The SEC Complaint Against Goldman Sachs

Big news today, that the SEC is suing Goldman Sachs for fraud.  The basic gist is that GS failed to disclose relevant information related to the structuring of CDOs it sold.   I'm on the road today, but I have a quick summary.

A friend of mine said to me recently "in thirty years, how will anyone be able to be President?"  He was referring to the ample digital records of everything nowadays, from those naughty pics you post on Facebook, to sarcastic comments you might leave on internet message boards or blog posts, to emails that are archived forever.  Fortunately for regulators, there is more of a paper trail (albeit, digital) now than there was even 10 years ago, which should make their cases more clear cut, and less of a case of "he said, she said."

A reader asked me for some sort of penance for having defended GS in the past, which is a legitimate question.  Now, when I used the phrase "don't hate the playa, hate the game,"  I was referring to legal activities which GS used to get an edge - like having the best technology, or being the most connected in Washington.  You might not like either of those things (and there are many more examples), but they are not illegal, and if you don't like it, you have to change the rules.  I will continue to defend capitalism in capital markets - which results in winners and losers - smarter and less smart - those on the right side of trades, and those on the wrong side.

However, I never have and never would defend the use of illegal methods by anyone - GS or otherwise - and write it off to "tough luck for the losers" or "sold to you, SUCKA."  Obviously, there have to be rules, and now we're seeing them come into play.  If GS consistently plugs their customers with bad deals, the customers should stop trading with them.  If GS is fraudulently misrepresenting its deals, the SEC should step in and prosecute them, which is what's happening.  If GS is frontrunning their clients, I'd LOVE to hear about it, believe me.  (but Daniel, every word I wrote in this prior post is just as true now as it was when I wrote it)

Now, of course, GS will certainly lose the benefit of the doubt (if they ever had any) and will certainly not reap the benefits of any sort of presumed innocence in any future appearance of impropriety.  Everyone's favorite target will perhaps justifiably be presumed GUILTY, and it will be interesting to see if the Powers That Be come down on them hard.  Yahoo's headline on the story mentions that investors lost "$1B" as a result of this fraud.  A billion dollar fine would be relative pocket change for GS.  The real question is what the lasting consequences will be. 

Note on the following quotes:  they are pulled word for word from the complaint, and are in order, but not complete. In other words, I tried to use ellipses (...) to indicate that there were words in between edited out by me)

quotes from the complaint:

"The Commission brings this securities fraud action against Goldman, Sachs & Co. (“GS&Co”) and a GS&Co employee, Fabrice Tourre (“Tourre”), for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) GS&Co structured and marketed to investors..."

"In sum, GS&Co arranged a transaction at Paulson’s request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson’s role in the portfolio selection process or its adverse economic interests..."

"GS&Co recognized that market conditions were presenting challenges to the successful marketing of CDO transactions backed by mortgage-related securities. For example, portions of an email in French and English sent by Tourre to a friend on January 23, 2007 stated, in English translation where applicable: “More and more leverage in the system, The whole building is about to collapse anytime now…Only potential survivor, the fabulous Fab[rice Tourre]…standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!” Similarly, an email on February 11, 2007 to Tourre from the head of the GS&Co structured product correlation trading desk stated in part, “the cdo biz is dead we don’t have a lot of time left.”

The problem gets magnified in the next section, where GS used the illusion of an independent third party manager to assuage potential investor concerns.

"GS&Co and Tourre knew that it would be difficult, if not impossible, to place the liabilities of a synthetic CDO if they disclosed to investors that a short investor, such as Paulson, played a significant role in the collateral selection process. By contrast, they knew that the identification of an experienced and independent third-party collateral manager as having selected the portfolio would facilitate the placement of the CDO liabilities in a market that was beginning to show signs of distress....GS&Co therefore sought a collateral manager to play a role in the transaction proposed by Paulson..."

"In or about January 2007, GS&Co approached ACA and proposed that it serve as the “Portfolio Selection Agent” for a CDO transaction sponsored by Paulson. ACA previously had constructed and managed numerous CDOs for a fee. As of December 31, 2006, ACA had closed on 22 CDO transactions with underlying portfolios consisting of $15.7 billion of assets..."

"Internal GS&Co communications emphasized the advantages from a marketing perspective of having ACA associated with the transaction. For example, an internal email from Tourre dated February 7, 2007, stated: “One thing that we need to make sure ACA understands is that we want their name on this transaction. This is a transaction for which they are acting as portfolio selection agent, this will be important that we can use ACA’s branding to help distribute the bonds...”

"Likewise, an internal GS&Co memorandum to the Goldman Sachs MCC dated March 12, 2007 described the marketing advantages of ACA’s “brand-name” and “credibility”: “We expect the strong brand-name of ACA as well as our market-leading position in synthetic CDOs of structured products to result in a successful offering.” “We expect that the role of ACA as Portfolio Selection Agent will broaden the investor base for this and future ABACUS offerings.” “We intend to target suitable structured product investors who have previously participated in ACA-managed cashflow CDO transactions or who have previously participated in prior ABACUS transactions.” “We expect to leverage ACA’s credibility and franchise to help distribute this Transaction...”

