Did Paulson Have A $2 Billion Bear Stearns CDS Short In Late 2006? Novel Observations On Abacusgate

Reading a 901 page Goldman document production (cover to cover) at 36,000 feet has proven to be both relaxing and quite productive. Among the plethora of emails, documents and memoranda, we may have stumbled upon something that could prove to be an even "bigger short" for John Paulson than RMBS: a $2 billion postion in Bear CDS initiated prior to January 2007, as well as all other financial firms. Additionally, we discover that arguably the world's richest hedge fund manager (for a reason) was prophetically putting on bank counterparty hedges as early late 2006, up to and including Goldman Sachs itself. Most relevantly, in what could be damaging disclosure by Fabrice Tourre, the Frenchman notes that as a result of Paulson's mistrust of Goldman's counterparty risk, the Abacus AC1 deal was structured in a novel way in which "they would be acting as protection buyer, facing the ABACUS SPV (as opposed to a structure where Goldman is protection buyer as is usually the case)." This little legalistic variation could make a world of difference in an Attorney General's hands. It may be time to very carefully read the indenture of AC1 and compare it with those of 2006 and earlier "Abaci."

An email thread from January 6, 2007, which features all the usual suspects (Tourre, Sparks, Swenson, Lehman, Rosenblum and Ostrem), located on page 755 of 901, has proven to be a cornucopia of information into the Goldman, and Paulson, thought process.

Starting at the bottom:

From: Tourre, Fabrice
To: Sparks, Daniel; Swenson, Michael; Lehman, David A; Rosenblum, David J; Ostrem,Peter L
Cc: ficc-mtqcorr-desk
Sent: Sat Jan 06 19 : 06 :41 2007
Subject: Post on Paulson

David Gerst, Cactus Razzi and I had a meeting with John Paulson and his team last Friday. The meeting was attended by [redacted] and [redacted] at [redacted]. The purpose of the meeting was for the Paulson team to meet [redacted] and understand whether [redacted] could be a good candidate for acting as portfolio selection agent for an ABACUS COO trade where all the risk would be provided by Paulson.

At the end of the meeting, the Paulson team told us that they were happy to have met [redacted] and assuming that (1) [redacted] could get comfortable with a sufficient number of obligations that Paulson is looking to buy protection on in ABACUS format , (2) [redacted] could get comfortable being in the market as early as end of January with a transaction under which [redacted] is disclosed as Portfolio Selection Agent (without any credit risk removal rights), and (3) Paulson, Goldman and [redacted] agrees on [redacted]'s required compensation for a transaction like this, then Paulson will want to proceed with [redacted] as soon as possible and be in the market as soon as possible .

We now know that the redacted firm is GSC, and that before ACA, Paulson would have been perfectly happy to go with GSC as portfolio agent: in fact he didn't care who the agent was as long as one existed, (and was not Goldman). The man just wanted to put on his big short (not to be confused with his bigger short, discussed shortly), and have somebody willing on the other side. In an email from January 29 (p. 480 of discovery), Fabrice writes:

As you know, a couple of weeks ago we had approached GSC to ask them to act as portfolio selection agent for that Paulson-sponsored trade, and GSC had declined given their negative views on most of the credits that Paulson had selected.

Sure enough, Tourre scrambled and promptly discovered Laura from ACA, who proved that 22 years of industry expertise is never a hindrance to blowing up your firm in record time, and ended up being a willing receptacle for Goldman's and Paulson's toxic detritus. We will leave the specifics of whether or not she was flimflammed by Tourre: after all that is at the heart of the civil, and now criminal case against Goldman. Although if Tourre's court testimony is as full of contradictions as his Senatorial one, we hope the Goldman whiz kid is a better buyer of Bail Bond insurance.

Going back to Tourre's long ago email. He concludes it with this rather stunning paragraph, which shoul be an eye opener to all who are following the Goldman case:

One issue remains w.r.t. this Paulson-sponsored transaction: it is related to the fact that Paulson is concerned about Goldman's counterparty risk in this illiquid CDO transaction, even with the existing CSA [ISDA Credit Support Annex] that is binding Goldman and Paulson. For this reason they are asking us to structure a trade under which they would be acting as protection buyer, facing the ABACUS SPV (as opposed to a structure where Goldman is the protection buyer as is usually the case). As an FYI, for single name CDS trades that Paulson is executing with dealers such as Goldman, [redacted] and [redacted] they are buying large amounts of corporate CDS protection (on the broker dealer reference entities) to hedge their counterparty credit risk!!!

Where to begin. Already in 2006 JP was distrustful not only of the crappy banks, but of all banks, top trading partner Goldman included. It is amusing that when faced with a question of how he approaches Goldman from a trading standpoint, Jim Chanos said he "never shorts his business partners." Ironically, a much more ruthless (and cynics could add richer) Paulson had no such qualms, and was openly insuring against a Goldman default. Yet as we pointed out above, the main observation here is that Goldman essentially changed the legal framework of Abacus when juxtaposed with previous Abacus-type transactions, and by implication all Goldman structured CDO deals: "they are asking us to structure a trade under which they would be acting as protection buyer, facing the ABACUS SPV (as opposed to a structure where Goldman is the protection buyer as is usually the case)."

Now this is interesting, because either Paulson changed his mind on this critical matter, or the transaction was misrepresented. As can be seen from the schematic for both AC1 (the 2007 Abacus), and the Abacus 11 from mid-2006 (we pulled the chart from the Credit Committee Memo on page 565 of the presentation), the protection buyer in both cases is in fact GSCM. This makes sense for the 2006 deal. It refutes completely how Paulson was envisioning structure of the AC1 deal.

