The SEC alleges that:

• GS failed to disclose that Paulson was involved in the portfolio construction of ABACUS 2007-AC1.
• GS misrepresented to ACA that Paulson was 200m long in the equity of ABACUS 2007-AC1.
• GS entered into CDS with Paulson that allowed Paulson to buy protection on tranches of ABACUS 2007-AC1s' capital structure but did not disclose this to investors

The deal closed 2007 04 26. By 2007 10 24 83% of the RMBS had been downgraded and 17% were on negative watch. By 2008 01 29, 99% of the portfolio had been downgraded.

ABACUS 2007-AC1 was a synthetic CDO. Its assets consisted not of RMBS but of CDS referencing RMBS. In the construction of the collateral portfolio ABACUS 2007-AC1 would have to enter into these CDS with counterparties. Was Paulson a counterparty, the major or only counterparty?

It is going to be hard for the SEC to establish that GS defrauded investors by its failure to disclose Paulson's role and intentions in ABACUS. Why? Paulson wanted to make a bet. A bet is not a sure thing. If Paulson or GS could affect the outcome of the bet then that is another matter. GS was effectively Paulson's agent. GS got paid 15m to do the deal. GS job for which they were paid was to go find someone who would take the other side of the bet. GS is not bound to tell the other parties who their opposite number was. GS is indeed bound to provide full disclosure of the nature of the bet which they appear to have done. In fact, GS had a fiduciary duty to Paulson who was the paying client, a duty which includes confidentiality. One could argue that GS had a tortuous duty of care to the investors in ABACUS. Certainly there were conflicts. However, these are most certainly circumvented by the fact that IKB and ACA were market counterparties or expert and professional investors. If each party acted with due care as fiduciaries it is hard to obtain a fraud. Paulson acted for his investors. Goldman acted for Paulson and for its own shareholders. ACA and IKB all acted for their shareholders. But a bet was made and there would always be winners and losers. If anything, the quality of due diligence of ACA and IKB and the ratings agencies should be questioned.

ACA was engaged to provide an extra set of eyes on the deal. They were engaged by GS as portfolio selection agent, as well as to provide the credibility necessary to distribute the deal. It appears that ACA Capital, ACA's parent turned up to effectively underwrite the deal as well. The SEC alleges that Paulson was involved in influencing the portfolio. This is trivially true by construction, however, things are not as clear cut as that. Paulson was specifying the bets he was willing to make. Out of the 123 underlying RMBS, ACA admitted 55. The final pool had circa 80 - 90 reference credits. ACA was not compelled to take the bets, and indeed only selected a subset of the Paulson portfolio. If we accept the SEC's point of view we are accepting as logical behaviour the turning down or accepting of a bet based on the counterparty and not the information about the prospects, outcomes and probabilities of the bet itself.

The fact that the deal would not have placed without ACA as an independent portfolio selection agent, that Paulson had a hand in the portfolio selection, that Paulson made lots of money, are immaterial to the allegation. They are, however, the realities of the industry.

Did GS’s failure to disclose Paulson's position long or short, constitute fraud, is the question before the courts.

There is the second allegation that is as important if not more. In my mind, this is the SEC's stronger allegation since the misrepresentation leads to fraud. This is the allegation that GS represented to ACA that Paulson would invest 200m in the equity of ABACUS 2007-AC1. The SEC complaint does not present supporting evidence. It is possible that the evidence exists, however, they have not referred to in the formal complaint at this time. For the time being what they have in the complaint seems to indicate that ACA assumed that Paulson would be long the equity, and GS simply failed to correct them. If so, it was a costly assumption for ACA and their parent.

Why might ACA assume that Paulson was long equity? The Paulson trade resembles a more common and widely executed trade which attempted to profit regardless of the direction of credit spreads in the reference portfolio. The Magnetar trades were of this nature. The trade involves being long the equity or junior tranche of the cap structure while being short the mezz or senior tranche of the cap structure on a delta neutral basis. This trade generates profits if spreads widen or tighten. How? The equity tranche is convex to spread widening. The more senior tranches are relative concave to spread widening. By delta hedging a long equity (convex) position with a short mezz (concave or negatively convex) position, the convexity of the bundle can be very pronounced leading to a long spread volatility position. As this was a common trade at the time, ACA might reasonably assume that the Paulson was attempting the same trade. It appears not, and that Paulson did not have a long equity position against the short mezz. It was in fact an unhedged and highly speculative trade for Paulson and one which could have gone wrong with serious results. ACA had probably assumed more sophistication on the part of Paulson than was the case. Paulson was no expert in structured credit. His background was in risk arb, a very specific hedge fund strategy. Betting on mortgages was a macro call. Using structured credit instruments to leverage this bet was arguably reckless. Fortune shone on Paulson and his bet paid off.

