Three Things Worth Reading, Mostly Economics, for April 19, 2010
Even Mark Halperin Won't Defend the Republicans Anymore

What Goldman Sachs Was Doing with Abacus: A Possibility

A Wall Street participant who wishes to remain anonymous says:

Perhaps the reason that Goldman Sachs is so outraged at being accused of playing the investors in Abacus by concealing from them material information--that John Paulson played a big role in selecting the portfolio--is that they are totally innocent. Perhaps they were not trying to play the investors in Abacus by handing them a sub-standard produc. Perhaps, instead, they were trying to play John Paulson--a man who showed up with irrational expectations, eager to make bad bets, and who would have lost heavily had not he struck it freakishly lucky.

Consider the view from Goldman Sachs. Paulson shows up, says he thinks the subprime market is going to crash and is going to crash hard and is going to crash soon and wants to start laying big bets to that effect. GS goes out, runs the numbers, tests the market, and decides that yes, they can create a great deal of AAA securities plus an equity tranche out of the long side.

The AAA securities will really be AAA securities: minimal risk. Thus they can be sold off at a healthy price to those who want AAA securities. This will burnish the reputation of the firm--look! we made some more AAA securities for you!--in a market that really likes AAA securities and is short of them. And the buyers will be happy because they will get Treasury+5 or Treasury+10 basis points on their cash without risk.

The equity tranche--well, there is a healthy carry trade associated with it in the short run. The short-term earnings from that carry trade will mount up over time, and will more than offset the losses even if the subprime market crashes. Only if the market crashes and not only crashes but crashes hard and crashes soon and moreover crashes freakishly hard and freakishly soon will the equity tranche be a loser.

The overwhelming probability, GS thought, is that Paulson will be the loser--but because his expectations are irrational he's willing to take the short side. So the important thing is to keep this big fish who promises to give us lots of money on the hook. Let him pick the underlying securities--it really doesn't matter, and it gives him the illusion of an edge. Don't bother telling Paulson's role to IBX and company--it really doesn't matter, and it might spook them off and then we might lose the real pigeon while we hunt for more counterparties to take the long side.

And, the GS people probably still think: It should have worked. Only a truly freakishly freakish mischance produced not only a crash but a freakishly hard and fast crash so that Paulson looks like a genius. But he isn't--he's a gambler who got lucky. And the idea that we weren't doing our duty to our long-side clients while we tried to land this particular fish--well, perhaps the people at GS think, that's simply insulting. We were injured when bad luck not only let this fish get away but get away with some of the money that is rightfully ours. And now we are being insulted by the SEC to boot. This is intolerable...

An interesting possibility that might explain why Goldman Sachs appears to have forgotten the lesson of Shaft: "when The Man wants you down, you go down," and that in this arena the government is The Man...