Of Abacus, Wild Things, and Inherently Dangerous Activities

Some traders and other folks in the securities business look askance at the SEC's case against Goldman Sachs in connection with the Abacus transaction because it seems like sour grapes from a party who wants to re-trade a deal that didn't work out very well. As Anal_yst wrote today at Stone Street Advisors:

The buyers were arrogant, over-confident in their experience and ability to analyze complex structured finance transactions ... IKB “KNEW” structured finance RMBS investing, they just didn’t know or expect the outcome we know so well with the benefit of hindsight. That’s it. Everything else is irrelevant. IKB knew the material that was going to be on the test (the composition of the reference portfolio and all other relevant deal information), they had the ability (experienced deal team) to prepare for the test (analyze the deal), they just came to what turned out to be the wrong conclusion, and didn’t do as well as they expected.

Fair enough. If you look at Abacus strictly as a matter of contract between two consenting parties, then I can understand how it might offend a trader's sense of craft for the government/courts/press/publc to come in after the fact and (i) reward IKB/ACA/ABN for sloppy due diligence and/or losing strategy and (ii) punish Goldman/Fab (Paulson some day?) for a winning strategy. I would feel the same way if someone were to come in after the fact of a real estate deal and try to achieve through the courts what they failed to achieve through contract negotitaions. What am I saying?!? I have felt the same way, because I have had it happen to me, more than once. It can be pretty maddening.

So, if the sole result of Abacus were that IKB/ACA/ABN’s representatives ended up making a bad deal and spending their retirement years eating dogfood, I could live with that. I have two issues:

1.  The SEC alleges (Complaint 44 - 51) that Fab/GS perpetrated fraud upon IKB/ACA/ABN by actively tricking them into thinking that Paulson was an equity investor in the deal (i.e., on the same side as IKB/ACA/ABN). If Fab/GS did perpetrate the fraud, then Fab/GS are toast, regardless of the failings of IKB/ACA/ABN as buyers, based on ancient Anglo-American legal principles of fraud and mispresentation that (a) can have the effect of setting aside a written contract, and (b) go back before Lord Blackstone wrote in 1753.

2. My main problem is that everybody knows it’s not IKB/ACA/ABN’s representatives or GS’s representatives who are going to end up eating dogfood (I'm sure they're all doing quite well, thank you, and probably still plying their craft): it’s people who lost 50% of their retirement accounts in 2008 who are eating dog food. As Heidi N. Moore writes in her excellent article from last Sunday's Washington Post, "The Myth of the Sophisticated Investor:"

It's not just the big clients, however, that get hurt. What Wall Street would like to ignore when it is taking bets in its casino is that a big pile of chips on the table come from regular consumers -- from their bank deposits, retirement accounts, credit-card balances, car loans and mortgages. That's why the distinction between ... Pension funds, for instance, are considered "sophisticated investors" on Wall Street. But those are just pools of retirement money owed to workers ... Pension funds play the Wall Street game to score a healthy return -- but when they lose, the money lost belongs to regular people ... Consider synthetic collateralized debt obligations -- which describes bets made on a bundle of securities tied to home loans -- like Abacus ... They took the basic subprime losses and magnified them to a point at which no one -- not banks, not investors, not entire governments -- could bear the cost of the massacre that followed. It cost only $35 million a year to buy protection against the failure of billions of dollars of assets. When these assets failed, the insurance holders didn't get $35 million a year; they received many multiples of that. Banks nearly collapsed trying to scrounge together the money to pay back these insurance policies. The two banks that bought the Abacus deal both received multiple bailouts from the taxpayers of Germany and Britain. Yet Goldman and Paulson insist their deals concerned only sophisticated investors. Tell that to the foreign governments.

Another way of looking at a massive synthetic CDO transaction such as Abacus is as a peril to the public, such as a wild beast that the owner fails to control, or a man-made pond that an owner creates, causing his neighbor's property to flood. Under ancient principles of Anglo-American law, this class of "inherently dangerous activities" pose such perils that society has an interest in imposing strict liability (not just negligence) upon the person causing the activity. In the words of the famous Rylands v. Fletcher case from 1868 in the House of Lords:

The person whose grass or corn is eaten down by the escaping cattle of his neighbour, or whose mine is flooded by the water from his neighbour's reservoir, or whose cellar is invaded by the filth of his neighbour's privy, or whose habitation is made unhealthy by the fumes and noisome vapours of his neighbour's alkali works, is damnified without any fault of his own; and it seems but reasonable and just that the neighbour who has brought something on his own property (which was not naturally there), harmless to others so long as it is confined to his own property, but which he knows will be mischievous if it gets on his neighbour's, should be obliged to make good the damage which ensues if he does not succeed in confining it to his own property. But for his act in bringing it there no mischief could have accrued, and it seems but just that he should at his peril keep it there, so that no mischief may accrue, or answer for the natural and anticipated consequence. And upon authority this we think is established to be the law, whether the things so brought be beasts, or water, or filth, or stenches.

Given the stakes involved, massive derivative plays are not really a simple matter of a contract between two parties: the deals are so huge, the consequences are so unknown (because the deals are so opaque), and the interconnectedness of humanity in this decade are all so gr.eat that the contractual consequences to the immediate parties to the transaction (or to be more precise, the consequences to the agents for the parties to the transaction) can be dwarfed by the consequences to society at large: “One who keeps a wild thing ‘must keep it at his peril.’”