Lexpert

What happens when an unstoppable force meets an immovable object? Philosophers pondering this eternal paradox should just hop on the next fight to the U.S. and take a seat in the Federal District Court for the Southern District of New York. They may just get to see the most entertaining fight since Muhammad Ali took on Joe Frazier – and just like that time, it looks like in the end, there’ll be one man standing.

According to a complaint filed in the Southern District on 16 April, 2010 by the Securities Exchange Commission (SEC) (the US equivalent of SEBI), it all began in February 2007, with the creation of Abacus 2007-AC1 - a type of sophisticated financial instrument known as a “synthetic collateralized debt obligation (CDO).”

So what is a synthetic CDO? Let’s suppose Amit, a moneylender, is owed Rs.1000 each by ten different people. Amit has two close friends – Ram and Shyam. Ram feels that Amit has amassed a series of bad debts – Amit’s debtors will not pay up, he feels. Shyam doesn’t share Ram’s pessimism – he thinks that Amit’s debtors are trustworthy and that they will keep their word. Shyam tells Ram “You pay me ten rupees every month. But if any of Amit’s debtors don’t pay on time, I will pay you what they owe Amit.” Ram and Shyam have just entered into a derivative transaction known as a “Credit Default Swap” – i.e., in exchange for a series of payments, on the occurrence of a default by any of Amit’s debtors, Ram will get paid.

Since Amit is owed ten debts, Ram and Shyam enter into ten credit default swaps. This portfolio of ten swaps, taken together, is known as a collateralized debt obligation and it is “synthetic” – i.e., the transaction is effected through credit default swaps rather than through the sale or purchase of the actual debts owed to Amit. That, in a nutshell, is a synthetic CDO.

The SEC’s complaint alleges that Goldman created Abacus 2007-AC1 at the request of John Paulson, a hedge fund trader who ran his own fund, Paulson & Co. According to the SEC, Goldman let Mr. Paulson select mortgage bonds that he wanted to bet against — the ones he believed were most likely to lose value — and packaged those bonds into the CDO known as Abacus 2007-AC1. Paulson and Goldman then proceeded to enter into credit default swaps based on the fact that the mortgages underlying the bonds would collapse. In other words, the SEC accuses Goldman Sachs of creating and marketing a financial instrument that Goldman knew was going to fail. The complaint states that Goldman did not inform either the investors in the mortgage bonds nor the CDO’s investment manager of Paulson’s role in selecting the mortgage bonds, nor of Goldman’s own position betting that the mortgage bonds would fail.

According to the complaint, the main architect behind Abacus 2007-AC1 was Fabrice Tourre, a Goldman employee in New York who subsequently moved to the firm’s London office. The deal closed on April 26, 2007. Paulson paid Goldman approximately $15 million (Rs.67 crores) for creating and marketing Abacus 2007-AC1. By October 24, 2007, 83% of the mortgage bonds in Abacus 2007-AC1 had been downgraded and by January 28, 2009, that number had increased to an astonishing 99%. The complaint alleges that this complex financial maneuver lost investors $1 billion (Rs.4400 crores) while Mr. Paulson pocketed a similar sum in profits.

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