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Who paid John Paulson?

The SEC case against Goldman Sachs is bewildering in its complexity to outsiders. It is very hard to know what actually happened without being familiar with the technical world of synthetic CDOs. Ambitious readers can go here and here to get a flavor of the complexity.

But some clarity is possible. John Paulson expected housing prices to go down. The ABACUS vehicle at the heart of the transaction allowed him to profit when they did go down. Who was on the other side of the transaction? Who lost the $900 million that Paulson collected?

Goldman had trouble selling the long side of the deal. Paulson was able to bet about a billion dollars that the housing market would go down by buying insurance against parts of ABACUS, insurance Paulson would collect if the housing market and therefore the underlying mortgages and therefore the underlying bonds of ABACUS plummeted, which they ultimately did.

Goldman told buyers of the package that ACA Management had chosen those underlying bonds. ACA Capital, another part of ACA, offered the insurance against losses. But ACA was only A-rated. (And ultimately grossly undercapitalized to keep all their promises.) So Goldman (I think, or maybe it was ACA) paid ABN Amro, a Dutch bank, to stand behind ACA’s insurance. For that promise, ABN Amro received $7 million. Alas, when the housing market went south, they ended up having to pay $841 million to Goldman and then John Paulson.

For reasons not clear to anyone that I can find, Goldman was left insuring a small piece of the losses, which is where the $90 million loss to Goldman comes in.

I may not have all of the above exactly right. What is more interesting to me given my claim that creditor rescue by government is the true cause of the crisis, is the rest of the story. From a CBS Marketwatch report:

Within months, the notes were “nearly worthless,” and IKB [which had purchased $150 million worth of ABACUS] had lost almost all of its investment. Most of this $150 million was ultimately paid to Paulson & Co. in a series of transactions between Goldman and the hedge-fund firm, the SEC explained in its suit.

ABN Amro assumed the credit risk tied to the highest-quality parts of the Abacus CDO, through derivative contracts known as credit default swaps, or CDS, the SEC said.

In late 2007, ABN Amro was acquired by a group of banks led by Royal Bank of Scotland.

The CDS contracts were unwound in August 2007, through a payment of $841 million from Royal Bank of Scotland to Goldman. Most of this money was subsequently paid by Goldman to Paulson & Co., the SEC said.

Royal Bank of Scotland was one of the hardest-hit banks in during 2008’s credit crisis, so much so that the U.K. government was forced to eventually become majority owner of the bank late that year. To date, RBS has received 45.5 billion pounds from British taxpayers.

IKB was similarly affected. It avoided collapse after the German government-owned KfW Bankengruppe stepped in with capital that ultimately gave it 91% of the bank. The rescue of IKB cost KfW roughly 8.5 billion euros, according to reports.

So the ultimate guarantor of Paulson’s play were the taxpayers of Germany and the UK. Is this any way to allocate capital or run a political system?

The other interesting twist is that as I mention in my narrative of the crisis, Gambling with Other People’s Money (link coming very soon), the Chief Risk Officer of the Royal Bank of Scotland, was and is, Riccardo Rebonato. Rebonato wrote a superb primer on risk management, The Plight of the Fortune Tellers, just before the crisis hit. In that book he explains how risk management is not a science and how Value at Risk (VaR) doesn’t really capture what is going on. I think he knew his bank was playing with fire. And yet the bank kept lighting matches. It suggests that the suits refused to listen to the geek, either because they felt they knew better or because they counted on government rescue while collecting their bonuses along the way.

BTW, I interviewed Rebonato for EconTalk. He attributed the failures of his bank and others to myopia and errors in judgment and attributing nothing to moral hazard and incentive asymmetries between management and creditors. But as an employee of RBS, and speaking on the record, it’s not surprising that that was his story. I wonder if that’s what he really thinks.


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