How Goldman exploited the information gap

200_west.rt.top.jpgBy Richard Field, contributor


(Fortune) -- There is a serious problem with the way data on structured finance securities is provided to investors. These securities should have the clarity of a clear plastic bag. Instead, they're about as see-through as a brown paper bag. In fact, Goldman Sachs' (GS, Fortune 500) exact alleged fraud was to misstate and omit key facts about a structured finance security (called ABACUS 2007-AC1) whose return was driven by the performance of several subprime mortgage backed securities.

The way Goldman and John Paulson profited handsomely on their Abacus trades was to exploit the fact that they could see into the bag, but others, including Goldman's customers, could not.

If investors had transparency, they wouldn't be stuck trying to determine the contents of a brown paper bag, and wouldn't be at a major disadvantage to firms saying the investments were sound, while filling them with subprime junk and only allowing themselves and savvy hedge funders like Paulson to know the truth.

Goldman, like many financial firms, enjoys an information advantage because it gets loan-level performance data on a daily basis. However, standard practice for other market participants -- investors and customers -- is to have to wait for the accumulation of daily data to arrive in a once-per-month or less frequent report. Not only does the data come in a brown paper bag, it's weeks old, too. Using old data to figure out what's in the bag today is a guessing game at best.

Goldman is currently claiming its customers are sophisticated investors and should have understood the risks they were taking. But should even sophisticated investors be allowed to buy, sight unseen, the contents of a brown paper bag, as if they were contestants on a game show? Further, the two main indicators of risk available to investors -- credit ratings and the role of the collateral manager -- were both misleading in this investment, and in many others.

Providing loan-level performance data on a daily basis to all parties would give investors the clear plastic bag view of what they are buying, making the question of purchasing the hidden contents of a brown paper bag, as in the Abacus CDO created for Goldman, and bet against by John Paulson, irrelevant. In short, better information would make crimes like the one Goldman is accused of impossible to commit.

Seeing vs. pretending to see inside the bag

To overcome their inability to see into the bag, structured finance investors relied on third parties, namely credit ratings agencies, who told them they could determine and value the bag's contents.

The Goldman lawsuit shows that the ratings agency system actually drives investors away from doing their own homework in the first place. The rating agencies have long held their access to confidential data sets them apart from other analysts.

Investors incorrectly thought this meant ratings agencies had more timely data than they did. They thought the agencies were looking inside the brown paper bag. They were not. The agencies did not tell the market that they could not see inside the brown paper bag either, as they were not privy to loan-level performance data on a daily basis.

If the data gap didn't exist, investors would have been able to see for themselves, rather than rely on ratings agencies, that the underlying securities weren't properly valued and that a bet they would retain their current price was a sure loser. They would have steered well clear of buying the Goldman product.

Not only did Goldman know what securities were going into the ill-fated Abacus CDO, it had its own window into the subprime mortgage world, with direct involvement in originating, billing and collecting other subprime mortgages: Goldman helped start and later solely owned a subprime mortgage originator and servicer named Senderra.

According to the Wall Street Journal, "Mortgage experts say [Senderra] likely gave Goldman a clearer view of the market as other parts of the company made bets on home loans." The paper also reported that the head of Goldman Sachs' subprime trading operation -- the group that made $4 billion betting against the housing market -- had visited Senderra multiple times to talk with employees there.

Investors, meanwhile, didn't have direct involvement subprime mortgages. Nor did they have access to a single third party vendor who collected and distributed loan-level data on a daily basis and delivered information to support the analysis and valuation of each asset-backed security. Instead, all investors had besides the credit ratings of the underlying securities was the presumption that their interests were aligned with the collateral manager who created the Abacus CDO.

Another false senses of security

The collateral manager, ACA Capital Management, selected the portfolio of subprime mortgage backed securities (MBS) that Abacus would contain. The manager presented itself as having a large sophisticated staff with backgrounds ranging from underwriting mortgage loans to analyzing subprime mortgage-backed securities.

It claimed to have a well refined methodology for doing extensive due diligence on each security including its underlying mortgage loans by accessing a half a dozen sources of information. It also was putting millions of dollars of its own investment at risk in every deal it made. The result was that ACA had a proven track record of selecting subprime mortgage-backed securities.

Up to the time of the ill-fated securities issuance, none of ACA's deals had lost money. In addition, its interests were theoretically aligned with the investors, since it could lose several hundred million dollars if there were significant losses in Abacus.

Given the expertise of the manager and the size of their financial exposure, an investor could reason he was unlikely to do a better job of analyzing the risk of the 90 selected securities that went into Abacus.

According to the SEC lawsuit, ACA was misled by Goldman about the role of John Paulson, a hedge fund manager who was looking to short subprime mortgage-backed securities. ACA selected a significant percentage of the subprime mortgage-backed securities that had been suggested by John Paulson.

Fixing the data gap in the ABS market may not have prevented the pressure ACA felt from Goldman Sachs to take Paulson's advice, but it would have prevented any careful investor from being hoodwinked into buying into Abacus just because of ACA's track record and Goldman's prestige.

The data gap fix

Providing investors with daily loan-level information would help restart the still-frozen ABS market, as investors could then analyze risk and value and fact-check the accuracy of the assumptions underlying the pricing of the security, independent of the banks, collateral managers and ratings agencies.

The market is frozen in part of out fear that what happened in the Goldman case has happened many other times, and investors still do not know exactly what is in the bags they are holding.

When investors have daily loan-level data, they can make buy, hold, and sell decisions independent of the 'take it or leave it' offers that Goldman Sachs and other firms typically make to them in offering securities for investment.

Investors' ability to make investing decisions independently of the paltry information the banks deign to give them will unfreeze the structured finance and credit markets without requiring either the billions of dollars in bailout money that helped save the big banks, or the aggressive zero interest rate policy the Fed is currently pursuing, which is propping up the economy while ABS markets remain largely frozen.

Richard Field is the Managing Director of TYI, LLC, a boutique portfolio strategy firm. Field designed, developed and patented a system to provide transparency about the performance of the collateral underlying structured finance deals to all market participants. Previously, he worked as an Assistant Vice President for First Bank System and as a Research Assistant at the Federal Reserve Board. To top of page