Abacus Let Goldman Shuffle Mortgage Risk Like Beads
From July 2004 through April 2007, as credit markets boomed, Goldman Sachs Group Inc. created 23 financial transactions called Abacus, the word for a relatively crude counting tool involving the shuffling of beads.
Yesterday, the Securities and Exchange Commission sued the bank for securities fraud in what would be the penultimate offering in the series, according to Bloomberg data.
The bank used the deals to off-load the risk of mostly subprime home loans and commercial mortgages to investors, either as hedges for similar positions or to bet against securities itself. While the data show New York-based Goldman Sachs issued at least $7.8 billion of Abacus notes, the risk passed to investors was multiples higher.
The Abacus transactions are so-called synthetic collateralized debt obligations, which marry two financial innovations that contributed to the worst collapse in financial markets since the Great Depression.
“Investors needed to ask some questions about synthetics they didn’t need to ask with other CDOs,” Joseph Mason, a finance professor at Louisiana State University in Baton Rouge, said in a telephone interview.
The financial tools, often called technologies, are credit- default swaps, used to transfer the risk of losses on debt, and securitization, used to slice the risk in a pool of assets into various new securities.
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.
Some of the cash needed for the potential payouts to Goldman Sachs would be raised upfront, and essentially placed in escrow, from sales of Abacus CDO notes with varying ratings. The grades were tied to how many of the underlying securities needed to default before the CDO classes would.
Such securitization enabled debt with the lowest investment-grade ratings to be transformed, in part, into AAA securities that turned out to not be as safe as that ranking suggested. At least $5 billion of Abacus slices now carry junk ratings, below BBB-, from Standard & Poor’s, or have defaulted, Bloomberg data show.
The SEC said that Goldman Sachs created and sold Abacus 2007-AC1 without disclosing that hedge fund Paulson & Co. helped pick the underlying securities and also bet the CDO would default. Paulson was proved correct, and his hedge fund eventually turned a $1 billion profit and CDO investors lost a similar amount, according to the SEC.
The deal was different from most Abacus CDOs in that Goldman Sachs said that a third-party, ACA Management LLC, was choosing the underlying debt instead of the bank itself, according to prospectuses.
At least $192 million of the debt was granted top grades by credit-rating companies, and an additional $1.1 billion was supposedly even safer, according to Bloomberg data. The latter, super-senior portions were derivatives and not securities.
“This would never have been possible if the ratings had been correct,” said Gene Phillips, director of PF2 Securities Evaluations, a New York-based advisory firm. “For these trades to come out so well for Paulson, the ratings agencies would not have been able to identify as well as Paulson did that these were crappy assets.”
An explosion in synthetic CDOs began in December 1997, with the first of the so-called BISTRO deals created by a predecessor to JPMorgan Chase & Co.. The transaction involved the bank laying off some of $9.7 billion of its risk tied to financing for 307 companies, according to “Fool’s Gold,” a book by Gillian Tett (Free Press, 2009).
Shortly after that, JPMorgan helped Bayerische Landesbank of Germany unload the risk of $14 billion of U.S. mortgages and then completed one more mortgage-linked BISTRO transaction, before stepping out of the market for home-loan deals because it couldn’t get comfortable assessing the risk it needed to retain amid a lack of historical data on how the debt would perform, according to the book.
UBS AG, in a series called North Street from at least 2000 through at least 2005, and Deutsche Bank AG, through its Start program in at least 2005 and 2006, also issued synthetic CDOs tied to mortgages, according to Bloomberg data. Doug Morris, a spokesman for Zurich-based UBS, and Renee Calabro, a spokeswoman for Frankfurt-based Deutsche Bank, declined to comment.
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.
Investors “came to Goldman Sachs and other financial intermediaries to establish long and short exposures to the residential housing market,” and the bank’s protection against home-loan bond defaults represented a way to offset risk it took on by selling the opposite position to clients, Chief Executive Officer Lloyd Blankfein said in the company’s annual report.
In 2006 and 2007, when the residential and commercial mortgages with the highest default rates now were made, the bank created more than $4 billion of Abacus notes, Bloomberg data show.
