Washington, D.C., April 16, 2010 — The Securities and Exchange Commission today charged Goldman, Sachs & Co. and one of its vice presidents for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter.
The SEC alleges that Goldman Sachs structured and marketed a synthetic collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS). Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO.
“The product was new and complex but the deception and conflicts are old and simple,” said Robert Khuzami, Director of the Division of Enforcement. “Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party.”
Kenneth Lench, Chief of the SEC’s Structured and New Products Unit, added, “The SEC continues to investigate the practices of investment banks and others involved in the securitization of complex financial products tied to the U.S. housing market as it was beginning to show signs of distress.”
The SEC alleges that one of the world’s largest hedge funds, Paulson & Co., paid Goldman Sachs to structure a transaction in which Paulson & Co. could take short positions against mortgage securities chosen by Paulson & Co. based on a belief that the securities would experience credit events.
According to the SEC’s complaint, filed in U.S. District Court for the Southern District of New York, the marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. The SEC alleges that undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.
The SEC’s complaint alleges that after participating in the portfolio selection, Paulson & Co. effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure. Given that financial short interest, Paulson & Co. had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson & Co.’s short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors.
The SEC alleges that Goldman Sachs Vice President Fabrice Tourre was principally responsible for ABACUS 2007-AC1. Tourre structured the transaction, prepared the marketing materials, and communicated directly with investors. Tourre allegedly knew of Paulson & Co.’s undisclosed short interest and role in the collateral selection process. In addition, he misled ACA into believing that Paulson & Co. invested approximately $200 million in the equity of ABACUS, indicating that Paulson & Co.’s interests in the collateral selection process were closely aligned with ACA’s interests. In reality, however, their interests were sharply conflicting.
According to the SEC’s complaint, the deal closed on April 26, 2007, and Paulson & Co. paid Goldman Sachs approximately $15 million for structuring and marketing ABACUS. By Oct. 24, 2007, 83 percent of the RMBS in the ABACUS portfolio had been downgraded and 17 percent were on negative watch. By Jan. 29, 2008, 99 percent of the portfolio had been downgraded.
Investors in the liabilities of ABACUS are alleged to have lost more than $1 billion.
The SEC’s complaint charges Goldman Sachs and Tourre with violations of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Exchange Act Rule 10b-5. The Commission seeks injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.
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I dont want to say that Goldman was doing this correctly, but we cant say it was illegal neither. I found reaction from Alhambra Investments, which I found appropriate:
Apr 18th, 2010 by Joseph Y. Calhoun, III
Caveat Emptor - let the buyer beware - is a principle that applies to any transaction where no warranty exists. The buyer bears the risk and should therefore exercise care and due diligence prior to purchasing such products, especially when the person doing the buying is acting on behalf and for the benefit of others. This principle is one that is too often forgotten when it comes to investing but if anything ever fit the definition of a product with no warranty surely it is the output of investment banks.
Friday the SEC sued Goldman Sachs for allegedly conspiring with hedge fund manager John Paulson to manufacture a financial product that was designed to fail. My first thought upon reading the phrase “designed to fail” was: And this is different from everything ever produced by investment banks how? Anyway, this Collateralized Debt Obligation (CDO) was manufactured by a Goldman employee primarily - or at least this is what the SEC is alleging - so that Mr. Paulson could bet against it - which he did successfully to the tune of $1 billion in profit. I do not intend to go through all the details here about what Goldman allegedly did or whether they are indeed a vampire squid on the face of the US economy as has been alleged by a certain writer with only a superficial understanding of financial markets. The New York Times and Rolling Stone are doing a more than adequate job of demonizing Goldman Sachs and all of Wall Street for that matter; no need for me to pile on. However, I would like to say something here about the purchasers of these CDOs and other products manufactured by the financial engineers of Wall Street.
Goldman Sachs created this product and offered it for sale to institutional investors such as banks. Institutional investors are considered knowledgeable by the SEC and presumably do not need to be protected from purchasing risky investment products. Most of them have multiple highly educated professionals to make decisions about what to buy and sell. In this case, what the SEC is alleging is that material facts about the creation of the CDOs in question were concealed from the buyers. The material fact allegedly omitted was that Paulson helped to select the crummiest mortgages he could find to include in the CDO so that his bet against it was a sure fire winner. That is of course a matter of contention; if Paulson had been wrong about the housing market - and there were a lot of smart people who thought he was - and he lost a bunch of his client’s money, would the SEC now be suing Goldman for alleged securities fraud? I have my doubts and that makes the suit questionable in my mind; is it only fraud if the wrong client is on the losing side of the trade?