In short, GS wanted to use ACA's name as a sort of stamp that everything was ok. The complaint then details the back and forth between Paulson and ACA involving the creation of the portfolio, and the returns with the doozy:

"Similarly, a 65-page flip book for ABACUS 2007-AC1 finalized by GS&Co on or about February 26, 2007 represented on its cover page that the reference portfolio of RMBS had been “Selected by ACA Management, LLC.” The flip book included a 28-page overview of ACA describing its business strategy, senior management team, investment philosophy, expertise, track record and credit selection process, together with a 7-page section of biographical information on ACA officers and employees. Investors were assured that the party selecting the portfolio had an “alignment of economic interest” with investors. This document contained no mention of Paulson, its economic interests in the transaction, or its role in selecting the reference portfolio..."

"On or about April 26, 2007, GS&Co finalized a 178-page offering memorandum for ABACUS 2007-AC1. The cover page of the offering memorandum included a description of ACA as “Portfolio Selection Agent.” The Transaction Overview, Summary and Portfolio Selection Agent sections of the memorandum all represented that the reference portfolio of RMBS had been selected by ACA. This document contained no mention of Paulson, its economic interests in the transaction, or its role in selecting the reference portfolio..."

But there was another problem: GS was also playing ACA!  ACA didn't want to sell out and compromise their reputation, so GS led them to believe that Paulson was investing on the long side of the portfolio in the equity tranche!

"GS&Co also misled ACA into believing that Paulson was investing in the equity of ABACUS 2007-AC1 and therefore shared a long interest with CDO investors....Had ACA been aware that Paulson was taking a short position against the CDO, ACA would have been reluctant to allow Paulson to occupy an influential role in the selection of the reference portfolio because it would present serious reputational risk to ACA, which was in effect endorsing the reference portfolio. In fact, it is unlikely that ACA would have served as portfolio selection agent had it known that Paulson was taking a significant short position instead of a long equity stake in ABACUS 2007-AC1."

"On January 12, 2007, Tourre spoke by telephone with ACA about the proposed transaction. Following that conversation, on January 14, 2007, ACA sent an email to the GS&Co sales representative raising questions about the proposed transaction and referring to Paulson’s equity interest. The email, which had the subject line “Call with Fabrice [Tourre] on Friday,” read in pertinent part: “I certainly hope I didn’t come across too antagonistic on the call with Fabrice [Tourre] last week but the structure looks difficult from a debt investor perspective. I can understand Paulson’s equity perspective but for us to put our name on something, we have to be sure it enhances our reputation.”

There is then a discussion of German investor IKB, who would only invest in the CDOs if there was an investment manager like ACA acting impartially to select the portfolio.

"In February, March and April 2007, GS&Co sent IKB copies of the ABACUS 2007-AC1 term sheet, flip book and offering memorandum, all of which represented that the RMBS portfolio had been selected by ACA and omitted any reference to Paulson, its role in selecting the reference portfolio and its adverse economic interests. Those representations and omissions were materially false and misleading because, unbeknownst to IKB, Paulson played a significant role in the collateral selection process and had financial interests in the transaction directly adverse to IKB. Neither GS&Co nor Tourre informed IKB of Paulson’s participation in the collateral selection process and its adverse economic interests."

GS's Tourre again looks to be in up to his neck here, describing the portfolio one way to IKB, and another in internal communications:

"Tourre maintained direct and indirect contact with IKB in an effort to close the deal. This included a March 6, 2007 email to the GS&Co sales representative for IKB representing that, “This is a portfolio selected by ACA . . .” Tourre subsequently described the portfolio in an internal GS&Co email as having been “selected by ACA/Paulson.”

"The fact that the portfolio had been selected by an independent third-party with experience and economic interests aligned with CDO investors was important to IKB. IKB would not have invested in the transaction had it known that Paulson played a significant role in the collateral selection process while intending to take a short position in ABACUS 2007AC1. Among other things, knowledge of Paulson’s role would have seriously undermined IKB’s confidence in the portfolio selection process and led senior IKB personnel to oppose the transaction."

But here's where things get strange.  ACA, the manager, also had a parent company, ACA Capital who provided insurance on these CDOs!!!

"ACA Capital was unaware of Paulson’s short position in the transaction. It is unlikely that ACA Capital would have written protection on the super senior tranche if it had known that Paulson, which played an influential role in selecting the reference portfolio, had taken a significant short position instead of a long equity stake in ABACUS 2007-AC1."

Now I think that is a load of crap.  ACA created the portfolio with Paulson.  They knew EXACTLY what was in it, and for them (or their parent company) to basically use the excuse "but we thought Paulson was long, not short" (not a direct quote at all!) is pretty weak.  ACA was providing insurance on the portfolio - it shouldn't matter who they were providing the insurance to - it should matter what they were providing the insurance on.  The portfolio is the same weather Paulson is a long equity  investor or a short investor.    GS misled ACA as to Paulson's true involvement, but that doesn't change the underlying assets, and is illustrative of the complacency on the part of ACA in effectively evaluating risks.  This is especially confusing, considering that ACA created the portfolio.

This is sure to be a MEGA story, and perhaps indicative of future backlash to come.

EDIT:  GS releases a statement: "The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation"

Wow.  That seems surprising. I mean, it's not surprising that they'd deny it,  but it's surprising that they deride the basis of law and fact involved.  Reading the complaint, you don't have to be a lawyer to conclude that it looks pretty damning. 

-KD

disclosure: short XLF