Tourre Trial Challenge: How to Explain a 'Synthetic CDO'

Tuesday, 16 Jul 2013 06:24 PM

 

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Throughout the morning, as the thermometer neared 100 degrees outside the Manhattan federal courthouse where former Goldman Sachs Group Inc. vice president Fabrice Tourre is being tried for securities fraud, jurors could be seen having trouble paying attention to the complex testimony.

Some were rubbing their eyes. One’s eyes were closed, head propped on a hand, while others looked at the clock as an expert testified on CDOs, synthetic CDOs and CDOs of CDOs.

“I think the jury was lost,” John “Sean” Coffey, a lawyer for Tourre, 34, said during a break this morning in the testimony of a professor called to the stand to describe the collateralized debt obligations at the heart of the case. “It is critical that they understand how a synthetic CDO works.”

The U.S. Securities and Exchange Commission sued Tourre and Goldman Sachs in 2010 over Abacus 2007-AC1, a synthetic CDO investors used to bet on mortgage bonds. They lost more than $1 billion on the wager. New York-based Goldman Sachs paid a then-record $550 million to settle the case.

CDOs are debt securities backed -- or collateralized -- by pools of mortgage bonds and other asset-backed securities. A synthetic CDO, by contrast, doesn’t directly hold mortgage securities. It’s linked to the performance of such assets and allows investors to use credit default swaps to bet on their performance.

Paulson Role

The SEC claims Tourre concealed the role of Paulson & Co., the hedge fund run by billionaire John Paulson, in selecting the assets in the Abacus portfolio — assets that Paulson was betting would fail.

U.S. District Judge Katherine Forrest asked why Coffey’s cross-examination of Dwight M. Jaffee, a professor of banking, finance and real estate at the University of California, Berkeley’s Haas School of Business called as an expert by the SEC, threatened to take longer than the hour to 90 minutes he had originally estimated.

Coffey said the jury didn’t seem to understand Jaffee’s explanation of how CDOs work.

“A good 20 minutes of that was necessary for all of us,” Coffey told Forrest, referring to his extended questioning. Jaffee, the first witness called in the trial, began testifying yesterday.

Short Investors

Coffey and Pamela Chepiga, Tourre’s lead lawyers in the trial, have argued that a synthetic CDO like Abacus requires short investors to match up with all the long positions that are sold. As a result, they contend, it was natural for Paulson to have input into the portfolio of residential mortgage-backed securities underlying Abacus.

Before Jaffee’s cross-examination, an SEC lawyer used a PowerPoint presentation to help him explain a CDO as a sinking cargo ship, with the equity and mezzanine investors the first to take on water. Not long after the super-senior deck flooded, the animated ship was shown sinking to the bottom.

Later, Forrest tried to rephrase one of Coffey’s questions to Jaffee about a failing CDO, apparently using the wrong aquatic metaphor.

“You’re talking waterfalls, I’m talking flood,” Coffey said.

After Jaffee left the stand, the SEC called Sihan Shu, a Paulson managing director who testified that the firm in 2006 and 2007 was in search of investment vehicles that would allow it to make short investments on U.S. mortgages.

‘Bearish View’

“We wanted to express a bearish view on the U.S. housing market via subprime mortgage-backed securities,” Shu said.

The jury wasn’t alone in grappling with the subject matter of Tuesday’s testimony. Paolo Pellegrini, a former top Paulson executive, testified after Shu.

“What does ‘CDO’ stand for?” SEC lawyer Matthew Martens asked Pellegrini, who wasn’t in the courtroom for Jaffee’s testimony.

“I’m not sure,” Pellegrini said. “It may stand for collateralized debt obligation, but I’m not sure.”

The case is SEC v. Tourre, 10-cv-03229, U.S. District Court, Southern District of New York (Manhattan).

© Copyright 2014 Bloomberg News. All rights reserved.

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