“Bloomberg – Goldman Is Fighting a New Abacus Battle With an Angry Hedge Fund”
I wrote a blog in March about Barclays paying $2B to settle it’s final outstanding DoJ suit related to the 2008 financial crisis. The opening line went a little something like this:
“The gift that keeps on giving: the 2008 financial crisis.”
Well six months later that statement still rings true, of course, as we see one of the juicier stories of the crisis resurrecting itself: Goldman’s family of Abacus CDOs. While this isn’t the same exact Abacus deal that placed Goldman and Paulson & Co. into the crosshairs of regulators, I can’t pass up an opportunity to discuss some crisis-era structured credit.
Goldman sold investors a synthetic CDO called “Abacus 2006-10” in the early spring of ’06. A synthetic CDO is a bit arcane of a concept but not that difficult to understand if it’s explained properly. Basically, Goldman had exposure to a bunch of mortgage bonds, known as reference obligations, and they were looking to hedge the risk of the bonds from default. They found a group of savvy investors to fund a special purpose vehicle (“SPV”) that would write Goldman a credit default swap on their reference obligations and Goldman would pay the investors quarterly premiums for that protection (just like insurance). But, if any of the reference obligations defaulted, then the investors would have to pay Goldman on that loss. At the end of the trade, the investors get back anything that’s left in the SPV (hopefully 100% of their principal) plus the premiums they had been receiving all along.
When the investors buy into the CDO, they don’t keep a bunch of cash in the SPV, though. That cash is managed by Goldman to build out a portfolio of high quality bonds, known as the collateral pool. Then, if any reference obligations default, the collateral is sold down to pay out Goldman. However, if nothing defaults then Goldman gets to keep any of the carry generated by the collateral pool – the CDO investors see none of it (which may sound unfair at first). But! While Goldman gets to keep any carry generated, they also need to reimburse any losses the pool suffers from poorly performing collateral so, ipso facto the CDO investors shouldn’t care about the collateral pool performance, just the reference obligations (which is exactly what they signed up for). The performance of the collateral pool has no bearing on the CDO investors’ return profile – only reference obligation performance does. It sounds quirky but this is just how the synthetic CDO market is structured and it’s players can at least agree on that much.
Here’s where it gets hairy. This distressed credit fund, Astra Asset Management, is claiming that Goldman breached the CDO’s collateral pool requirements in 2013 by purchasing riskier bonds that didn’t meet quality requirements laid out in the indenture. They’re now suing to terminate the CDO contract as of 2013 and insisting that Goldman return $124M in default payments that they received from the CDO over that period. On top of that, wouldn’t you know it, the CDO is overcollateralized by ~$70M and Astra wants that too. Although, it seems pretty clear cut the excess collateral belongs to Goldman – not sure what the legal basis would be for that.
Goldman’s counter to all of this is that the indenture is pretty clear that they’re responsible for any collateral shortfalls like I mentioned above, so even if they technically did breach the agreement they never put any CDO investors at risk as they’d make the pool whole. That makes sense, but it also makes sense that if there’s a technical breach of contract the infringed upon party has some sort of recourse. In the end, I doubt this moves works for Astra but kudos to them for trying. Either way, I’m just happy to be talking about Abacus deals again.