Before hiring ACA, the people at Goldman went back and forth as to which firm they might select as their dupe, or, as they say in Wall Street code, "is easy to work with." All day on December 18, 2006, from 9:33 am until 5:48 pm, the emails went back and forth as to prospective candidates. David Gerst explained how potential candidates should be ranked:
There are more managers out there than just____. The way I look at it, the easiest managers to work with should be used for our own axes [i.e. investments to be unloaded or shorted]. Managers that are a bit more difficult should be used for trades like Paulson given how axed Paulson seems to be, (i.e. I'm betting they can give on certain terms and overall portfolio increase).In plain English, Gerst says lets save the dumbest managers for own synthetic CDOs, and assign Paulson a not-so-dumb, but dumb enough, manager. As Tourre told David Lehman, Abacus 2007-AC1 was his idea, it was Paulson's idea to hire a manager, and it was Tourre's idea to hire ACA.
ACA was hired by Goldman and Paulson & Co. for one reason and one reason only, to delude potential investors into the false belief that the portfolio was selected by an outside party unhampered by conflicts of interests. So while everyone at Goldman and at Paulson was in on the sham, Schwartz and ACA were kept in the dark.
What Insiders Knew and What Outsiders Didn't
So let's take a step back to get a sense of the big picture at the time. In late 2006 and early 2007, there were two types of investors, the insiders and the outsiders. The insiders like Pellegrini, who were able to penetrate the veils of secrecy around CDOs and credit default swaps and receive investor presentations from Greg Lippmann of Deutsche Bank, were made aware that Standard & Poor's, Moody's and Fitch were assigning patently fraudulent ratings to residential mortgage-backed securities and their progeny. They also knew that the recent data on declining home prices made it almost as certain as death and taxes that any triple-B tranches of those securities would be wiped out.
The chasm between the insiders, like Pellegrini, and the outsiders, like Schwartz, was made evident in the two email messages they sent, almost simultaneously, just after 4:00 pm on January 14, 2007.
This was just around the time that the second Paulson Credit Opportunities Fund was about to be launched, so Pellegrini sized up the situation for another insider, a prospect from 3A Investors. He said the insiders were perpetuating the sham as long as they could:
It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while "real-money" investors have neither the analytical tools nor the institutional framework to take action before the losses that one could anticipate based the "news" available everywhere are actually realized.To put it mildly. The math was pretty simple. If home prices stopped appreciating, triple-B bonds got wiped out. Or as Pellegrini put it:
The probability of writedown of BBB (not just BBB-) RMBS bonds is bond-specific, although some key inputs are common. The most important common input is home price appreciation (HPA) nationally, regionally and at the "metropolitan area" level... (it is very difficult for subprime borrowers to refinance if their property has not appreciated)...
By January 2007, home prices were falling fast in California and Florida.
At almost the exact same time, Schwartz, an outsider, emailed Goldman to express concern about seeming too antagonistic. She had no idea that she was being played for a fool.
Softening Up Laura
Things seemed to work out exactly as expected. On December 20, Tourre explained to colleagues that they were looking for an asset manager which, "will be flexible w.r.t. portfolio selection (i.e. ideally we will send them a list of 200 Baa2-rated 2006-vintage RMBS bonds that fit certain criteria, and the portfolio selection agent will select 100 out of the 200 bonds)..."
And one month later, on January 22, Schwartz sent the kind of email response they were looking for:
From: Laura SchwartzThree days later, on Thursday, Schwartz was pleased to receive an engagement letter from Goldman that assured ACA's position as Selection Agent. Fortunately, she had a chance to review the document before she left town for the weekend, prior to attending a Morgan Stanley conference in Jackson Hole, Wyoming.
Sent: Monday, January 22,20071 :52 PM
To: Tourre, Fabrice; Kreitman, Gail; Gerst, David
Subject: proposed Paulson Portfolio
Attachments: Paulson Portfolio 1-22-07.xls
Attached please find a worksheet with 86 sub-prime mortgage positions that we would recommend taking exposure to synthetically. Of the 123 names that were originally submitted to us for review, we have included only 55. We do not recommend including the other 68 names because either: 1
1) we did not like them at the recommended attachment point;
2) there are lower rated tranches that are already on negative watch; and
3) some names (Le. Long Beach and Fremont) are very susceptible to investor push back.
The 31 new names are heavily weighted to new issue since we believe the underlying collateral to be of better quality. We provided a total of 86 names to give us some room since the term-sheet mentioned 80 names at 1.25% each.
Please let me know if you have any questions.
Soon after she arrived in Jackson Hole on Friday, serendipity. Early Saturday morning, she emailed everyone at Goldman:
I am in Jackson Hole and Paolo is out here with his family skiing for a week and we ran into each other last night. He called me this morning and wants to meet for a drink and discuss the deal this afternoon. Will keep you informed.The next morning, she briefed everyone:
I don't think he wants the A3 names and wasn't too keen on the Baa3 names. Let's do the Baa3 names at Baa2. He also wanted to know if we had to have so many names - I said Goldman needed 100 to help sell the debt. He also wanted to talk about the super senior - I said we would definitely look at it if Goldman planned on placing it. We also talked about the auction call - he wants a 2 year. This may be tough to sell without a makewhole. We left it that we would both work on our respective engagement letters this week - I certainly got the impression the he wanted to go forward on this with us. He is also headed to ASF. Can we meet sometime on Feb 5th to discuss mechanics of this deal?Jackson Hole was the setting for the he-said/she-said dispute. Here's how Steve Liesman reported the he-said version back in 2010:
Paolo Pellegrini met at least three times with Laura Schwartz, the head of ACA's CDO Asset Management. At those meetings they discussed either Paulson's recommendations for criteria to be placed in the CDO, for which ACA was to act as a Selection Agent, or the intention for Paulson to short the portfolio. He told ACA executives at least at one of the meetings, which took place by the way at a bar in Jackson Hole, Wyoming, that the hedge fund intended to short the portfolio.
In an interview with a government attorney Pellegrini was asked about one of those meetings with Schwartz: "Did you tell her that you were interested in taking a short position in Abacus."
C "Yes, that was the purpose of the meeting.
Government attorney: "And how did you explain that to her?"
Pellegrini: "That we wanted to buy protection on tranches of a synthetic RMBS portfolio."
Buy protection on a portfolio, well that's the same thing as a shorting.