While we are on the subject of pure bets, when will there be a prediction market on the outcome of this case? When will you be able to place your bets?
I am not ready to take an official position - "Goldman is liable" or the "SEC will lose." What law professor would given that we are only at the beginning of learning the facts?
But that doesn't stop you from making educated guesses and bets. There is of course an active arbitrage market on Wall Street betting on the outcome of things like high profile litigation and whether a regulator will allow a merger to go through.
When there is a Goldman prediction market, prices will change as new facts come up.
Is there any social value to this type of bet? -- you can probably predict what I will say if you read a previous post -- depends if any party to a bet has a pre-existing risk.
And there is entertainment value.
Would there be any intellectual value to a prediction market beyond giving me something to blog about? Remember Oliver Wendell Holmes' old adage that law is just a prediction of what a court will do.
Does that mean a prediction market is the law?
Addendum: I wouldn't be at all shocked if lawyers -- even law professors -- will be hired by arbitrageurs to evaluate bets on the case. There may be a lot less professional risk if you are placing a bet without putting your name in writing or on a blog.
Here is a more gossipy question: if you were hiring a lawyer or law professor to help you place a bet on the outcome of the case, who would you pick?
Here is a half serious legal question: could there be market manipulation if a professor then writes statements to influence the price without disclosing her interest?
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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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As I posted yesterday, the legal case against Goldman boils down to disclosure, particularly to this question:
“Did Goldman have to disclose to investors in the ABACUS CDO that the Paulson hedge fund, who was shorting the CDO, was involved in selecting the collateral?”
Listening to the radio last night, I heard a number of commentators talk about how investors should have known that there were investors – including Paulson -- out there that would buy credit default swaps and bet against their CDO investments. When you gamble, you should assume someone will bet against you. The question in this case is whether you should be told that that this gambler betting against you selected the cards in the deck.
Would a reasonable investor want to know who picked the cards in the deck?
My guess is that a reasonable investor would indeed want to know that Paulson was involved in selecting the deck. What’s the support for this beyond the SEC’s Complaint? Look at the “flipbook” for the transaction provided to investors by Goldman (posted on the NY Times). It goes on at length of why ACA is a good collateral manager for the CDO. On p. 27, it includes a bullet point “Alignment of Economic Interest.” The SEC complaint zooms in on this little nugget (see Complaint Para. 38). (Note to law students: bullet points in “powerpoint” style are not only bad devices to communicate ideas, they have some itty bitty securities law problems when used to market securities. If you can’t formulate something in a complete sentence, try again.) Nowhere does the flipbook mention that the Paulson hedge fund was involved in selecting the collateral for the CDO.
Hurdles for the SEC
Does this mean the SEC has a slam dunk case? No; they have plenty of other legal hurdles. [More after the break]
For starters, even though Paulson’s role in selecting the deck wasn’t disclosed to investors, the deck itself likely was. In other words, investors probably were told of the assets put into the CDO (I can’t say for sure, since I have not seen the prospectus given to investors, but would be shocked if it didn’t disclose in some detail the “reference assets”). This disclosure might lessen the importance of disclosing Paulson’s role in selecting the assets.
ACA’s role
A large chunk of the SEC Complaint focuses on the fact that ACA was duped into thinking that Paulson had invested in the CDO and was not betting against it. This section of the complaint highlights that the SEC needs to downplay the ACA’s ultimate responsibility for the collateral. The SEC’s argument goes like this:
1. ACA did not know Paulson was betting against the CDO. It thought Paulson was investing in the CDO.
2. If ACA had known that Paulson was betting against the CDO, it would not have acted as collateral manager (largely because its reputation would suffer because it would be seen as picking cards that would hurt the CDO investors).
3. If ACA had not acted as collateral manager, investors (like the German bank IKB) would not have bought the securities.
Goldman will likely try to saw away at each of the links in this chain. I am assuming that the SEC is not making these statements out of thin air, but has the cooperation of ACA and IKB. How well will these allies do in depositions? Did ACA really not know (or should it have known) that Paulson was not investing in, but betting against the CDO? Other commentators have noted that Paulson was becoming famous on Wall Street for betting against mortgage backed securities. The assertion that ACA didn’t know of Paulson’s bet may be a weak spot in the SEC case.
