The Synthetic CDO That Was Designed to Fail

In April 2010, the Securities and Exchange Commission filed civil-fraud charges against Goldman Sachs and one of its young vice presidents, Fabrice Tourre, alleging that Goldman had structured a synthetic collateralized-debt obligation called Abacus 2007-AC1 in 2007 that was designed to fail. The allegation, in essence, was that Goldman had allowed the hedge fund Paulson & Co. — which intended to bet against the CDO through credit default swaps — to participate in selecting the underlying mortgage securities that the CDO would reference. The CDO had then been marketed to other investors without disclosing Paulson's adversarial role in the security-selection process.

The Abacus transaction generated approximately one billion dollars of trading losses for the institutional investors who had purchased exposure to the CDO, and approximately one billion dollars of trading profits for Paulson & Co. through the offsetting short positions. Goldman, as the structuring intermediary, had earned approximately fifteen million dollars in fees from arranging the transaction.

The Structuring Conflict. What the SEC charges illustrated was a particular kind of conflict of interest that had become endemic in structured-finance transactions during the 2005-2008 housing-bubble era. Investment banks were structuring securities for institutional clients while simultaneously taking opposing positions through other parts of their operations. The disclosure obligations to either side — to the buyer about the seller's intentions, to the seller about the buyer's positioning — were governed by complex and inconsistently enforced legal frameworks. The Abacus case was the first major SEC enforcement action that explicitly addressed the conflict in fraud terms rather than as a routine disclosure deficiency.

The Settlement. Goldman settled the SEC charges in July 2010 for five hundred and fifty million dollars without admitting wrongdoing. The settlement was, at the time, the largest in SEC history against a single financial institution. Fabrice Tourre, the individual vice president named in the charges, was eventually found liable in a civil trial in 2013 and ordered to pay personal penalties of approximately eight hundred and twenty-five thousand dollars. He subsequently left finance and reportedly pursued an academic career in economics.

The Industry Reset. The Abacus case became one of the more visible regulatory responses to the structured-finance excesses of the 2005-2008 period. It produced no fundamental change in the legality of the underlying CDO structuring business; synthetic CDOs continue to exist and continue to be marketed. It did produce a particular kind of compliance reset within investment banks regarding the disclosure obligations on dual-role transactions — the bank cannot, in subsequent practice, structure a transaction for a buyer while another part of the bank takes the opposing position without significantly more elaborate disclosure protocols.

The broader question — whether the structured-finance industry should be permitted to operate at the complexity it had reached by 2007 — was largely deferred. The Dodd-Frank legislation, passed in the same year as the Abacus settlement, included various provisions addressing systemic risk, but did not fundamentally restructure the CDO marketplace. The conflicts that the Abacus case illustrated persist in slightly modified forms. The settlement, in the broader history, was an expensive corrective that addressed one transaction without resolving the structural issue underneath.

Goldman continued to be one of the most profitable Wall Street firms. The SEC continued to bring enforcement actions, generally one transaction at a time. The compliance budgets at the major banks rose materially. The structured-finance industry, after a brief pause, resumed.