A transaction named Abacus 2007-AC1 became one of the most infamous trades of the financial crisis, netting more than $1 billion for Paulson & Company, a hedge fund that successfully wagered that the housing market would crash.
According to a crucial witness who took the stand on Tuesday at the trial of a former Goldman Sachs trader, the trade would never have happened had ACA Management, a firm that helped assemble it, been told that Paulson & Company was betting the trade would fail. The witness, Laura Schwartz, was testifying at the trial of Fabrice P. Tourre, who has been accused of participating in a scheme to defraud investors in connection to the trade and who is now on trial in Manhattan.
Ms. Schwartz was a senior executive at ACA and the main contact between her firm and Goldman, where Paulson & Company was a client eager to create a new security to capitalize on the housing market.
She is one of most important â€" and controversial â€" witnesses to take the stand in this trial, which on Wednesday will enter its eighth day. The civil case was brought in 2010 by the Securities and Exchange Commission, which also sued Goldman. Goldman settled its case in 2010, paying $550 million without admitting or denying guilt. That has left Mr. Tourre as the sole employee to battle the charges that ACA was misled about Paulson & Company’s role in the transaction.
The lawsuit is among the biggest cases the S.E.C. has brought stemming from behavior during the financial crisis, and Mr. Tourre, 34, has steadfastly denied wrongdoing. If the jury finds he did defraud investors, he faces a possible bar from the securities industry and financial fines.
Ms. Schwartz was a convincing, well-spoken witness as Matthew T. Martens, a lawyer for the S.E.C., questioned her about the deal, which started to come together in January 2007. She frequently looked at the jury when answering questions, explaining that ACA got involved in the transaction after receiving an e-mail from a Goldman managing director, Gail Kreitman.
Soon after receiving Ms. Kreitman’s e-mail, Ms. Schwartz sent out a meeting notice to various people, including Mr. Tourre and officials from Paulson & Company. The subject field read “Meet With Paulson, Potential Equity Investor.†This note set the tone for Mr. Martens’s questioning, as he presented Ms. Schwartz with countless ACA documents and e-mails, all referring to the hedge fund as an “equity†investor. Ms. Schwartz explained that she understood that the firm was betting the deal would succeed, or rise in value. In fact, Paulson & Company had taken a short position, in hopes of profiting if the security lost value.
“I believed Paulson was the equity investor in the transaction,†she said, repeating this refrain multiple times to the jury. She added that no one from Goldman Sachs, including Mr. Tourre, ever corrected e-mails to the firm from ACA that stated Paulson & Company was taking an equity position. In addition to arranging the trade, ACA was an investor, betting the security would rise in value.
Ms. Schwartz’s testimony contradicted testimony from a former Paulson & Company executive, Paolo Pellegrini, who told jurors last week that he made it clear to ACA that his company was betting the housing market would fall precipitously, and that the security would fall in value.
The trade in question, Abacus 2007-AC1, is what is known on Wall Street as a collateralized debt obligation, or C.D.O. Such instruments typically compile a package of mortgage-backed bonds into one deal for investors to buy. Abacus was a synthetic C.D.O., which, rather than selling securities with the actual bonds, is arranged through an insurance contract that is linked to the bonds’ performance.
The complexity of the security, as well as the way Wall Street does business, could make it hard for the jury to understand exactly what happened. In fact, the presiding judge, Katherine B. Forrest, tried to emphasize to both sides the need for clarity before the trial began.
Ms. Schwartz was far from a perfect witness for the S.E.C. A week before Mr. Tourre’s trial began, the court was notified that the S.E.C. had decided not to bring a case against Ms. Schwartz; the jury heard about this reprieve on Tuesday and may conclude that it colored her testimony.
Sean Coffey, a lawyer for Mr. Tourre, cross-examined Ms. Schwartz, and her demeanor was decidedly less friendly as he peppered her with questions.
Mr. Coffey stressed to the jury that in a synthetic C.D.O., one investor bets the trade will fail while another bets it will succeed. So, even if Paulson & Company was a long, or bullish, investor, a short investor was still needed to complete the trade.
Ms. Schwartz testified that she assumed Paulson & Company was wagering the trade would succeed and that she did not know who was on its other side.
Mr. Coffey was also quick to zero in on how ACA carefully analyzed each component that went into the Abacus trade, so it should not have mattered if the portfolio had been picked by Paulson & Company or by Joe, a court clerk for Judge Forrest.
“How about if you had found it on the floor?†he asked. Ms. Schwartz said that in each case, ACA would have done its own analysis of the various components of the C.D.O.
On Wall Street, the long investor is typically called the “transaction sponsor,†a term often used to describe Paulson & Company in documents. At least one witness, however, has said that the term could in certain circumstances describe a short investor, and on cross-examination Ms. Schwartz said she did not know if it meant long or short, a point that may bolster Mr. Tourre’s case.
Ms. Schwartz will be followed on the stand by Mr. Tourre. It is expected that he will testify all day Thursday as well.