Guilty or innocent, GS has already been condemned by the public. Investor forums are replete with condemnations of Goldman the Vampire Squid. That much is clear. Whether this is justified or not is another matter which is not so clear.

The constructive fraud issue I think is unfounded and in any case will be very hard to prove. The related misrepresentation issue will imply fraud and boils down to the evidence, which has yet to be presented definitively by the SEC.

The lesson in all this is clear. Caveat emptor. What kind of investor are you? In the context of Poker, if you play the hand, then all you are concerned with are the details of the deal. If you play the player then it is your job to find out all about who you are playing against. And do your own homework. Quite how some of the CDO liabilities got rated AAA is a mystery to me. The speed at which the underlying collateral and the tranches were downgraded certainly calls into question the quality and value of credit ratings agencies judgment.

If the SEC is successful in its complaint, it will certainly open a can of worms. Lets just look in one narrow area, retail structured products. See all those retail structured products which are offered by private banks? Some of them are constructed with the needs of the investor in mind, but some of them are constructed because someone wanted to make a bet, and the other side of the deal needed to be found. Look at the disclosure in a structured product. Are you told who designed it? Who had a hand in designing it? Who is on the other side of the trade? Was it initiated by the structurer or their client? How many private investors would even dream of asking these questions?

There is a more interesting although less likely scenario.

Say that the SEC wanted to prosecute Paulson. Why is not important. Say the SEC has no proof. A formal complaint would go nowhere and there would be a risk of a libel countersuit, or a frivolous litigation countersuit.

The SEC might decide that it has a case against GS in a related capacity, that of a conflicted agent. The case is thin but it would allow the SEC to bring allegations against Paulson, that it cannot substantiate, with immunity from libel prosection in the course of prosecuting its case against Goldman.

This is of course mere speculation.

Posted by biginla at 10:29 PM BST

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India's criminal tribes

by Susan Kumar for the BBC and the Economist's Biodun Iginla

Millions of poor Indians are considered criminal by tradition. Most are nothing of the sort

Apr 22nd 2010 | ASHTI, MAHARASHTRA | From The Economist print edition

Badshah, not bad man

INSIDE his hovel of branches and rags, a grizzled pauper called Badshah Kale keeps a precious object. It is a note, scrawled by a policeman and framed by Mr Kale, proclaiming that he “is not a thief”. For members of his Pardhi tribe, who are among some 60m Indians considered criminal by tradition, this is treasure.

Squatting beside Mr Kale, on a turd-strewn wasteland outside Ashti, a village in India’s western state of Maharashtra, Pardhi men and women describe what it is like to be branded criminal at birth. A woman says her husband is hauled in every week or two by the police, against whom the Pardhis have ring-fenced their wretched colony with thorny branches. He has thrice been tried for robbery but was never convicted. Sporting a bright pink turban, another Pardhi says six of his seven sons have been imprisoned numerous times. All, predictably enough, claim to be law-abiding—though, giggling, Mr Kale’s wife admits to hawking copper trinkets as gold. “Even if we try to live like normal people,” she says, “the [Hindu] upper-castes will never accept us.”

This stigma goes back over a century. Mostly itinerant—some blue-eyed Pardhis look like they might come from the far north-west—India’s “criminal tribes” have always lived on society’s edge. Yet their plight was made worse by a series of 19th-century changes, including rapid deforestation, which stopped them from hunting, and the imposition of a tax on salt, which many had traded. No doubt this drove many to crime—which encouraged India’s British rulers to a harsh conclusion. Imbued with a bureaucratic aversion to nomadism and a Victorian relish for the Hindu caste system, they adjudged many Indian tribesmen, Pardhis included, to be preordained crooks. According to an 1880 report of the Bombay Presidency, an area dominated by the modern states of Maharashtra and Gujarat, members of a Pardhi sub-tribe are “always ragged and dirty, walking with a sneaking gait”.

To fix these vagabonds, the Raj introduced the 1871 Criminal Tribes Act, under which members of around 150 tribes were forced to register with the police, forbidden to move around freely and, in many cases, herded into barbed-wire camps. The law was scrapped soon after India won independence, and the criminal tribes were formally “de-notified” in 1952. Some have prospered: in Rajasthan, the Meenas dominate a preferential-treatment scheme to allocate government jobs to tribal people, which has let them become part of India’s elite civil services. Yet the fortunes of many de-notified tribes (DNTs) have scarcely improved.

The Pardhis, of whom there are more than 200,000 in Maharashtra, are especially wretched. They are mostly jobless and landless, and they are often informally barred from villages. Thousands live destitute in Mumbai, Maharashtra’s capital. In response, the state government has made two of the three local Pardhi sub-tribes eligible for positive-discrimination measures. Yet few Pardhis have the documentation or education needed to take advantage of this. Around 80% are illiterate, even if more than half of Pardhi children may now be in school. Among 60-odd Pardhis squatting outside Ashti, only one has a formal job, as a school janitor. He credits his success to passing himself off as a dalit, one of Hinduism’s former “untouchables”.