Causation and damages after Freefall
In a 10b-5 case, my Business Associations 2 students can tell you that the SEC still has to prove various other elements beyond whether the disclosure was materially misleading. Causation and damages might prove particularly tricky. The SEC focuses in the complaint on the number of the ABACUS CDO bonds that were downgraded. Downgrades don’t give us a sense of monetary damages. True – the complaint later mentions that the IKB lost most of its $150 million investment.
This looks a little grim for GS, but one big question is about “the baseline.” In other words, “shouldn’t we subtract market-wide losses from damages?” As the SEC Complaint notes, the ABACUS CDOs lost in value in the midst of market-wide losses in asset-backed securities tied to mortgages. Analyzing elements like causation and damages is extremely tricky during market-wide crashes. But not impossible – (see Lev & de Villiers, Stock Price Crashes and 10b-5 Damages: A Legal, Economic, and Policy Analysis, 47 Stan. L. Rev. 7 (1994) for an one, older treatment of this question.) Analyzing causation and damages would be greatly complicated if the market for a given class of security is frozen – with very few buyers.
What should investors be charged with knowing about the risk?
Many commentators asked whether the investors in the ABACUS should have known that the securities they were buying were extremely risky. Again, lots of mortgage-backed securities plummeted in value. This case is noteworthy for how late the ABACUS deal closed – April 2007, when the subprime real estate, mortgage-backed security, and ABS markets were already wobbling hard. That was pretty late in the game of musical chairs to be starting another dance.
Goldman will likely use this particular argument – investors should have known the general risks in these securities -- in multiple doctrinal places in the litigation – not just causation and damages.
Usha’s post reminded me of the 2003 opinion by Lewis Pollack in In re Merrill Lynch, in which Judge Pollack (known as a securities law expert) dismissed claims against Merrill Lynch, Henry Blodgett and others in one of the internet stock analyst cases because the collapse of the internet bubble was an intervening cause of the plaintiff’s losses. [My name is Erik. I’ve been addicted to studying bubbles and financial regulation for 8 years.]
Pollack’s particular ruling may not apply to this case, but it underscores that courts are not always sympathetic to investors investing in risky securities during boom times. The countervailing position is that issuers, underwriters, and others should bear responsibility for hidden practices that made the securities more risky. Claiming that a bubble occurred doesn’t necessarily mean that investors should bear losses because they were Tulipmaniacs; issuers and bankers often play a big role in blowing up a bubble.
Facts not overly general normative assertions should govern. Nevertheless, it is hard to escape normative judgments in the messy allocation of losses between investors and market players in the aftermath of a boom and crash. It is far easier to ask who is the “cheapest cost avoider” than to come up with a value-neutral answer. Answers usually have much to do with gut reactions and where you fall on an ideological spectrum.
A close look at the "investors"
Enough generalities, let’s go back to the Complaint – particularly the discussion of the Investors. IKB seems like a solid witness for the SEC. ACA, as mentioned above, less so. The Complaint details not only ACA’s role as collateral manager, but its parent, ACA Capital, as an investor that lost money. But ACA Capital is not your usual investor that lost money. It lost money when it issued a financial guaranty to some of the ABACUS investors. Essentially, ACA Capital wrote an “insurance policy” and would not have done so had it known that Paulson was betting against not investing in the CDO. But how did they not know? The timing in paragraph 62 of the complaint is odd. ACA Capital issued the guaranty in May 2007 – a month after the CDO closed. They didn’t have access to the list of investors in the CDO? They didn’t check that Paulson & Co wasn’t included? Did some firewall between the collateral manager ACA and the parent prevent them from putting two and two together? Did ACA Capital think Paulson invested in the CDO?
ABN Amro is also listed as an “investor,” because they entered into a series of credit default swaps under which they basically guaranteed ACA Capital’s guaranty. I buy a little more that ABN Amro had no reason to know of Paulson’s involvement.
Paragraph 66 is interesting too. What it looks like is that when Goldman sold the credit default swaps to Paulson (in which Paulson was betting against the CDO), Goldman hedged itself with the credit default swaps with ABN. Goldman sold the swaps to Paulson, but may not have taken any risk itself. According to the Complaint, ABN’s payment on the swaps mostly went to Paulson. Framing IKB as an “investor” is straight forward. ABN is not: it will be interesting to see how 10b-5 and 17(a) antifraud protections apply in this case when the “investor” is an OTC derivative counterparty, not a purchaser of the securities. (For example, 10b5 claims must involve the "purchase or sale" of securities).
