Financial Innovation
Is this $1 billion?

Many centuries have passed since, yet the origins of the abacus remain unclear. Some historians say that the Chinese invented the device, while others claim it was the Babylonians; estimates of when this mechanical counting contraption was first used range from 2,500 to more than 7,000 years ago.

In the wake of a different variety of historical speculation, a modern-day abacus (model # AC1-2007) has emerged to reignite controversy. Financial engineers replaced a few handfuls of uniform wooden beads with dozens of unique, toxic BBB-rated “mezzanine” subprime mortgage bonds. The suddenness and spectacular size of the gains and losses realized by the parties to Abacus AC1-2007 caught the attention of reform-minded regulators and politicians. On April 16, the SEC filed a civil fraud suit against Goldman Sachs in U.S. District Court in New York, and the Senate Permanent subcommittee on Investigations promptly followed with a day of intense hearings eleven days later. (The fuss had nothing to do with missing beads, but a $1 billion swap transaction referencing a synthetic subprime mortgage CDO comprised of the aforementioned bonds). Although only hindsight proves just how inevitable doom was to be for those on the wrong side of the Abacus trade, the billion-dollar gains and losses on this bespoke, binary bet painted a bulls-eye for dusty microscopes calibrated to discover forensic evidence of fraud.

The heart of the SEC fraud allegation is a claim that Goldman misled, by allegedly failing to disclose to two ostensibly sophisticated, institutional transaction parties, that Paulson & Co. - at the time, an unheralded hedge fund sponsor with a decidedly bearish housing view (see “Inside John Paulson’s Shorts”) but no established track record in subprime mortgage or real estate investments - had a hand in selecting the reference securities comprising Abacus.

The profits and losses realized on Abacus and similar deals might have been difficult to track on an abacus. This might be why, during the April 27th Senate Permanent Subcommittee on Investigations hearings, the specific disclosure controversy forming the basis of the SEC charges at times devolved into demagoguery and expanded into more sweeping and moralistic indictments of “shorting the housing market” (as though allowing the subprime credit and housing bubbles to continue their expansion unabated would have been desirable and wise). From some of the rhetoric, casual observers might have inferred that every well-timed speculative bet against the housing market, and every well-timed home price hedge strategy, used some variety of mysterious inside information about impending housing market doom and were part of a broader conspiratorial strategy to bankrupt unsuspecting customers and homeowners.