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The Mother of All Disclosures

The mountain of home price risk was not only in plain view, but had been rising at an unusual pace over a period of several years. For example, in 2003 alone, Barrons, The Economist, and Money magazine published feature stories about it, and Case & Shiller authored a whitepaper about it. In the second edition of Irrational Exuberance, published in February 2005, Shiller plotted home prices since 1890, and described the dramatic spike that began to form in the late 1990s as “a rocket taking off”.

This plot garnered attention throughout financial, mainstream print and internet media around the world. An August 2005 article in The New York Times featured a version of Shiller’s “rocket” chart, and his quote warning of the risk of home prices correcting by 40% in inflation-adjusted terms. Although Pellegrini reached a remarkably similar conclusion several months later (see “Inside John Paulson’s Shorts”), unfortunately for Shiller, he didn’t buy a swap on Abacus or any other form of subprime mortgage credit protection. He couldn’t have even if he wanted to.

Like other individuals who were queasy about the prospects for housing and/or subprime credit performance, the professor would have been deemed unqualified to do so – in contrast to the rocket scientists at esteemed institutions such as AIG Financial Products, Fannie Mae, Freddie Mac, etc. who were, in effect, selling protection on or otherwise going (very) long housing with little, if any, discretion. A year later, Shiller’s chart was reproduced in The New York Times yet again. The plot was even transformed into “The Real Estate Roller Coaster”, an online, nausea-inducing virtual thrill ride that has been experienced by more than 558,000 people as of this writing (free rides).

The SEC’s civil fraud complaint against Goldman Sachs regarding the structuring and marketing of Abacus 2007-AC1 contains serious charges related to the accuracy of representations and completeness of disclosures (to date, GS has vigorously denied wrongdoing and it is unclear whether a settlement is imminent). The complaint has stimulated lively debate regarding aspects of the disclosure controversy, and the discussion has been intensified by one side asserting a few very plain (and, they claim, exculpatory) facts. The most oft-cited defense among those sympathetic to GS is that the binary, “zero-sum” nature of counterparties’ stakes within a CDS transaction undermines any implication that certain institutional investors who sold subprime mortgage CDSs didn’t realize that someone had a diametrically-opposed view and financial interest to their own. This obvious and fundamental market dynamic should have compelled all (institutional, ostensibly sophisticated) parties to closely scrutinize the final collection of “reference securities” – regardless of what party or parties were involved in reference security selection.

“I then remember how depressed I felt when I saw, sitting in a New York hotel room, my first NINJA mortgage advertisement, which I brought back to Australia. I recall having lunch with a close friend in London in July 2005 who managed CDOs for one of the biggest CDO firms in the world. I talked to him about the NINJA mortgage advertisement and my view on the American housing market. I showed him the Robert Shiller chart on U.S house prices and said I think the bubble is about to burst. I begged him to run the numbers and see what impact a 20% decline in U.S house prices would have on his CDOs. He looked at me as if I was from Mars.”
- Jonathan Pain, from The Market Oracle, “The Broken Euro Club Bailout, Calling All Martians”, May 29, 2010

Another exculpatory fact relates to The Mother of All Disclosure. The evidence of mounting home price risk that surfaced over the years leading up to Abacus 2007-AC1 was compelling and in public view around the world. Shiller’s chart was just one warning flare, but it was spot-lit starting in 2005, casting a very tall and ominous shadow that the fearless “long & wrong” crowd chose to discount or ignore altogether.

“You can lead an investor to disclosure, but you can’t make him think.”
- Jason Zweig

The foregoing observations should not be construed as a suggestion that the SEC’s civil fraud allegations against Goldman are unwarranted. They are very serious charges, and there are many facts relevant to the complaint and investigation that are not public. The separate SEC subpoenas and preliminary federal criminal investigations of several major Wall Street firms regarding concerns that some or all of them may have misled investors about mortgage-related investments (or manipulated the markets for them) are also serious, and these inquiries underscore the very real possibility that concerns about the degree and quality of disclosure related to the reference security selection process for Abacus 2007-AC1 is the small tip of an iceberg.
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Disclosure: No positions