Bigger picture questions
This last point raises some bigger picture issues for legal scholars. Securities law and the SEC has come a long way from the image of protecting mom & pop investors from sharp practices. As financial markets have been institutionalized and institutional investors have assumed a larger role (see Langevoort), how will the SEC’s role change? How should it?
You can make a strong case that protecting institutional investors benefits not only their beneficiaries (like pensioners), but also the small fry retail investors. But protecting institutional investors does not always translate into protecting mom & pop. Moreover, when you are protecting “big kids” in the playground, when do we let them fight for themselves and make their own mistakes?
The outcome of this case will also have much to say about the viability of Goldman’s business model (and the model of other conglomerates) to have their fingers in many different pots – and to play many different angles in the same transaction. But if the potential for conflicts of interest is a chief concern, let’s not think of litigation as anything other than a very poor substitute for regulation.
On another note, I often relish finding ways in which market players could get caught up in conflicting arguments. Here is one to watch for: many Wall Street executives have claimed “we could not have foreseen this.” Will this come back to haunt them in litigation when the lawyers claim that investors should have been on notice about risky securities? These mixed messages may create more political than legal problems. But then again, many commentators, like Larry Ribstein, have contended that the Goldman suit may be more about firing a salvo in the financial regulatory war – and putting Wall Street on the defensive as regulatory reform heats up -- than just the facts of this case.
The Question you’ll get asked at a party: Why didn’t the SEC go after Paulson & Co.?
The short answer is that – maybe it could have, but that would have made the case much harder to win. This case is about disclosure and Paulson didn’t say anything to the CDO investors and didn’t owe them any fiduciary duty to disclose. Perhaps the SEC could have brought a 10b-5 claim against Paulson on a “scheme” theory, but they may not have the evidence to do so. The Complaint doesn’t say Paulson intended to deceive the ABACUS investors. The hedge fund would likely take the position - “We were looking for an investment, so were the CDO investors. We didn’t create a “scheme” to defraud anyone and it was Goldman or the issuer’s job to disclose to investors.”
Perhaps the hedge fund employees were also smarter in what they put in e-mails than the 31 year old Goldman employee defendant. The SEC may also want to enlist Paulson in the case. Here is something else that may sound semi-smart to say at the party:
“Goldman may have more pressure to settle given that they have more of a reputational stake to lose with clients in their various businesses, they are much more heavily regulated than Paulson, and they may be even more regulated if financial reform gets any traction.”
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Those Supreme Court watchers out there may remember that Massey Coal, the company at the center of last week’s mine tragedy in West Virginia, was also at the center of last year’s Supreme court decision in Caperton v. Massey (129 S. Ct. 2252).
In that case, the Supreme Court faced the issue of whether a West Virginia Supreme Court justice should have been forced to recuse himself in a case involving Massey Coal. The company had spent $3 million to support the judge’s reelection to the state Supreme Court – roughly 60% of the total spent in support of the judge’s campaign.
Justice Kennedy wrote a 5-4 opinion for the Court ruling that the justice should have recused himself because of the “risk of actual bias” from these campaign contributions. The dissent argued that this imposed a new recusal standard that would greatly unsettle the law.
If there is state litigation in the wake of the mine collapse, how many judges would have to recuse themselves?
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If Saab does meet its demise (I hope it doesn't) and now that Volvo seems to be thinking outside the box (wink) and marketing itself to Republicans, what will academics drive? Here are some of the candidates with a thumbnail analysis of implications for parking one in the faculty lot:
1. Volkswagen: verboten.
2. Prius: Check plus on assauging social guilt, check minus on panache.
3. Subaru: A strong candidate except doesn't exactly scream "I'm a European Social Democrat stuck in the U.S."
4. Jaguar: Screams "I'm a Tory, and you don't even know what that means."
5. Land Rover: The toxic connotation combination of yuppiedom and colonialism.
6. Mercedes/BMW: makes it hard for the driver to make social justice arguments in faculty meetings on the parking situation.
7. Mazda/Honda and everything else: a little too lower case "d" democratic.
I guess that leaves us with ... Audi. Just don't check its corporate structure or you'll be back at square 1.
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I would really like to read some good reporting on why GM is unwilling to sell Saab. At first blush, it seems odd; wouldn't G.M. be better off selling at any price than incurring the costs of shutting Saab down? What is it about GM's diligence on the Russian-backed Spyker that cause the deal to fall apart? Concern about protecting GM intellectual property? It is pretty unusual for a seller's diligence on a buyer to scuttle a deal.
