The Case Against Abacus Doesn't Add Up

Includes: BAC, C, GS, LEHMQ
by: Bernard Thomas
Goldman (NYSE:GS) continues to dominate the news. An editorial by the Wall Street Journal's, Holman Jenkins, makes the argument that Goldman and Paulson are being made an example because the winning side of the bet was the short side. I think there may be something to this, After all, it was the short sellers who were blamed for starting the financial crisis in spite of the fact that many institutions were in fact in trouble and bordering on insolvency. Firms such as Bear Stearns, Lehman (OTC:LEHMQ) and Wamu were in fact insolvent.
Also in Wednesday's WSJ, columnist James Stewart condemns Goldman for permitting Paulson to choose the collateral on which he wanted to take a short bet. With all due respect to Mr. Stewart, duh!
Whenever any investor takes a short position, they choose the securities or vehicle with which they wish to go short. Imagine if you wanted to go short Treasuries because you believed that interest rates would rise due to inflation and regulators told you that you could only short the six-month bill because shorting the 10-year or 30-year would push long-term borrowing costs higher.
Investors should have the right to choose what securities or collateral in which they wish to speculate, short or long. The only wrong-doing here would be if Goldman misrepresented the collateral. That is unlikely, as the long speculation side consisted of banks and investment banks who had other long bets on subprime mortgages and had qualified personnel who knew how to analyze collateral. They made a bet and lost.
The idea of pure bets (speculation) with no other economic benefit other than to the winning better may seem foreign to many of us on the retail side of the business, but this IS the institutional side of Wall Street. Bets are made every day. Some as hedges, and some as speculation. Also, short sellers have their place in the markets. Market participants have to be able to take negative positions when they see that markets are overvalued. This helps to minimize bubbles and makes for efficient markets.
I am no Goldman apologist and the firm is known for winning the majority of its bets, but based on the information which has surfaced up until now, I cannot see any wrong doing on the part of Goldman.
The SEC's civil case against Goldman Sachs may be hitting a few speed bumps. One of the main tenants of the SEC's case is that ACA was duped into believing that Paulson and Co, was making a long bet on the pool of toxic subprime asset CDS used to collateral the CDO known as Abacus. However according to the Wall Street Journal, a Goldman executive told ACA that Paulson was buy protection the Abacus.
The idea that the financial institutions naively assumed that if Goldman and ACA constructed the deal, the collateral was solid and no investigation and modeling of the collateral was needed is ridiculous. The market participants buying Abacus were betting long on subprime for a long time. They had their own modelers, etc. Either this is another example of models being incorrect or management at these firms went long any how.
The bottom line here is that the buyers of abacus were sophisticated and were betting long on subprime already. If Abacus was never created, the institutions in question would have continued to go long subprime any way as their flawed models or greed would have told them that home prices would trend ever higher.
Disclosure: Author long BAC and C