To examine the plight of India’s estimated 100m-odd DNTs and other nomadic people, the central government appointed a commission which reported back in 2008. Its recommendations, to which the government has not responded, included taking steps to extend positive-discrimination measures to those tribals—perhaps a fifth of the total—who lack them. It also urged state governments, which control policing in India, to scrap draconian laws used by the police to lock up repeat offenders. These are often used against DNT members, enforcing a cycle of poverty and discrimination that keeps many in crime. Pardhi poachers, for example, are one of the biggest threats to India’s dwindling population of tigers, which they have eradicated from several national parks.

According to Ashti’s police chief, S.S. Gaikawad, a quarter of local thefts are carried out by Pardhis. His deputy reckons half of Pardhi men are criminal. Mr Gaikawad attributes high rates of criminality to poverty, but believes culture also plays a part: “The more criminal cases against a Pardhi man, the higher his status, and therefore the better his marriage prospects are.” In a country where over a quarter of parliamentarians face criminal charges, this is not as surprising as it might seem. Yet Rajendra Kale, a Pardhi activist in the nearby town of Ahmednagar, says it is exaggerated. He reckons no more than 10% of Pardhi men break the law. To help his poor community, Mr Kale, who says he was twice wrongly imprisoned for theft as an eight-year-old, demands a reform that the government cannot easily provide: “Pardhis must be accepted into the village.”

This is happening, he says, but slowly. He points to some bloodied figures, a Pardhi man and two women, waiting on the pavement nearby. The man, Faillu Bhosle, said they had been attacked by high-caste Marathas while they were cultivating common grazing-land. They had come to town seeking treatment for Mr Bhosle’s father, who lost an eye in the attack, and to report the incident to the police. The policemen of their own village, who have arrested Mr Bhosle four times, refused to record their complaint.

Posted by biginla at 10:20 PM BST

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Cyber-crime

by Tamara Kachelmeier, Tech Analyst for the BBC and the Economist, for the BBC's Biodun Iginla

International efforts to police the net remain deadlocked

Apr 22nd 2010 | From The Economist print edition

WHEN people talk about the digital divide, they usually mean the gap between people who are benefiting from the information revolution, and those who through lack of education or money are missing out. But at a United Nations conference in Brazil that concluded on April 19th, a different (though related) sort of divide was on show, and ten days’ chatter by over 100 countries failed to bridge it.

If there was one thing on which almost everybody agreed, it was that criminals are mastering computer technology much faster than most governments are learning to foil them. Rich countries say they are beset by fraudsters, pornographers and hackers operating from poor places where they will never be caught—because their “host” governments can’t or won’t stop them.

One response is the Budapest Convention, an accord launched at the Council of Europe in 2001, and ratified by the United States in 2006. One of its aims is to let authorities in one country give chase, at least electronically, to criminals in another.

But Russia has opposed the principle of “transborder access”, especially since 2000, when American agents hacked into the computers of two Russians who were defrauding American banks. Instead, Russia is backing a UN treaty which would be respectful of borders while also giving police more powers to shut down websites dealing in “propaganda.” Many countries like that idea—but not enough to push it through. For now, the only winners are the criminals.

Posted by biginla at 5:38 PM BST

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After the volcano

by Biodun Iginla of the BBC and the Economist

Disasters are about people and planning, not nature’s pomp

Apr 22nd 2010 | From The Economist print edition

IT IS a peculiar, if blessed, sort of natural disaster in which nobody dies. The Icelandic volcano Eyjafjallajokull produced a thrilling show—and may continue to do so—but did most of its damage simply by shutting down air traffic in and out of large parts of Europe for nearly a week. Rather than bereavement, it brought the eeriness, and sometimes the joy, of displacement. Colleagues were absent from their desks, and teachers and pupils from their classrooms; the clear blue skies were bereft of the silver needles that sew the world together. Birdsong made loud the silence of the jets, florists’ vases missed the bright blooms of far-off fields, and far-off farmers missed the cash those blooms would have brought. But, this time, almost all that went missing will be returned.

Two arguments spout up from this demonstration of earthly power. The first is immediate and practical: was all this chaos man-made—an immense and costly overreaction by regulators to a spectacle that posed only a minor and manageable risk? The second is more philosophical: what does this say about man’s apparent inability to control nature?

