By James Kwak
I actually suspected this, but I haven’t had the time to look at the marketing documents. But thankfully Steve Randy Waldman did. I don’t think I can improve on his description — these things take hundreds of words — but here’s a quick summary.
An ordinary CDO is a new entity that raises money by issuing bonds in tranches, uses the money to buy some other bonds (say, residential mortgage-backed securities) and uses the cash flows from those bonds to pay off its own bonds.
A synthetic CDO is similar except instead of buying the underlying bonds, it sells credit default swap protection on those bonds (the reference portfolio) and uses the premiums from the CDS to pay off its own bonds. (The money it raises by selling those bonds is usually parked in low-risk securities so it is available to pay off the CDS if necessary.)
ABACUS was different. There was a reference portfolio. But instead of selling CDS protection on all of those bonds, Goldman said (to paraphrase), “Imagine we sold CDS protection on all of those bonds. Then imagine we used those CDS premiums to issue bonds in tranches A-1, A-2, B, C, D, and FL. The derivative I’m selling you is one that will behave exactly as if it were an A-1 (or A-2) bond in that scenario — even though we’re not actually selling all of the tranches.”
Does this matter? To think about that, I recommend yet another post by Waldman, in which he takes apart Goldman’s claim that it was brokering a trade between a long side and a short side. Goldman likes to say this because it implies that the long side had to know there was a short side, and hence the failure to disclose Paulson’s role was not material. But that’s not what was going on.
Goldman was creating a new company (a CDO of any variety is a new legal entity) and underwriting bonds issued by that company. In this case, the company’s “business” was writing derivatives that were essentially highly customized credit default swaps (since the swaps mimicked what would have happened had there actually been a synthetic CDO). An underwriter’s role is to induce investors to put their money in the company it is underwriting, which means talking up the qualities of that company while also disclosing its defects; it is not to broker a trade between investors who want the company to do well and other investors who want the company to do badly. And even if the “company” in question is a synthetic synthetic CDO, that doesn’t change.