Insurer ACA Financial Guaranty Adds Paulson & Co. to Its Suit Against Goldman.

[ by Melanie Gretchen and Howard Haykin ]

Abacus 2007-AC1, that infamous complex "synthetic collateralized debt obligation" sold in 2007, cost Goldman Sachs $550 million (in fines to settle SEC charges), cost investors $1 billion (in losses), but produced $1 billion in profits for Paulson & Co.  By now, you probably are beginning to recall the deal, which led to the SEC's exhaustive investigation, that was settled 3 years later with the then-largest-ever penalty paid by a Wall Street firm.

Background Information.   A synthetic CDO transaction requires 2 parties taking opposite views.  The "long" party profits if the underlying securities rise in value;  the "short" party profits if they fall.  Each side places a bet and, in effect, the loser's losses become the winner's gains. 

In the Abacus deal, completed in April 2007, Paulson took the short side and 2 major investors took the long side - IKB, a large German bank, and ACA Capital Management, a New York-based investment firm.  Paulson worked with ACA to choose the 90 underlying mortgage-backed securities - i.e., the portfolio of the CDO.   That is where the dispute arises - what was Paulson's exact role. 

The SEC claims Goldman led ACA to believe that Paulson was taking the long side and that he would bet the securities would rise in value.  Accordingly, ACA went into the deal on the long side with the belief or understanding that Paulson thought the securities selected were safer than they were, and that ACA's interests and Paulson's were the same.  It thus would have made sense to ACA that Paulson would try and select underlying mortgage bonds for the CDO that were strong securities that were likely to rise in value.

IKB, the German bank, did not know Paulson's role, according to the SEC, which states that this role was material information that would have alerted IKB to the high risks.

But Paulson went into the deal expecting the housing bubble to collapse and in order to place such a bearish bet, he needed a CDO that based based on mortgage bonds likely to fall in value when homeowners stopped making their payments.  Logic would forewarn an investor to be wary of investing on the long side of a CDO knowing that:

• Paulson was, from the get-go, bearish on housing;
• Paulson wanted to take the short side of the CDO deal;  and
• Paulson was to be involved with selecting the underlying securities for the CDO.

Based on the above scenario, the SEC made the claim that Goldman acted illegally  by withholding material information from the 2 Abacus buyers as to Paulson's intent.

BTW:  Paulson was not included in the SEC complaint and has not been accused of any wrongdoing.

Back to the Abacus Lawsuit.    Apart from the SEC settlement with Goldman Sachs, the insurer on the Abacus deal, ACA Financial Guaranty, went after Goldman Sachs as well, by naming the firm in a 2011 lawsuit that sought $120 million in damages.  Now, nearly 2 years later, ACA Financial Guaranty is adding the Paulson & Co.hedge fund as a defendant, claims that Paulson and Goldman conspired to induce ACA to provide financial guaranty insurance for the Abacus deal, "doomed to fail," the firm said in papers filed yesterday in New York State Supreme Court in Manhattan.

A Paulson spokesperson said the decision to include the company as a defendant "is completely without merit."

The case: ACA Financial Guaranty Corp. v. Goldman Sachs & Co., 650027-2011, New York State Supreme Court (Manhattan).