked. Ms. Schwartz said that in each case, ACA would have done its own analysis of the various components of the C.D.O.6

Apparently Coffey also asked Schwartz a question to the effect of: what if Paulson had, instead of being short say $30mm of senior, been short $40mm of senior and long $10mm of equity? Aren't those the same thing?7 Of course he wasn't, but he could have been. The point is that it's a little silly to rely on simple statements like "Paulson was buying the equity" or "Paulson was not buying the equity." Paulson's interest in the quality of the underlying securities is measured by the totality of his positions; it's measured by his delta and his gamma and the shape of his payoff curves and what other trades he might have on in addition to this one. And those things are not disclosed, and there's no reason for ACA to expect that they would be.8

This isn't particularly a, like, moral or legal argument. Paulson could have been long the equity and still been "betting against the deal," but he wasn't: he bought none of the equity. And if Fab lied to ACA about that, and if that lie was material,9 then the SEC is perfectly entitled to go after him for fraud.

It is, though, a useful dividing line. Like: there are conflicted CDO trades where, if you do them, the SEC will go after you for fraud, and there are others where they won't. Fab allegedly told ACA that Paulson was buying all the equity, but he bought none of the equity and was short instead: fraud! (Maybe.) If he'd bought some of the equity and grossed up his short to compensate: not fraud! Or at least, not take-it-to-a-jury fraud. You can barely say "short" to a jury. Never mind "well he was long the equity but if you look at his delta his overall position was short." Get outta here with your delta. The jury's not gonna follow that. There may be a theory of financial complexity in here somewhere.

Witness in Tourre Case Describes Difficulty in Knowing Deal’s Friends From Foes [DealBook]

1.Not sure how much Paulson bought, but paragraph 61 of the SEC's original complaint against Goldman and Fab notes that "ACA Capital sold protection or 'wrapped' the $909 million super senior tranche of ABACUS 2007-AC1, meaning that it assumed the credit risk associated with that portion of the capital structure via a CDS in exchange for premium payments of approximately 50 basis points per year."

2.Very stylized. Actually Magnetar seems to have been doing its protection buying mainly through CDS on underlying assets (though those assets were CDOs), and its protection selling on the equity tranche of a CDO-squared packaging those underlying assets - so less "long the junior short the senior" than "long the junior short the entire capital structure" as it were. And there is real dispute about whether it was net long, short, or market neutral, as well as questions about intent, order, etc., there. Here is a good discussion from 2010. Here is a controversial ProPublic piece and follow-up. Here is the SEC release on their suit against JPMorgan, which settled for around $154mm, as well as the complaint, and the complaint against Edward Steffelin, of GSC Capital, the collateral manager of the CDO-squared whose equity Magnetar bought. Which was later dismissed by the SEC.

3.I mean, ProPublica and the SEC will tell you it's a fact. Magnetar would disagree.

4.The Times article on the Magnetar CDO guy whom the SEC hassled and then released is fascinating reading. If for nothing else because The New York Times said this:

... the biggest flaw in the S.E.C.’s theory may have been the fact that Magnetar was not betting against the C.D.O. that JPMorgan structured. On the contrary, it bought equity in the deal, which meant that its interests were aligned with other investors.

This is very different from Mr. Paulson’s position in the Abacus deal, because he was betting against other investors in Abacus.

The S.E.C. may have been slow to grasp this distinction. It is true that Magnetar bet against some of the individual assets that made up the C.D.O. But in a synthetic C.D.O., every mortgage-based asset in the security represented a bet between two parties — one betting the asset would rise and the other that it would fall. Those investors had no interest in the performance of the pooled assets in the security.

The economic reality of that argument is debatable - see note 2 for the debate - but, just, the Times saying that a synthetic CDO necessarily requires a two-way bet seems somehow significant.

5.Surely the latter, no?

6.It's possible that I've been too harsh about ACA's lack of effort as collateral manager; I guess they really did run some analysis on the collateral and sign off on it. The problem is that there's no way to be sympathetic to ACA: either they just relied on Paulson's aligned interests, did no homework, and effectively lied about their role as collateral manager; or they did their own credit work and so have no business complaining that they misunderstood Paulson's role. Or some linear combination. It doesn't seem to me like there's a "we were really diligent but also needed to rely on Paulson having our interests at heart" argument for them. (Whereas the regular investors do, I think, have a fair argument for "we relied on Goldman and ACA to sell us a thing they stood behind, and so we didn't do our own credit work.")

7.NO, but, y'know. The chart.

8.The Abacus offering memo has tons of conflict-of-interest disclaimers, including this, from page 33, which is not as dire and explicit as you might like but which I think gets the job done (emphasis added):

The Initial Purchaser, the Protection Buyer, the Basis Swap Counterparty, the Collateral Put Provider, the Collateral Disposal Agent and their respective affiliates may hold long or short positions with respect to Reference Obligations and/or other securities or obligations of related Reference Entities and may enter into credit derivative or other derivative transactions with other parties pursuant to which it sellsor buys credit protection with respect to one or more related Reference Entities and/or Reference Obligations. The Initial Purchaser, the Protection Buyer, the Basis Swap Counterparty, the Collateral Put Provider, the Collateral Disposal Agent and their respective affiliates may act with respect to suchtransactions and may exercise or enforce, or refrain from exercising or enforcing, any or all of its rights and powers in connection therewith as if it had not entered into the Credit Default Swap, the Basis Swap,the Collateral Put Agreement and the Collateral Disposal Agreement, and without regard to whether anysuch action might have an adverse effect on the Issuer, the Noteholders, a related Reference Entity or any Reference Obligation. If the Initial Purchaser, the Protection Buyer, the Basis Swap Counterparty,the Collateral Put Provider, the Collateral Disposal Agent or their respective affiliates, holds claims against a Reference Entity or a Reference Obligation other than in connection with the transactions contemplated in this Offering Circular, such party's interest as a creditor may be in conflict with the interests of the Issuer.

Of course Paulson isn't listed there but the point is "really anyone can do whatever they want."

9.Though the equivalence is perhaps an argument that the lie was not material. If "Paulson is long the equity" tells you nothing about Paulson's interest in the deal - which is not quite true though also not entirely false - then lying about it is immaterial.