Following is the original text of a letter sent out to clients of hedge fund firm Paulson & Co. in the wake of the SEC charges against Goldman Sachs.Dear Investor,
Many of you have asked questions in the past few days about Paulson & Co.'s ('Paulson') participation as an investor in mortgage securities from 2005 through early 2007, and specifically about our investment in a synthetic collateralized debt obligation ('CDO') which is the subject of a civil complaint by the Securities and Exchange Commission ('SEC') against Goldman Sachs. We wanted to provide you with accurate information and context regarding the decisions we made during this time to preserve and enhance our clients' capital.
Prior to the market collapse, mortgages were viewed as among the safest investments possible.
It is easy to forget that before the collapse, the overwhelming view of investors, ratings agencies and economists was that the housing market was strong and would continue to get stronger. Between 2005 and 2007, investment-grade mortgage securities were considered almost as safe as U.S. Treasury securities. Defaults of investment-grade mortgage securities were almost non-existent, and there was enormous global demand for these products.
The global demand for subprime mortgage-backed securities was also huge. Even though close to $1 trillion of these securities were issued in 2005-2006, robust synthetic Credit Default Swap ('CDS') and CDO markets referencing the underlying cash mortgage securities developed to meet the exploding demand from investors.
Paulson was transparent and open regarding its concerns about the mortgage market, which were driven by analysis of publicly available data.
Our concerns centered on the very foundation of the subprime mortgage security market and related derivatives. We believed that the two-year adjustable table rate mortgages made to lower income borrowers with poor credit history, little or no documentation, no down payment and rates that would shortly reset at usurious interest rates, set the stage for significant delinquencies and foreclosures, thus eroding the value of these securities.
While Paulson was often a lone voice of concern on these issues at industry conferences and meetings during this period, we remained committed to our thesis, pursuing an investment strategy that involved the purchase of CDS protection on RMBS with underlying subprime mortgage collateral.
Sophisticated and experienced investors were cager to make bets that the value of mortgage securities would continue to increase.
Paulson was not known as an experienced mortgage investor prior to late 2007. When we expressed our concerns about the mortgage markets, many of the most sophisticated investors in the world, who had analyzed the same publicly available data we had, were fully convinced that we were wrong, and more than willing to bet against us. At the height of our participation in the market, our purchases of protection on CDO tranches represented less than 1% of the estimated $400 billion total CDO Issuance.
Paulson did not structure or originate the ABACUS transaction. The ABACUS program was a Goldman Sachs shelf program created in 2004. Goldman Sachs issued approximately 25 separate transactions under its ABACUS program. In order to structure a synthetic CDO, Goldman Sachs needed the same amount of CDS protection to be both bought and sold on the reference portfolio. In other words, the 'short' side of the synthetic CDO had to be the same size as the 'long' side of the synthetic CDO. In the particular transaction, ABACUS 2007ACI, Paulson expressed our interest to be on the short side.
While Paulson suggested securities to be included in the reference portfolio as the protection buyer, ACA, as collateral agent for ABACUS 2007-AC I, represented the long side and had full and final authority for selecting the reference collateral. ACA was a highly experienced CDO manager of 22 outstanding CDOs, at the time, with underlying portfolios consisting of $15.7 billion of assets. They ultimately approved the pool of reference securities underlying ABACUS 2007-AC1. According to the SEC Complaint, of the 123 securities originally suggested by Paulson, 62 had been previously purchased by ACA at the same or lower ratings, and ACA decided to include 55 while rejecting 68. ACA also added approximately 35 additional securities independent of any suggestions by Paulson.
After the reference collateral was selected by ACA, the CDO was tranched and rated by Moody's Investors Service and Standard & Poor's Rating Service, both of whom assigned a 'AAA' rating to ABACUS 2007-AC I.
After ABACUS 2007-ACI was structured, tranched, rated, and issued, Paulson purchased CDS protection on the 'AAA' tranches from Goldman Sachs, our only counterparty.
Paulson's role in the ABACUS transaction was appropriate and conducted in good faith.
Every synthetic CDO by definition has a long and short side. These products are designed specifically so that buyers and sellers can take positions based on their view of the expected performance of a given market. We have always been forthright in expressing our opinions, and we have never misrepresented our positions. All of our dealings were through arms-length transactions with experienced counterparties who had opposing views based on all available information at the time.
Paulson's investment strategies continue to evolve with the market.
As important as credit protection purchases were to our performance in 2007, our investment focus completely shifted in the fourth quarter of 2008. Since then, Paulson has been almost exclusively focused on long distressed credit opportunities and on providing capital to companies who are restructuring to reduce debt and strengthen their balance sheets. We have been a welcome and sought-after provider of capital to numerous banks, insurance companies, industrial firms and educational companies over the past 18 months. Our capital has been crucial either in helping companies emerge from bankruptcy, helping them avoid bankruptcy, or otherwise delever and re-emerge as healthy, growing organizations.
Paulson & Co. Inc.
Paulson has been in business for 16 years and has been a Registered Investment Advisor with the Securities and Exchange Commission since 2004. Over this time period we've established a strong track record and abiding by both the spirit and the letter of the law. As fiduciaries, it is our duty to preserve and enhance our investors' capital and we have a hard-earned and highly held reputation for doing so with honesty, integrity and thorough research. This was the motivation behind the investment we made in the mortgage markets before the collapse; and it is the same motivation that drives our decisions today.
Sincerely,
John Paulson