Here is the 2006 Abacus schematic:

And here is the identical boilerplate for the 2007 Abacus deal:

We doubt that Paulson agreed to let the fine print stay on such a critical issue for him. If indeed he was buying up protection as a hedge for all corporate deals, he would certainly with to disintermediate Goldman from the process. Either way, this could be a rather substantial variation in the Reg-S/144A language of the prospectus, which would ostensibly go straight to a 10(b)-5 violation issue. Ultimately, if there was in fact predetermined legalistic commingling and/or misrepresentation of the initial protection buyer, that could make the legal defense case much more problematic.

One tangential question we have in this regard is how has Goldman's Abacus outside counsel McKee Nelson not gotten an iota of press coverage so far. As the Mortgage Capital Committee memo from March 12, 2007 discloses (p. 505), "The transaction disclosure notes the various capacities in which Goldman entities act as counterparty to the transactions and the risk factors section notes the potential for conflicts of interest. As with prior ABACUS transactions, we receive advice of outside counsel (McKee Nelson) regarding disclosure in ABACUS securities offerings and all such disclosure will be reviewed and approved by Tim Saunders in Legal."

Another tangent: in his email from February 8, 2007, David Rosenblum proves he is unbelievably prophetic. A day earlier, with regards to the Abacus process, Fab Tourre wonders (p. 482):

Gerstie and I are finishing up engagement letters with ACA and Paulson for the large RMBS CDO ABACUS trade that will help Paulson short senior tranches off a reference portfolio of Baa2 subprime RMBS risk selected by ACA. We intend to go out in the market and distribute ABACUS notes off this trade starting on February 23. At the time we distribute, we will cross the tranches into Paulson -- therefore no commitment for us to take down any risk. Happy to sit down tomorrow to walk you through the economics. Do you need us to go to Mortgage Capital Committee for this trade? Let us know, thanks.

To which Rosenblum responds:

Still reputational risk, so I suggest yes to MCC.

Good call David.

Anyway, all these are issues for the disclosure lawyers, and scandal media to debate. Even though we are merely the former, and in our free time we allegedly ghost write for MTV miniseries, we will leave this topic to bigger experts in the field.

What we will focus on however, is Michael Swenson's response to Fab in early January 2007:

I can not believe it!!! Absolutely amazing.

Believe it Swennie. Less than two years later the government will have to come and bail you out, once again vindicating Paulson for being the most prophetic person on Wall Street in the 2005-2008 period.

And it continues. Fab next describes the GSC meeting in detail. And here is where you should pay very close attention.

The meeting itself was surreal. Am hearing that Paulson bought $2bn of [redacted] CDS protection, sucking all the liquidity on that name in the corporate CDS market. Also, on the side [redacted] mentioned to me that he had heard from many different sources that one reason why the ABX market was trading down so much in December was related to [redacted] building a sizable short and buying large amounts of ABX protection from the market.

The first bolded [redacted] is the 64k question as this would set off a chain of events of everyone copycatting Paulson into shorting whatever he was shorting. His Oracular star was ont he rise. And the anwer is provded by Michael Swenson's response following 4 minutes after the Fab email.

I wonder who gave bear the liquidity

In other words, who sold the protection... on Bear Stearns. Was Paulson massively short Bear as early as 2006? If so, the amount of money he made shorting RMBS may pale in comparison with how much he likely made on the short synthetic side in financials.

As the chart below demonstrates, Bear CDS in late 2006 was trading around 18 bps. Days before it was handed off to JPM for pennies it hit a record 751 bps.

As $2 billion notional has a DV01 of about $800,000, assuming that paulson sold at or near the top he made nearly $600 million by shorting Bear via purchasing its CDS. Surely, as Fab disclosed earlier, he did not stop there, and was long protection each and every bank he was trading with. That financial short trade alone likely netted about $3-4 billion in total.

What is funny, is that an ever ready to piggyback on any good idea Goldman Sachs, decided to do precisely what Paulson was doing. As disclosed on p. 765, by March 27 Goldman was accumulating a massive short in Bear share, to the tune of an $18.6 profit in Jump To Default, i.e., should the firm fail.

By July 27, this number had nearly doubled to $33. Yet observe which firm had the highest JTD value at this date: none other than rating agency Moody's, in which Goldman had accumulated a whopping short position.

So much for nobody having heard of Paulson as CNBC claims: Goldman's entire prop trading strategy in late 2006 and early 2007 was determined exclusively by JP's actions - after all, unlike all other obsequious Goldman clients, Paulson would not bat an eyelid before shorting Goldman. And however Goldman is positioned on prop, so the entire market soon follows. We wonder at what point Goldman decided to start accumulating AIG CDS, and whether that trade was also predicated by following the "Paulson" example. To be sure, there are 1,999,099 discovery pages still held by the Senate and the SEC. We urge them to release these pages immediately so that every action of Goldman Sachs can be deconstructed by the objective public.

And in parting, we wanted to leave you with this eail from Peter Kraus to Lloyd Blankein, in which Krais implicitly acknowledges that the firm is a monopolist, and that clients really have no choice than to stay with his firm (p.655):

From: Kraus, Peter
Sent: Wednesday, September 26,2007 10:15 PM
To: Blankfein, Lloyd
Subject: Re: Fortune: How Goldman Sachs defies gravity

I met with 10+ individual prospects and clients (and 5 institutional clients) since earnings were announced. The institutions don't and I wouldn't expect them to, make any comments like ur good at making money for urself but not us. The individuals do sometimes, but while it requires the utmost humility from us in response I feel very strongly it binds clients even closer to the firm, because the alternative of take ur money to a firm who is an under performer and not the best, just isn't reasonable. Client's ultimately believe association with the best is good for them in the long run.

Thank you Peter, we completely agree: it is very "unreasonable" for anybody to think about leaving the monopolist. After all (and by implication) - just where the hell could will they go?