Chung, J. (2013, Jan 14) Goldman: Insurer Knew Paulson was 'Shorting' The Wall Street Journal, p. C3
Majia paraphrasing here: ACA Financial Guaranty Corp. filed suit against Goldman Sachs in 2011, asserting that Goldman deliberately misled ACA about a 2007 collaterized mortgage debt deal known as Abacus.
Goldman allegedly told ACA that Paulson & Co (one of Goldman's clients) "was betting on a deal, when in fact Paulson was betting against it."
ACA claims it would never have done the deal if it had known Paulson was betting against it, or 'shorting it.' Paulson used credit default swaps to short Abacus. ACA lost money on the plummeting value of the CDOs.
It is indeed absurd that Goldman is claiming it did not mislead clients like ACA. Goldman knew exactly what it was doing, as evidenced by Goldman employee Fabrice Tourre's emails to his girlfriend.
Goldman Sach’s Fabrice’s email to his girlfriend illustrates the blatant criminality at issue here.
Tourre referred to himself "fabulous Fab" and described creating "Frankenstein" products that were nothing more than "pure intellectual masturbation" sold to naive widows and orphans (cited in Clark, 2010a). Tourre masterminded Abacus, a synthetic CDO, sold to clients who were not informed that the mortgages making up the CDO were expected to default (Clark, 2010b).
The hedge-fund Paulson & Co had helped Goldman assemble the CDOs and had bet against them by purchasing credit default swaps [a type of insurance] from the Royal Bank of Scotland, which incurred a $840 million liability from backstopping the hedge funds deal (Goldfarb & Tse, 2010, p. A1).
Unfortuntely, no justice seems possible where Goldman is concerned:
U.S. Not Seeking Goldman Charges. The Wall Street Journal August 10, 2012 p. C1 by Reed Albergotti and Elizabeth Rappaport
[excerpted] After a yearlong investigation, the Justice Department said Thursday that it won't bring charges against Goldman Sachs Group Inc. or any of its employees for financial fraud related to the mortgage crisis.
In a statement, the Justice Department said 'the burden of proof' couldn't be met to prosecute Goldman criminally...
Majia here: The article explains that a civil fraud investigation was leveled by the SEC against failing to disclose to investors that hedge-fund Paulson & Co had helped select the underlying securities and was betting the securities would default (using credit default swaps).
Goldman settled the civil fraud suit by paying $550 million.
What are collateralized debt obligations: They are a kind of derivative. Derivatives such as futures have been around for centuries, but the reification and quantification of risk enabled by computerization expanded global derivatives products and trading and also enabled creation of ever more abstract derivatives based in bundled securities such as collateralized debt obligations (CDOs), which essentially are risk-based products derived from the calculations of risks for defaults of mortgage-backed securities.[i] By 2006, the CDO market was valued at $4.7 trillion (Prins, p. 55). Indeed, in 2006 alone, there were $US550 billion of "collateralised debt obligations" issued” http://www.news.com.au/business/story/0,23636,23393912-462,00.html)
Speculators used credit default swaps to short CDOs. Credit default swaps (CDS) were invented in 1997 by JP Morgan Chase’s Blythe Masters (Prins, 60). CDS were (and continue to be) sold by insurance companies to investment and commercial banks alike. They “insure” risky investments, often in excess of the value of the underlying insured investment. Before the crisis CDS were unregulated and companies that issued them typically failed to hold adequate reserves (collateral) against outstanding contracts (see Levisohn, 2008). American Insurance General (AIG) sold credit default swaps to the large investment and commercial banks, among other buyers, on securities (particularly CDOs) derived from mortgages. For the most sophisticated players, the risk of default on the debts underlying the securities was hedged by purchasing these credit default swaps from insurers, such as AIG. Indeed, betting on debt default using a credit default swap could be more profitable than holding and trading intact debt-based securities. Credit default swaps are a derivative that succeeds with financial volatility. By 2008 the market for credit default swaps was valued at $45.5 trillion (Prins, p. 60).
[i] Janet Tavakoli, a recognized expert on CDOs, defines them accordingly:
A Collateralized Debt Obligation (CDO) is backed by portfolios of assets
that may include a combination of bonds, loans, securitized receivables, asset-backed securities, tranches of other collateralized debt obligations, or credit derivatives referencing any of the former… Up to the end of the 1990’s, collateralized debt obligations all used Special Purpose Entities (SPEs), also known as Special Purpose Vehicles(SPVs), that purchased the portfolio of assets and issued tranches of debt and equity. The special purpose entity purchased the assets from a bank’s balance sheet and/or trading books. (http://www.tavakolistructuredfinance.com/cdo.pdf)