Throughout the day of congressional hearings with Goldman Sachs officials this week and in countless news stories, editorials and blogs we keep hearing the word “complexity” when referring to the Abacus 2007-AC1 collateralized debt obligation (CDO) at the heart of the Securities and Exchange Commission’s (SEC) case against Goldman.
Albert Einstein is credited with the phrase, “Make things as simple as possible but not any simpler.” Basically it means make things clear but do not leave out material details. Some things, rocket science for one, are complex by their nature. But what is the purpose of the complexity of something like the Abacus CDO?
It was made up of securities, which were bundles of subprime loans. Because there were already securities based on these loans there was no need to create a product so that people could speculate on or hedge exposure to the housing market. What then was the purpose of creating a derivative on a derivative? Seeing that the hedge fund Paulson & Co. had selected the securities to go into this vehicle and was looking to short the market, the only purpose appears to be that these securities based on subprime mortgages and dodgy debt had already been exposed as being extremely risky and perhaps overpriced and needed a makeover. So they were bundled together with other tranches of securities — perhaps throwing in something with more value to mask the smell — placed in an opaque box, given a fancy name, some how some way given a AAA rating and then marketed.
That is the real problem. These products were not complex by their nature, complexity was created to help mask their nature. U.S. Treasury bond returns are expected to be modest but people invest in them because they believe they are secure. People invest in penny stocks hoping to catch lightning in a bottle but understand they will pick many losers while looking for the one gem. Investors are told they should balance conservative investments that are expected to provide consistent though modest returns with a few investments that offer better returns but have more risk of loss. They are also given guidance as to what constitutes conservative and more risky investments. The ratings agency provided guidance — false guidance — to the investors of Abacus. Some can say that is hindsight but that would be wrong. If the housing market continued to soar Abacus would have been extremely profitable but it would not have been less risky.
Should investors in Abacus have looked into these things more closely? Perhaps. I am not an expert on regulation of securities but I have a feeling that things with AAA ratings do not have the scary warning of say your basic Commodity Trading Advisor disclosure document. But an investor investing in a CTA can find out that he or she is going to have long or short exposure to a basket of futures products—which are listed in that document—and the general methodology (long-term trend, short-term trend, market breakout) used to signal a trade. If it is a managed account he is going to know every position he has every day. I don’t think the investors in Abacus opened up a statement and found that he had bought exposure to the performance of a home loan given to someone in Florida with no money down and no requirement that person provide proof of income. By the way that person may have declared bankruptcy a few year back and the lending institution making the loan “specializes in non-prime residential first- and second-lien mortgage loans.”
Investors should have access to this information even if they don’t ask for it specifically. Even if they are institutional and should know to ask. Food products are required to put a list of ingredients on their package, why would investment products be any different.