Abacus Doesn't Add Up

I'll endorse the conventional wisdom that Goldman Sachs' Abacus deal does not pass the smell test, but it is a bit more tricky to isolate just why not. Back in the winter when the New York Times breathlessly disclosed that Goldman was selling long positions in stuff it was also shorting, the response was something on the order of a collective yawn. Hey, Goldman is a department store; is it a scandal that they sell both dum-dums and bulletproof vests?

The story comes back to life now, of course, mainly in the baggage of an SEC civil fraud complaint. The substantive wrinkle is supposed to be not just that Goldman was workng both ends of the deal, but that the securities in Goldman CDOs were being chosen by the short of shorts, John Paulson, so as to assure that the CDOs would fail. It's a touch, although in fairness to the Times, the original December story did say

One focus of the inquiry is whether the firms creating the securities purposely helped to select especially risky mortgage-linked assets that would be most likely to crater, setting their clients up to lose billions of dollars if the housing market imploded.

It doesn't name Paulson, but ioot looks to me like the main point was on the table way back when. Still, I can think of three questions that seem to me to invite more thought.

One, exactly what can we say about the buyers who went long the CDOs? Or more precisely, what if Goldman had said: "we think this stuff is all rock solid and gold plated; of course there are other guys who are betting against them--and we are making money on some of their deals--but that's just business; we still like what we see". Wouldn't Goldman have covered itself if its pitch went something like that? Or to turn the point around, should Goldman have warned people who were buying short positions that other people were going long?

Two, just exactly who was covering the shorts--I gather, by writing default swaps--? Is this just one of those bad breaks you get in the insurance business or isn't it (rather more likely) a colossal failure of risk management, a grotesque underpricing?

The final question is--even assuming everybody gets to walk away from sovereign sanction here, is there anything--Anything? Anything?--about this long-short stuff that does anybody any good? Except, of course, the traders who pocketed the commissions? So we're back again to a too-familiar mantra: grant that the world needs a functioning finance system, haven't we lost all touch with function here, in favor of letting the casino gamble with the unwitting house's money?

Update: Much more exhaustive lists of questions here and here.