Other possible explanations -- buyers are looking for GM to finance the acquisition or assume various Saab liabilities. Or are tax implications playing a role?
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Just on Sunday, I wondered when Google would take on Lexis and Westlaw in the legal research field as Bloomberg has already done.
Google scholar now includes features where you can search for cases (legal opinions and journals) and patents in addition to articles:
I couldn't resist searching for my name. One of the top results: a European patent for "Apparat for Avvanning Av Slam" translated as "Apparatus for Draining of Sludge." I didn't know I had Dutch relatives working in financial markets.
I still am curious when Google will move into Bloomberg's home turf of financial data, analytics, and content.
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Now that the kids are asleep, I finished the Sunday Times. A few questions based on the profile of Bloomberg's expansion:
1. When will Google take on Bloomberg?
2. When will either take on Lexis and Westlaw?
There was a one sentence hint in the article that Bloomberg is beta testing some web-based product for law firms. Anybody know what that product looks like?
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This caption was part of a full page ad from USAA Bank in the Washington Post last week, and is part of a larger ad campaign emphasizing the fact that the bank did not take any TARP funds. The ad went on to note that "We believe the only banks that can claim financial stability are ones like USAA that didn't take a dime in TARP funds." In fact, the bank not only boasts of making a healthy profit in 2008, but also notes that it returned millions of dollars to its members through rebates and rewards.
The ad caught my eye because while obviously aimed at promoting the bank, it also suggest that there should be a stigma associated with banks that accepted TARP funds. In some respects, this stigma may have been what the government sought to avoid when it convinced some of the more prominent banks to be the first participants in TARP. Yet the ad plays on people's fears and frustrations not just about companies that needed a bailout, but also about the seemingly unfair fees and other practices in which some banks have engaged even after accepting TARP funds. Interestingly, at least one Business Week article notes that while USAA did not take TARP funds, "it did benefit from federal guarantees established by the same legislation." The ad nevertheless seems accurate given that USAA has not actually accepting any TARP money. But is the ad working? As I noted, it certainly caught my eye. On the one hand, ads that play on our fears and concerns aboutthe bailout may be risky, particularly for those who would rather focus on the rosier stories suggesting that we are moving towards recovery. On the other hand, the ad seems more appealing than those from banks touting the strength of their performance and programs post-bailout.
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Layoff Tracker: "As of July 5, 2009, over 12,829 people have been laid off by major law firms (4,985 lawyers / 7,844 staff) since January 1, 2008."
Seems like a perfect time to start a new law firm.
Dion Persson is seizing the opportunity with gusto. Dion and I worked together at Skadden in Delaware, and for the past 15 years, he has been working in house and as Senior Vice President at Johns Manville. Now he is trying to build a national law firm that would provide services only to small businesses and entrepreneurs.
So far, Simplicity Law has two lawyers, with a few others on call. Dion tells me that this is an attempt to "build the law firm of the future," which is exactly what you would expect him to say. But could it be more than just a marketing pitch?
Dion is imagining a "new model" of law firm, one that relies on technology to provide super-fast service at fixed costs for many of the more-or-less routine transactions that arise in the small business context. Among the many things I like about the idea is the possibility that Simplicity Law will be more amenable to lawyers who are stay-at-home moms or otherwise have a hard time making it in the traditional law firm model. I am rooting for Simplicity Law.
But what do you think? Have you seen anything like this before? Is Dion onto something?
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The New York Times has an interesting article on a textbook renting business called Chegg.com. It caught my eye because, as the article points out, students so often complain about the high cost of textbooks. Indeed, after tuition, room and board, textbooks represent the largest expense for students. So it is no surprise that students always appear to be looking for ways to cut down on their textbook costs and thus this seems like an area ripe for innovation, especially in this economy. Chegg.com and its rival BookRenter.com not only allow students to rent books, but also enable students to buy or sell books. The Chegg.com website indicates that since 2004 over 6,000 campuses have used its services. And for every book sold, rented, or bought, Chegg.com plants a tree. I initially thought that the textbook renting service applied only to college books, but when I searched available books on both Chegg.com and BookRenter.com, I found that law school books also were available for rent. It is not clear how many law students utilize the service and if such a service is the same as the college textbook rental market given that law school books seem to change editions often, but it is certainly an intriguing alternative to the used book market. Moreover, BookRenter.com appeared to have the latest edition of many law books—though it seemed that the cost savings for semester rentals of such books were not as significant as discounts on some other books. The New York Times article noted that while Chegg.com’s revenue in 2008 was over $10 million, the company surpassed that amount in January of 2009 alone—so it appears to be a concept that is taking off. The founders of Chegg.com credit Netflix for part of their success because Netflix has made people more comfortable with an online rental system. I am sure they also can credit the high cost of books and tuition, as well as the status of the economy.