That figure doesn’t reflect the fact that banks such as Goldman Sachs often would retain some of the slices they created. The bank said in a statement yesterday that it lost $90 million on the transaction the SEC sued it over. The $7.7 billion in Abacus CDOs doesn’t include most of the so-called super-senior tranches that were supposedly safer even than AAA debt. Super-senior transactions were often private.
For instance, with Abacus 2005-3, initially 68 percent linked to subprime-mortgage securities, Goldman planned to create a $1 billion super-senior class along with $825 million of notes, according to a May 10, 2005, preliminary term sheet. Super-senior classes, or those in which the cash that would be potentially paid out to Goldman Sachs wasn’t collected upfront, often made up larger portions of the deals.
American International Group Inc., the insurer whose mortgage losses led to its need for a U.S. bailout, took on the super-senior risk on the 2005-3 deal, along with six others, according to an internal memo posted on CBS News’s Web site.
That included the last Abacus deal, which priced April 17, 2007, and focuses on commercial-mortgage securities, Bloomberg data show. Its most-senior class below the super-senior one is now rated CCC by Fitch Ratings, its third-lowest level.
AIG guaranteed $6 billion through Abacus deals, a person with knowledge of the matter said this month. That figure shrank to $4.3 billion by November 2008 as some of the mortgages linked to the derivatives were repaid or refinanced, the person said.
The insurer last year terminated about $3 billion of the swaps with Goldman Sachs that made up the super-seniors, resulting in $1.5 billion to $2 billion of realized losses, said the person, who declined to be identified because the specific transactions weren’t disclosed. AIG, based in New York, has about $1.3 billion in remaining swaps tied to the CDOs, the person said.
The swaps weren’t included in AIG’s 2008 government rescue because they insured pools of derivative bets, rather than actual securities. AIG and the Federal Reserve Bank of New York retired $62.1 billion in swaps by fully reimbursing bank counterparties in exchange for obtaining the securities, which are held in a taxpayer-funded vehicle called Maiden Lane III.
Still, some Abacus classes are in Maiden Lane III, because they’re held by other CDOs. One is Davis Square III, a CDO underwritten by Goldman Sachs in 2004 and managed by TCW Group Inc. that bought $24 million of Abacus slices, including some created after Davis Square III was, according to Moody’s Investor Service reports.
Erin Freeman, a spokeswoman for TCW, a unit of Paris-based Societe Generale, said none of the CDOs managed by TCW purchased the Abacus deal at the center of the SEC suit.
The holdings of CDOs by other CDOs mean that some bond buyers and insurers may not know they’re exposed to Abacus deals. Royal Bank of Scotland Plc, the bank now controlled by the U.K. government, was the bigger loser in the deal in which the SEC alleges Paulson & Co. was involved, paying out $840.9 million to Goldman Sachs in 2008, most of which it then passed to Paulson’s hedge fund, according to the SEC complaint.
Even as subprime defaults soared in 2007, more than $1.1 trillion of CDOs were created, about the same as in 2006, according to JPMorgan data. The figures, which also include CDOs backed by assets such as buyout loans and bank capital securities, include unfunded super-senior classes. Funded issuance totaled about $1.05 trillion during those two years.
Some of Goldman’s Abacus CDOs were “static,” meaning the portfolio of securities they referenced didn’t change over time, while others allowed for reinvestment into different investments as initial holdings paid down, with Goldman choosing the new securities.
That’s partly because investors including Dusseldorf, Germany-based IKB Deutsche Industriebank AG, a buyer of part the CDO the SEC is suing over, asked for the reinvestment because they would be given higher yields, a person familiar with the matter said earlier this year.
A dispute over replacement collateral involving UBS landed in New York Supreme Court in 2008. Hamburg-based HSH Nordbank AG, the world’s biggest shipping financier, said in a complaint that UBS had been “deliberately selecting inferior quality” assets for a synthetic CDO called North Street 2002-4.
Goldman Sachs may have lost money on Abacus 2007-AC1 because in at least some Abacus deals, the bank used the cash raised from note sales, which would be owed to either the owners or itself, to buy securities including AAA-rated mortgage bonds and CDOs, according to Fitch and Moody’s Investors Service.
It then guaranteed that, in most cases, it would buy the escrow account securities at face value if needed to pay the owners of the Abacus notes, unless those escrow holdings defaulted, according to the rating firms’ reports. Declines in the value of the purchased securities could limit how much Goldman Sachs could pay itself.
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