GS Abacus CDO deal ... A Thought Experiment

[econoclast]

Wednesday evening on Bloomberg radio, there was a panel discussion regarding the SEC's fraud lawsuit vs GS. One of the participants proposed a thought experiment I found fascinating. I'll give you my version...

Suppose, in early 2007, Warren Buffet went to JP Morgan and said:
"I am a value investor and always on the lookout for underpriced assets. I have discovered a group of mortgage related bonds that are rated Bbb or worse. I have done the homework and think they are waaaaay undervalued. The rating agencies have it wrong. I think theese things are going to take off. They are going to the moon! I want to invest in these particular bonds. But, I don't want to go through the time and effort to locate the owners of these bonds and try to make separate deals for each one. I want you -JP Morgan- to create a synthetic CDO for me. A CDO composed of credit default swaps on a portfolio composed of these specific securities. The CDO will be composed of the end of the swaps that will benefit enormously when the underlying bonds go through the roof. Can you do it?"

JP Morgan knows they'll have to find a counterparty for the other end of those swaps. Someone to be "short" what Buffet is "long". They have someone in mind. They go to John Paulson who they know has been shorting mortgage related bonds. They market the "short" end of the "Buffet portfolio" to them and Paulson buys it.

So Buffet is long, Paulson is short. But Morgan hasn't told Paulson that Buffet is on the other end of his "short"

Six months later the bonds have indeed gone to the moon, Buffet makes a killing and Paulson looses his shirt.



How do we feel about this deal? I'll admit that is feels MUCH less dirty / wrong / slimey to me than the GS Abacus deal. I think it is because in the hypothetical above, it is the short seller who looses. Nobody loves the short sellers. Is it just me? The facts are exactly the same, but they FEEL different. How much if our ire over the GS Abacus deal is not the behavior of the broker but...

1- the short seller won
and
2- it is Goldman ... The giant vampire squid