ACA Financial, a bond insurance company, sued Goldman Sachs in a state court in New York, January 6, 2011, charging Goldman with fraud and unjust enrichment in connection with the already-infamous ABACUS 2007-AC1 deal.
Specifically, ACA Financial contends that Goldman fraudulently induced it to ensure ABACUS, a special purpose vehicle (SPV) that issued synthetic collateralized debt obligations, CDOs.
A traditional CDO is a security issued by such an SPV and based upon a large number of loans, mortgages, and other assets. These instruments are in turn divided into tiers, determined by their level of risk. A speculator can buy an interest in the riskier or the safer tiers, receiving greater or lesser return respectively. Of course, in the event of a wave of defaults on the underlying loans, the riskier and thus higher-paying tiers are supposed to be the first to fail.
A synthetic CDO is a little different, in that the SPV itself doesn’t have any interest in the underlying collateral. The loans at issue are “reference collateral” – they don’t properly speaking underlie anything. The SPV is selling protection, or in effect it is betting that most of the debtors in the reference transactions will pay what they owe, just as a fire insurance company is betting that only a few of the houses it ensures will catch fire. The parties buying the CDOs from such an SPV are betting that there will be a lot of defaults, or hedging themselves against that possibility.
In either a traditional or a synthetic CDO, though, the highest risk/highest return investors are known as “equity” investors. Therein lies the nature of the alleged fraud. ACA contends that Goldman persuaded it that Goldman was itself an equity investor in this SPV. Thus, ACA insured the SPV, in effect writing insurance on the insurer. Further, ACA says, Goldman was not in the position of equity investor at all, because its real interest in this product to let a favored client, Paulson, take the other side of it, and collect investment-banker fees on that.
Goldman, then, was betting on the arsonists while pretending to be a fire insurance company, and letting ACA become the fire re-insurer. Such at any rate is the accusation.