April 19, 2010
Cash vs. Synthetic CDOs: Which team was Paulson on? (Plus the dangers of lawyers judging the level of fraud in a market)
Posted by Erik Gerding

Jeff Lipshaw helpfully points out that there is a difference between a cash CDO (in which mortgage-backed-securities or other asset-backed-securities are themselves being securitized) and a synthetic CDO, in which the CDO vehicle is entering into credit derivatives that would mimic it holding a real portfolio of ABSs.

As I noted in my first post, a synthetic CDO is more like a pure bet. True, the collateral manager and investor in the CDO should have known that there were investors like Paulson out there on the opposite side of the transaction. Those investors would indeed have an incentive to put worse reference assets into the CDO.

This goes back to the question in another of my posts, of was ACA misled into thinking that Paulson was on its team, not the opposite side. That’s where we need to wait for more facts as to what Goldman did, said, and did not say. I'm not ready to make any conclusions based only on a complaint, a flipbook, and assorted press releases.  It is safe to say that both the SEC and Goldman are selecting the facts most helpful to them and facts will likely still be uncovered. Expect some fuzziness and for radically different interpretations of the same testimony and written record.

Even if ACA was “suckered” but not necessarily defrauded, the CDO investors might reasonably have wanted more disclosure of the process – and Paulson’s role -- in selecting the assets.

What's the point of the paper I commented on earlier - that shows lemons can be hidden from investors even when the collateral is fuly disclosed?  Two things.  First, it weakens arguments that investors in CDOs are protected just by virtue of knowing what the collateral and structure of the deal is.  It sounds like investors would be fully protected if they knew the meat that went into the sausage grinder and they were given a schematic of the grinder itself.  But the paper suggests that the person that chooses the offal and builds the grinder still has a huge informational advantage. 

Second, it means investors would therefore like to know about the process of selecting the collateral -- particularly if the person selecting the collateral had their interests at heart or might be hiding lemons.  So again, the question of whether ACA was deceived is critical.

In response to Jeff’s reference to his practice and being unconvinced that parties are hoodwinked, I practiced for 8 years including time served on structured finance deals. I didn’t see fraud in transactions I worked on. But that isn’t at all surprising. There is a danger in making conclusions about the level of shady conduct based on personal experience. Any lawyer’s experience is not a representative sample. Why? Because if something shady in a deal negotiation comes to you as an attorney, it is a lot less likely to progress much further to a full blown misrepresentation. This also means that less conservative clients are less likely to tell the lawyer of shady dealings that the lawyer might block. Conservative clients will come to a lawyer and the misrepresentation will never reach fruition. Less conservative clients will never come forward. Perhaps a lawyer will find out later – but professional rules and plain old self interest might combine to mean that many misdeeds later learned aren’t later disclosed fully.

For us law professors, it will be interesting to see what we learn about what Tourre and the Goldman team told the Goldman lawyers as the deal was developing.  We of course won't fully know that either - again because of attorney client privilege.

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