In a previous post, I noted that the SEC's case that Goldman failed to disclose the Paulson & Co hedge fund's role in selecting the collateral might be weakened, because the investors themselves likely were told which assets went into the CDO. To rehash my metaphor, it isn't as critical to know who selected the deck when you know the cards in the deck. Evidently, I was not alone in this conclusion -- see some of the reactions of other law professors in the NY Times.
Offline, a reader pointed me to a paper that convinced me that I might be completely wrong about this. The paper's conclusions may turn out to have pretty significant implications for this case.
Here's the insight, an October 2009 paper by a team of computer scientists and an economist at Princeton argues that the parties that structure a CDO may be able to hide lemons -- that is assets that they know are subpar -- in the collateral of a CDO through carefully structuring the CDO. The investors in the CDO may find it impossible to detect these lemons even when the collateral is fully disclosed and the investors are sophisticated and have significant computing resources.
Why? The paper (Arora et al., "Computational Complexity and Information Asymmetry in Financial Products") argues that the complex structuring of derivatives can create "computational intractability." In layperson terms, finding the "lemons" can become an inordinately difficult mathematical problem. Unless an investor has unlimited computational power, it may not be able to "solve" the problem and detect the lemons. It's the same problem that occurs with trying to decode computer messages protected with a certain level of encryption. The structuring of the deal functions as a kind of encryption to camoflauge the bad assets.
This means that the party that both selects the collateral and structures a complex derivative (like a synthetic CDO) has a potentially insurmountable information advantage over its counterparties. One blog commentary on the paper likened this advantage of the structurer to being able to hide a booby trap in plain sight. (In an amusing twist, the paper argues that "even Goldman Sachs" wouldn't be able to detect the lemons).
What could this mean for the Goldman case? Many things. First, we shouldn't assume that even when the investors (or ACA, the collateral manager for that matter) knew what the collateral was that they could easily detect any lemons. Arguments that the investors and ACA were sophisticated and should have been able to fend for themselves should be given less weight. Conversely, arguments that investors need to rely on the proper incentives (or at least the disclosure) of both the party that selected the collateral and the party that structured the deal gain a lot more weight.
Second, how the deal was structured (not just how the collateral was selected) may prove to be crucial. From the SEC Complaint, it looks like Goldman structured the deal and that ACA was mainly involved in the collateral selection. It is unclear if Paulson played a role in structuring the deal. Did Goldman structure the deal to "hide" the Paulson-selected assets? Unfortunately, based on the conclusions of the Princeton paper, detecting this hiding is subject to the same intractibility problem. Unless there is some "smoking gun" evidence -- e.g. loose-lipped e-mail correspondence, testimony from Goldman employees. Even the absence of a smoking gun doesn't detract from the first point -- that the investors wouldn't be able to detect lemons even if the collateral was fully disclosed to them.
Third, this insight means that an already complex case may require even more expert witnesses -- let's see if the Princeton team gets a call.
On a personal level, I need to think more about what this means for my own research on using technology to improve securities disclosure and address "complexity."
(I would like to thank the reader (who'd like to remain anonymous) who prompted this post and pointed me to the Princeton paper.)
Addendum 4/21: Several readers have noted that the Princeton study that a seller of assets can hide "lemons" in a CDO through structuring is premised on the fact that the seller enjoys an advantage of asymetric information. We don't know if Paulson had nonpublic information about the assets it wanted in the CDO. If ACA and the CDO investors had access to all the information Paulson did about the assets Paulson requested go into the portfolio. Drawing a bright line between public and nonpublic information is not as easy at it may sound. We could always say that an investor should have done more homework on a particular asset-backed security -- even, to use the Princeton example, inquiring whether there were "liar's loans" backing certain collateral a seller is putting into a CDO. This goes back to a recurring point in my posts -- that how much homework the ACA/investors would do on Paulson-requested collateral and how toughly they would negotiate with Paulson depends on whether they thought he was betting with them or against them.
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