Goldman’s role in this case is as a broker. Paulson wanted a particular type of product to bet against and apparently other clients wanted a similar product to bet on. If that were not true, Goldman would not have created the product. As a broker they facilitate trades between buyers and sellers; they don’t need to make judgments about whether the investment will rise or fall. They just need to find enough buyers and sellers to create a market. And that is apparently what they did; Paulson wanted to sell and some institutions wanted to buy. Who were these institutional investors? Well, one that is known is IKB Deutsche Industriebank AG whose specialty is lending to small and midsized businesses in Germany.
If this bank’s specialty is lending to small and midsized businesses in Germany why was it purchasing CDOs from Goldman Sachs? Did the bank conduct any due diligence on these synthetic securities - which amounted to nothing more than a bet on the US housing market- before they risked shareholder capital? Or did they just look at yields that were 150-200 basis points higher than what they could get on other mortgage securities and think, hey, what a bargain? Did they really think they - who specialize in lending to small and mid-size German businesses- knew more about the US housing market than whoever was on the other side of the trade? Did they not question why these securities had higher yields than similar securities? Did they think Goldman was offering them a gift? Or did they do their research and decide that the yield offered was adequate compensation for the risks? Or did they just buy the thing without reading the offering memorandum? I don’t know the answers to those questions but it seems pretty obvious that they didn’t exercise the most basic of due diligence - that of caveat emptor. IKB Deutsche Industriebank AG is not a victim of Goldman Sachs and John Paulson; they are victims of their own employees’ hubris. Why should I have any sympathy for the purchaser of a CDO in 2007, well after the point when even nominally conscious individuals knew that the real estate market was in deep kimchi?
I am cynical enough to believe that the timing of the SEC suit against Goldman is not coincidental. The administration is trying to pass financial regulation reform before the election and it can’t hurt to let Wall Street know that lobbying against it can be hazardous to your corporate health. In other words, the politicians have something to sell too. They are trying to get re-elected in the fall and they believe that looking tough on Wall Street will help in that regard. The key is to look tough for the public while not doing anything to upset your banking campaign contributors. It’s a tricky balance but I’m sure they’ll get it just right. Goldman Sachs will not be hurt too badly by this - they’ll pay a fine and admit nothing.
Real financial system reform would start at the root of the problem - the Federal Reserve. Why was a German bank buying CDOs from Goldman Sachs? The simple answer is yield. When the Fed and the rest of the central banks of the world hold interest rates artificially low investors have to take on more risk to achieve their return goals. And in doing so, they take risks they really can’t afford to take - often without realizing it. It takes time for the malinvestment caused by the Fed’s interest rate manipulations to be revealed, so for a time the risky investments pay off and investors are lulled into believing the risks don’t actually exist. It is only when the malinvestments are revealed, usually when the Fed raises interest rates, that the risks are fully realized. That’s when suddenly the creators of risky financial products look like bad guys; up to that point they are called financial innovators and no one cares because the risks are paying off.
Real financial reform would give the Fed a single mandate it can accomplish with minimal market intervention. Right now the Fed’s mandate is “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” It is the Fed’s attempts to influence employment - which it can only do in the short term through credit manipulation - that have gotten us into our current predicament. Every recession the Fed reduces interest rates in an attempt, usually successful, to induce borrowing to create economic activity and jobs. It doesn’t much care what the borrowing is for or what types of jobs are produced and neither do their political minders. But it obviously makes a difference as we have found out twice in the last decade.
In the long run, the Fed can only control one thing - the value of the US Dollar. With monopoly control over the supply, the Fed can control the value. If their only mandate was to maintain a constant value for the dollar, interest rates would respond to market forces and the supply and demand for credit would balance. The needs of lenders (savers) and borrowers would balance rather than the absurdly imbalanced situation we have now. When the Fed reduces interest rates it is explicitly favoring one group of Americans (borrowers) at the direct expense of another (savers). That isn’t a situation we should tolerate much less mandate.
The financial reform bill that is being debated by Congress is over 1000 pages long and fails to address the most basic and obvious flaw in our financial system - the Fed’s manipulation of the price of credit. What that means is that no matter how detailed the regulations, no matter how diligent the regulators, financial reform will not prevent the next crisis. Yes, there are other things that also require change - much higher capital requirements for banks is a good example - but if the Fed is allowed to continue manipulating the credit market everything else is just window dressing. It is during times just like this that the seeds of future financial disasters are sown. Right now, investors are taking risk and stretching for yield because the Fed has pushed interest rates to zero. Now is the time to remember that there is no such thing as a free lunch. Caveat Emptor.
