SEC Sues Goldman for Fraud

Oooh, things are starting to get interesting.

A number of journalists and commentators (yours truly included) have taken issue with the fact that some dealers (most notably Goldman and DeutscheBank) had programs of heavily subprime synthetic collateralized debt obligations which they used to take short positions. Needless to say, the firms have been presumed to have designed these CDOs so that their short would pay off, meaning that they designed the CDOs to fail. The reason this is problematic is that most investors would assume that a dealer selling a product it had underwritte was acting as a middleman, intermediating between the views of short and long investors. Having the firm act to design the deal to serve its own interests doesn’t pass the smell test (one benchmark: Bear Stearns refused to sell synthetic CDOs on behalf of John Paulson, who similarly wanted to use them to establish a short position. How often does trading oriented firm turn down a potentially profitable trade because they don’t like the ethics?)

The SEC is now mounting a civil suit against Goldman against one of its Abacus trades, which was a series of synthetic CDOs used to take short positions in real estate. Interestingly, the deal in question was on behalf of John Paulson. Greg Zuckerman’s book on subprime shorts, The Greatest Trade Ever, indicated that Paulson wanted to take down the all the credit default swaps created through the CDO issuance process (which would typically leave him 95% short the par value of the CDO, since Paulson would put up the equity tranche, usually 4-5%). The SEC may have started with this transaction because the communications between Paulson and the SEC would make it easy to show the intent, that of putting crappy CDS in the CDO.

Strange as it may seem, structured credit-related litigation is a new area of law, with few precedents. Until the credit crisis, unhappy investors seldom sued dealers and other key transaction participants.

From the New York Times:

Goldman Sachs, which emerged relatively unscathed from the financial crisis, was accused of securities fraud in a civil suit filed Friday by the Securities and Exchange Commission, which claims the bank created and sold a mortgage investment that was secretly devised to fail…

The instrument in the S.E.C. case, called Abacus 2007-AC1, was one of 25 deals that Goldman created so the bank and select clients could bet against the housing market…

As the Abacus deals plunged in value, Goldman and certain hedge funds made money on their negative bets, while the Goldman clients who bought the $10.9 billion in investments lost billions of dollars….

Goldman let Mr. [John] Paulson select mortgage bonds that he wanted to bet against [for Abacus 2007-AC1] — the ones he believed were most likely to lose value — and packaged those bonds into Abacus 2007-AC1, according to the S.E.C. complaint. Goldman then sold the Abacus deal to investors like foreign banks, pension funds, insurance companies and other hedge funds.

But the deck was stacked against the Abacus investors, the complaint contends, because the investment was filled with bonds chosen by Mr. Paulson as likely to default. Goldman told investors in Abacus marketing materials reviewed by The Times that the bonds would be chosen by an independent manager.

Mr. Paulson is not being named in the lawsuit.

Update 11:30 AM. The complaint is here. Reading through it quickly, the SEC is seeking to apply traditional securities law standards (the overarching charge is “making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) GS&Co structured and marketed to investors,” with the key issue being that John Paulson’s role in having a significant influence in the selection of the collateral was not disclosed:

After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (“CDS”) with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure. Given its financial short interest, Paulson had an economic incentive to choose RMBS that it expected to experience credit events in the near future.

Yves here. This is also interesting because Paulson appears not to have bought the CDS created to serve as collateral for the transaction, but instead shorted (via Goldman) some of the tranches. We’ve been told that shorting CDO tranches (as opposed to shorting BBB supbrime bonds) was pretty uncommon, but “pretty uncommon” may not be quite as rare as we had been told. Later in the complaint, we get further detail:

Paulson discussed with GS&Co the creation of a CDO that would allow Paulson to participate in selecting a portfolio of reference obligations and then effectively short the RMBS portfolio it helped select by entering into CDS with GS&Co to buy protection on specific layers of the synthetic CDO’s capital structure.

Yves here. Paulson could have simply taken down all the CDS in the deal and achieved the same result. But Goldman itself may have taken down the CDS (a New York Times story on the Abacus program suggested as much), or the swaps could have gone to other clients. Presumably, doing it this way was more attractive to Goldman (arranging a short on a CDO tranche has to have been a higher fee event), but I’m a bit perplexed as to how this mechanism would have been to Paulson’s advantage (unless the shorts on the lower-rated CDO tranches, which would fail first, hence assuring Paulson a faster time to profit realization).

It is also interesting that the SEC is suing Goldman and one of its employees, and not the collateral manager, ACA Management:

Fabrice Tourre [a Goldman employee who is a party to the SEC suit] also misled ACA into believing that Paulson invested approximately $200 million in the equity of ABACUS 2007-AC1 (a long position) and, accordingly, that Paulson’s interests in the collateral section process were aligned with ACA’s when in reality Paulson’s interests were sharply conflicting.

Second update 12:00 PM: Reader Hubert points out that the SEC suit was announced minutes before this e-mail was sent out in Obama’s name. Coincidence?

I cannot stand these Obama missives, so I am only including the beginning, which is sufficient to give you the drift of the gist.

Friend –

It has now been well over a year since the near collapse of our entire financial system that cost the nation more than 8 million jobs. To this day, hard-working families struggle to make ends meet.

We’ve made strides — businesses are starting to hire, Americans are finding jobs, and neighbors who had given up looking are returning to the job market with new hope. But the flaws in our financial system that led to this crisis remain unresolved.

Wall Street titans still recklessly speculate with borrowed money. Big banks and credit card companies stack the deck to earn millions while far too many middle-class families, who have done everything right, can barely pay their bills or save for a better future.

We cannot delay action any longer. It is time to hold the big banks accountable to the people they serve, establish the strongest consumer protections in our nation’s history — and ensure that taxpayers will never again be forced to bail out big banks because they are “too big to fail.”

That is what Wall Street reform will achieve, why I am so committed to making it happen, and why I’m asking for your help today.

Please stand with me to show your support for Wall Street reform.

Originally published at Naked Capitalism and reproduced here with the author’s permission. 

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