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Here are a few thoughts of mine.
It seems a little disingenuous for the administration to cast the Chrysler bondholder holdouts as knaves. Unlike the big banks that received billions in TARP funds and have gone along with the administration's restructure plan, these smaller bondholders are not beholden to the government for favors. They're secured and deserve the priority they bargained for. One possible solution in bankruptcy--separately classify the TARP bondholders from the holdouts for purposes of voting and payment in reorganization, since they have different interests (in bankruptcy, only "substantially similar" claims may be placed in the same class). Give the TARP bondholders the haircut they've agreed to, and pay the holdouts commensurate with their secured position. My understanding is that the holdouts only amount to about 30% of the $6.9 BB of the bond debt--or just over $2 BB--and they've already been offered $0.29 on the dollar, so with separate classification and payment, maybe the parties aren't that far apart.
OTOH, it looks like Chrysler may try to sell the assets out from under the holdout bondholders without ever confirming a plan. Which is a whole other can of worms.
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I'm catching up on blogging after traveling and doing some other things, and I noticed this Freakonomics post by Ian Ayres wondering if people are willing to pay a premium to not have a similar economic transaction with obligatory human contact. Having a professional house cleaning service rather than a chatty weekly housekeeper, buying online rather than at a store, etc. Of course, it's hard to separate out the "avoiding human contact" aspect from the "avoiding the hassle of driving, shopping, etc." aspect in some of these substitutes.
But I have to say I do this all the time. I like to get manicures from time to time, and I know that if I go to the one where no one speaks English, I can just sit and relax and not have to answer questions about my kids, family, vacation plans, etc. These nail salons are usually cheaper than other ones, but I would be willing to pay a premium not to engage while having my precious "me" time. My gym membership also came with a few free personal trainer sessions. At our first session, I told the poor guy that I really didn't want to chat while I worked out. He seemed relieved, actually.
This trend also seems to be changing business models of firms who historically focused on time-intensive personal contact to sell products, such as Tupperware and Creative Memories scrapbooking. Not too long ago, I tried to buy both types of products without a representative, and could not. Here, these businesses are not only selling products, but also trying to "sell" job opportunities to become sales representatives. If customers can buy online, then that selling opportunity is gone. But sometimes, I just wanted scrapbooking supplies and really didn't want to create a scrapbooking relationship at that time. So, I went to Michael's and bought cheaper scrapbooking supplies. Well, recently, Creative Memories began selling online. I notice now Tupperware does also. Want to buy Skin So Soft without waiting for an Avon lady to come by with a catalog and leisurely have coffee at your kitchen table -- Avon lets you do that now.
And if you're wondering where the catchy title phrase came from, read the Freakonomics post, which details Charlie Sheen's response to why he was an aficianado of paid escorts. Just when I thought he might be smarter than I gave him credit for, commenters point out that he is not the first celebrity to explain that he was not paying for sex, but instead paying for someone to leave.
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In the midst of its fight for bailout $$, GM is very publicly putting on the hair shirt. In an ad in a widely
read trade journal, GM admits it has "disappointed" consumers:
At times we violated your trust by letting our quality fall below industry standards and our designs became lackluster.
We have proliferated our brands and dealer network to the point where we lost adequate focus on the core U.S. market.
We also biased our product mix toward pick-up trucks and SUVs.
Wow. Is this an invitation for a shareholder suit? At the same time, GM stated that CEO Rick Wagoner has the support of GM's board. Hmmm.
In other news, the UAW is negotiating for a seat on GM's board (see here, too) in exchange for further labor concessions, reminiscent of the '79 Chrysler bailout when the then-UAW president was appointed to Chrysler's board. Such a governance structure of course would move GM a bit closer to the German public company model, which reserves half the supervisory board seats for employee representatives. We live in interesting times.
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