“HAVE YOU NO SENSE OF DECENCY, SIR?”

4/27/10

I told my son today as we drove home from his soccer practice that his children will read about today’s testimony in their history books. Being 11, and a more normal 11 year old than his father was in 1968, he didn’t care that much. I, however, found the hearings fascinating, providing plenty of grist for a follow-up to my 4/19/10 post HE THAT PLAYS WITH GOLDMAN MAKES THE RULES.

Many times in the course of the hearings and the CNBC post game show, Blankfein and the other Goldman witnesses, and such CNBC estimables as Jim Cramer and Larry Kudlow, made the perfectly logical point that whenever someone sells a security, whether the seller is an Wall Street firm, a local trader, a sophisticated investor, or a not so sophisticated investor, he is taking the other side of the trade from the buyer. Cramer and Kudlow made the point derisively, as if this were a concept so simple that even a Senator should be able to get it. Clearly, it is an obvious point, but consider two things.

First, the smaller, and equally obvious point. Yes, a seller is by definition on the other side of a trade from a buyer. But that one trade says nothing about the seller’s overall position. A seller could be selling a small portion of his long position, leaving himself net long or he could be shorting a security, leaving himself net short. It makes a difference. A particular trade says nothing about that trader’s overall position. However, in any case, it would not seem that the seller’s overall position needs to be disclosed to the buyer. Cramer, Kudlow, Blankfein, etc. are doubtless right on this point.

Second, the more important point. We are not talking about any seller here, but an underwriter. In fact, when one of the senators (And it may have been Levin but I was either in the car or looking elsewhere; I only got the audio, but it doesn’t matter for these purposes.) quoted a senator who was involved in the hearings in the ‘30s about the causes of the Great Depression, that quote from the ‘30s specifically cited the “underwriter” of securities, not just any seller or not just any dealer. If an investment banker is underwriting securities, should that firm be simultaneously shorting the securities it is promoting to the public? One can understand a small and temporary short, which I understand is common in oversubscribed issues, to partially or completely fill customer orders. One can also understand a small, temporary short in order to make a market in securities a firm has underwritten. But a large, long term net short is another story, a bet against the very securities the investment banker is underwriting.

What this all has to do with the Abacus deal is not clear. Goldman underwrote the deal but ended up net long when it couldn’t sell the whole position. It was Paulson, not Goldman, who was effectively shorting the deal by going long the protection. I guess one could argue, as some senators seemed to be arguing, that one should not be underwriting any CDOs while being net short the mortgage market, but that is a stretch. That would almost be like saying that an underwriter of junk bonds should not be shorting any junk bonds, which would make no sense at all.

Another observation on the Abacus deal…

It is becoming even clearer that ACA’s role is the key here. ACA at least nominally assembled Abacus. The SEC alleges that ACA was little more than a cover story, that, indeed, it was Paulson who assembled the CDO with ACA as the financial equivalent of a codpiece. But ACA wound up losing substantial money from a long position in Abacus, and a long position that was completely volitional, unlike Goldman’s long position. This allegation thus doesn’t make a lot of sense, at least on its face. Why would ACA accede to stuffing a CDO in which it intended to take a long position with securities that would assure that CDO’s demise? It seems clear, as I said in my 4/19/10 post HE THAT PLAYS WITH GOLDMAN MAKES THE RULES, that ACA was not some kind of co-conspirator. Was ACA another victim in this situation, a witless dupe, deceived every step of the way by Goldman and Paulson? Or did ACA legitimately put together a portfolio in which it had enough confidence to take a substantial long position but was just wrong on the market, with no excuses given its expertise in the CDO markets? Goldman obviously, argues the latter, and cites ACA’s rejecting numerous Paulson suggestions for inclusion in the portfolio as evidence. If the latter is true , there is much adieu here about very little. If the former is true, who really put the portfolio together while letting ACA think it was in charge? The only answers would be Paulson & Co. (which made a bundle on its effective short in Abacus and fully intended to do so), Goldman, or some combination of the two. If that is the case, and Goldman, Abacus’s underwriter, did not disclose Paulson’s, or its own, role, then Goldman has a problem.