Capital Market : ABACUS 2007-AC1

Alex K. Mathews, Research Head

Abacus, as we all know, is a calculating tool used primarily in parts of Asia for performing arithmetic processes. But recently, "Abacus" had a totally different connotation. On April 16th, 2010 the US government accused Goldman Sachs of committing a fraudulent act that caused investors to lose heavily. The US Securities and Exchange Commission filed charges against the company. Let us now look at what Abacus has to do with the Goldman Sachs fraud case.

It started in 2006 when the hedge fund Paulson & Co.'s fund manager Mr. John Paulson approached Goldman Sachs with a proposal. Mr. Paulson wanted Goldman Sachs to create a derivative instrument with its underlying being a portfolio of risky mortgages and he also said that he wanted to take short positions on them. The mortgage bonds that Paulson wanted to short were essentially subprime home loans repackaged into bonds which were rated "BBB".

Now, Goldman Sachs was on the lookout for potential buyers for the proposed risky assets which Paulson & Co would be shorting. Goldman Sachs knew that German Bank IKB would be interested in buying the exposure that Paulson was looking to sell. But IKB would not buy these exposures unless the portfolio was created by an outsider. Goldman Sachs identified ACA Management LLC to facilitate the creation of the portfolio. Paulson and ACA worked on the portfolio of mortgages and came to a final agreement in late February 2007. Goldman Sachs at no point in time revealed to ACA that Paulson & Co would be betting against the mortgage assets. ACA were under the impression that Paulson & Co would be interested in owning some part of the risky securities.

Goldman Sachs put together a deal known as a "synthetic collateralized debt obligation" which was created using 23 financial transactions also called "Abacus 2007 AC1". Goldman Sachs now had a potential seller and a buyer for the newly made instrument. German bank IKB took $150 million of the risk from sub-prime mortgage bonds in late April 2007. ABN Amro took some $909 million of exposure along with protection on its exposure from ACA Management affiliate ACA Financial Guaranty Corp in May 2007.

Even after these deals, Goldman Sachs did not disclose the fact that Paulson & Co had shorted more than $1 billion worth of securities for which Goldman was to receive $15 million as fees. It took just five months for IKB to lose $150 million, the whole of its investment in Abacus. In late 2007, ABN Amro was taken over by a consortium of banks including RBS(Royal Bank of Scotland). In August 2008, RBS unwound ABN's position in Abacus by paying Goldman an amount equal to $840.1 million. Most of this money went to Paulson who was the winner of the game which led to the death of many banks, pushing the economy further into recession.