To fly or not to fly

The initial position of Europe’s regulators was that the safe level of volcanic ash was, in effect, zero, thus grounding all flights in the broad swathes of sky which computer models said could be tainted. The fact that this regulatory stance changed in the face of an affluent cadre of displaced people, airlines feeling the pinch, a looming threat to some supply chains and (in Britain) an election, makes it all the more suspicious. Areas with low concentrations of dust and ash are now suddenly deemed navigable, and aircraft passing through them will be given thorough post-flight engine inspections (see article).

How exactly the new safety threshold came to be set at 2,000 micrograms of dust or ash per cubic metre is not clear; the figure appears to have come from engine manufacturers, but the evidence on which it is based has not yet been made public. Regulations without a clear and open argument behind them are worrisome. But that doesn’t mean the threshold, equivalent to about 100 times the typical level of dust in the atmosphere at ground level, is necessarily a bad one (test flights found patches of dust of up to 20 times normal levels). And the previous position that there was no safe level clearly lacked any sort of evidence base at all.

Had better policies been in place beforehand, much inconvenience might have been avoided. But it is wrong to dismiss the week’s woes as an over-precautionary fuss over nothing. Northern Europe has many hub airports downwind of one of the most volcanic countries in the world, and the emergence of the global aviation industry just happened to coincide with a period of relative inactivity there. Some of Iceland’s volcanoes can shoot hundreds of times as much gunk into the atmosphere as Eyjafjallajokull has, and over long periods. There are other volcanoes, notably in the American north-west and Japan, capable of disrupting a lot of airspace around big cities. The fact that the long-distance risks posed by volcanoes are not, for the most part, insurable seems to have led to them being less well studied than other kinds of natural disaster. A wake-up call was needed, and it has been sounded. The new regulatory approaches now need to be openly justified, and perhaps taken further.

With great power comes great responsibility

But the week of absences also offers a less obvious lesson. One of the things that went missing in the shadow of that volcanic dust was a sense of human power. And as with the quiet skies, this absence found a welcome in many hearts. The idea that humans, for all their technological might, could be put in their place by this volcano—this obscure, unpronounceable, C-list volcano—was strangely satisfying, even thrilling.

Such pleasure in the face of overpowering nature, as seen from a place of safety, was at the heart of the idea of “the sublime” as expressed by the great conservative Edmund Burke 250 years ago, and its aesthetic and spiritual allure remains strong. The sublime offers solace and inspiration, but it makes a poor guide to policy. For humans are not completely powerless in the face of nature: rather the reverse.

There is no technology to plug volcanoes which pierce the earth’s crust, or to bind the faults which cause earthquakes. There is not yet even a science for predicting when faults and volcanoes will let loose. To that extent, mankind is still vulnerable to the vagaries of the planet. But the story of human development is one of becoming better at coping with them.

Death by disaster is in many ways a symptom of economic underdevelopment: witness the very different consequences of the earthquakes in Haiti and Chile. In general, richer places and richer people are better able to survive and rebound. More interconnections provide more ways to mobilise resources and explore alternatives when things go wrong. If the Eyjafjallajokull plume had been as risky as it first appeared and long-lived to boot, such interconnectedness would undoubtedly have provided ways to keep Europe supplied, though probably at substantial cost and with a fair bit of lasting disruption. The apparently sublime power of the volcano was largely the result of an initially supine reaction.

Very few events are able to perturb an increasingly globalised world. The Indian Ocean tsunami of 2004 was a murderous event, but the world pushed on and many areas recovered quickly (see Buttonwood). For a natural disaster to represent a global threat, it has to act on a global scale. An eruption of hot plasma from the sun, called a coronal mass ejection, which could do damage to electricity grids over an entire continent, might fit the bill. The largest volcanoes might cause short-term climate change profound enough to reduce agricultural production precipitously in many places at once. A large asteroid strike would do yet more damage.

These are, though, rare events. Very large coronal mass ejections are thought to happen every 500 years or so (the most recent was in 1859). Volcanoes that change climate enough to affect agriculture round the world are perhaps 100 times rarer than that, and cataclysmic asteroids rarer still. What is more, such asteroids could, in principle, be identified and, with plausible technology, nudged aside. Here Burke’s sublime is turned on its head, and human capability seems to humble nature.

This is worth applying to climate change. Many of Burke’s descendants find it difficult to believe that something as big as the earth’s climate could really be at risk from human activity, and even harder to think you could do something about it. But the risk, if not full certainty about its consequences, is there. Moreover, the idea of a counterbalancing, “geoengineered” cooling to counteract some aspects of climate change is worthy of study and discussion. Large volcanic eruptions spread cooling palls through the stratosphere. Techniques for doing something similar in a less dramatic way are plausible.

When people talk about the charms of powerlessness in the face of nature, part of what they are saying is that they don’t want to be bothered with facing up to what humans can do, and to what they might have at risk. The business of looking after a planet requires being bothered in advance—and not just about little matters like volcanoes.

Posted by biginla at 5:54 PM BST

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