All the Fuss About the Goldman Fraud Charges
So April 16, the SEC charged Goldman Sachs and VP Fabrice Tourre with civil fraud charges stemming from 2007 CDO deals with John Paulson’s hedge fund (the eponymous Paulson & Co.)– and since Goldman and Paulson are huge names and the prospect of scandal makes us all salivate, everyone has their panties in a twist. The basic gist of the whole thing is that Paulson, who was notably bearish on subprime mortgages, was involved in having Goldman creating the crappiest, most toxic part of CDOs (known as “equity”) he packaged into the “Abacus” investments he recommended to Goldman and which he later bet against by buying credit default swaps– but Goldman never disclosed this information to investors. Paulson saw that the housing market was going to collapse and he saw an opportunity– so he picked out the people most likely to default (people with crappy credit scores) and bet that they weren’t going to pay off their mortgages. Pretty safe bet. Moody’s had apparently placed their once revered AAA rating on the Abacus deal, so investors thought it was a good thing– only it wasn’t, and it was quickly downgraded when Moody’s realized it was crap. The deal could never have been done without the stellar initial rating.
Apparently the SEC doesn’t have enough to go to trial against Paulson… because technically there is nothing illegal (though the words “douche-y” and “unethical” come to mind) about going to Deutsch and Credit Suisse Bear Stearns and Goldman and asking them to create a toxic mortgage product just so he could bet against it. And a statement from Paulson & Co. quoted in the New York Times has emphasized that the firm was “not involved in the marketing of any ABACUS products to any third parties,” and that the deal’s CDO manager and not Paulson “had sole authority over the selection of all collateral in the CDO, securities of which were subsequently rated AAA by both S&P and Moody’s.” But the SEC is pursuing the case against Goldman and Tourre– because the the public bloodlust demands that someone pay. Goldman is saying the charges are unfounded and vowing to fight them and defend its reputation. Right.
The whole thing is pretty simple: Goldman (like other firms who will probably emerge as part of a similar investment scheme betting on the housing downturn and be charged later– Soros Asset Mgmt. and Magnetar profited from similar deals, but don’t appear to have had any special relationships with investment banks that have been discovered thus far) teamed up with one of its most valued hedge fund clients to create subprime mortgage products the hedge fund would later bet against. And the SEC, like many others, feels that Goldman and Tourre owe investors more than just a “my bad”.
The SEC maintains that Goldman should have told investors that the product they were being sold was linked to the performance of certain mortgages and that the hedge fund betting on the mortgages’ demise helped design the product. In fact, Goldman brought in a third party, ACA Capital, to manage the deal named Abacus 2007-AC1. So Goldman told investors that ACA was responsible for picking the bonds– not Paulson. The SEC says this is enough to support civil fraud charges. When this was announced on Friday, Goldman’s stock dropped some 13 percent, while the stock of several of the underwriters of those mortgages, such as Deutsch, Morgan Stanley, and Bank of America, which owns Merrill Lynch, and Citigroup, dropped 9 percent, 6 percent, 5 percent and 5 percent, respectively.
Deutsche Bank AG, UBS AG and Merrill Lynch & Co. are among those firms that created mortgage deals that went sour. It is not yet known who the SEC is investigating. Traders say that the deals generated about $1 billion in total fees for the firms. Investors in the CDOs Paulson helped create/Goldman sold ended up losing $1 billion in what was one of the worst-performing deals of the housing-crisis. Paulson & Co. walked away with something like $3.7 billion in 2007 by betting against the housing market, according to the LA Times. Turns out Paulson really knows how to pick ‘em. According to the Wall Street Journal, future cases may hinge not just on questions such as whether a deal favored one client or another, but whether there was misrepresentation.
A critical part of the SEC’s case against Goldman is that the firm allegedly misled investors by not notifying them of the role of hedge-fund investor John Paulson—who was dubious of the housing boom—in selecting what went into the mortgage deal Goldman sold. Goldman said it fully disclosed the investments and didn’t need to reveal the Paulson connection.
According to a different New York Times article, Goldman’s mortgage group consisted of several hundred people split up into several subgroups, each with a specialty, which took different positions on the mortgage market. Fabrice Tourre’s mortgage group’s position clashed with many of the others by betting against the housing market, most of which took positive positions. “[Golman employee Jonathan] Egol and Fabrice were way ahead of their time,” said a former Goldman worker. “They saw the writing on the wall in this market as early as 2005.” Although an unpopular position within the company at the time, it turned out to be incredibly prescient. Unfortunately for Goldman, it just might turn out to have been a little illegal.
If you want insight into the whole CDO thing and don’t want to spend money on Michael Lewis’s The Big Short, you can read AK Barnett-Hart’s Harvard Thesis, which Lewis mentions in the acknowledgments section of his book here for free. It’s a lot drier and more academic than Lewis’s book, but it’s still insightful– and it’s well written and, most importantly, it’s free.
If you enjoyed this post, please consider to leave a comment or subscribe to the feed and get future articles delivered to your feed reader.
Loading ...