SEC Charges Goldman Sachs With Fraud; May The Perp Walks Begin

From the SEC:

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.

This is a very big deal.  Goldman is down 8% already. Given the charges, I can’t imagine that Magnetar will be able to escape the now emboldened SEC because the allegations against Magnetar’s cherry picking collateral for CDOs are identical to the cherry picking by Paulson described here. It seems the regulators have finally awakened from their slumber.

Get ready. The perp walks are finally coming.


Update: Here is the court filing below.

Goldman Paulson Abacus Complaint

  1. Jake says

    big difference legally between goldman and magnetar. magnetar did not sponsor the underwriting or market the long portion of the structure to clients…

    1. Edward Harrison says

      And that may be why they are going after Goldman. I say in another post that you would think that Paulson would be the target given it was Paulson’s actions which triggered the investigation. yet the Paulson firm has escaped without a complaint. Will the same occur with Magnetar? If so, will we see the CDO underwriter face charges there?

      1. Marshall Auerback says

        Goldman is a good target, but also politically convenient. They are probably the single most reviled Wall Street institution right now (which in itself is saying a lot), but they don’t have a significant deposit taking role and therefore the collateral damage to the real economy relative to, say, going after JP Morgan or BofA, is considerably less. Plus, to paraphrase Richard Nixon, the charges probably also have the benefit of being true. It’s a nice way to “decourager les autres” and mitigate GS’s impact as they seek to lobby against many of the provisions in the Finance Reform Bill, weakening an already weak bill. And of course, it’s politically cost-free to an Administration widely perceived to be too pro-Wall Street.

        1. Edward Harrison says

          Good points, Marshall. I will note that when I write later today in the NYTimes.

      2. Jake says

        only if those CDO underwriters sold the tranches under the guise that the underlying mortgages were independently selected

        1. Edward Harrison says

          which seems likely. Why would they have sold them under the guise that they were crookedly selected?

    2. Edward Harrison says

      Also, the WSJ has learned this is a part of a broader investigation. So I suspect we will see other charges in other cases.

  2. David Pearson says

    The politics of the Goldman charge are complicated. Yes, the Administration has an incentive to get Financial Reform passed. On the other hand, they steer the economy by the constellation of the S&P, and hardly have an interest in people losing faith in the market. After all, regardless of the observer’s politics, the corporatist bent of this Administration is its most salient feature. So, maybe they would like to give Goldman a “slap on the wrist”. If so, they picked a curious way of doing it, for the charges against the firm open it up to State Attorney’s General investigations and endless civil lawsuits, and they create vulnerability for other firms, as well as for the political sponsors (Rahm Emmanuel) of firms such as Magnetar. Finally, there is the role of populism in hijacking prosecutions, one which has been significant and unpredictable throughout history.

    No, if the Administration had planned this, you would have heard the announcement this morning of a 3-way settlement — including a record but insignificant (relative to GS profits) fine — between Cuomo, the SEC and Goldman, combined with some Goldman firings and a Mea Culpa press release from Blankfein. This would have been in keeping with the strictures of crony capitalism. Its just as likely that the SEC’s source — Paolo Pellegrini of Paulson & Co. — forced their hand in doing something that was really in no one’s perceived interest given its potential effect on TBTF institutions and confidence in financial markets.

    So what are the politics of this civil charge? Its too early to tell…

  3. stendahl says

    I’m a little lost here – Goldman has said ACA managed the CDO, Paulson has said ACA manged the CDO, and ACA will argue they managed the CDO or else open themselves up to liabilities. It appears the govt case hinges on arguing that ACA were patsies, not doing their job or both. If ACA were professionals with subject matter expertise and did proper due diligence, short of some sort of lying on the part of GS or Paulson, it isn’t clear how disclosing Paulson’s intentions is even relevant.

    Unless there is some smoking gun which has yet to be brought to light, I think the govt has chosen a difficult case to win.

    Too bad they didn’t accuse Fab of being an idiot – thats a case they would definitely have won.

    1. Edward Harrison says

      The SEC is alleging that Tourre misled ACA into believing Paulson was going to be long Abacus. ACA was unaware that Paulson wasn’t just participating in the equity tranche. They would have assumed that Paulson had a long position that allied their interest with other investors. But in fact Paulson was effectively massively short in the CDO market.

      1. stendahl says

        I’ve now had a chance to read the SEC document in full. The emails referenced in the charges appear to confirm that GS was looking for a patsy manager for the CDO (paragraph 21) and that GS acknowledged internally and to ACA that Paulson was the sponsor of the portfolio (paragraphs 27, 29, 30, 43, 47, 57, etc.) but did not disclose this to investors in or insurers of the CDO.

        Following the money seems to support the SEC’s case, though it requires some reading between the lines. It appears that GS created the CDO to give Paulson a way to short a target group of RMBS. Essentially GS would write CDS to Paulson and then lay the risk off on the investors in the CDO (paragraph 60). You get a sense that Paulson was looking high and low for ways of being short the RMBS market and when they ran out of CDS writers, they asked Goldman to help them go short against investors.

        It sounds like ACA sold CDS on the super senior tranche and that ABN Amro backed up ACA’s insurance (paragraph 61, 63, 66). It appears that GS sold those CDS to Paulson.

        It seems inevitable that IKB and other investors in the deal will sue Goldman (paragraph 60). Sounds like ACA/ABN Amro is also likely to sue (paragraph 63, 66). The document says that IKB lost $150 mln and ACA/ABN lost $841 mln. It would appear they have grounds to sue even if GS beats the SEC charges.

        The fact that GS created this vehicle to allow Paulson to go short sounds material, and its lack of disclosure sound like a violation of the Exchange Act.

        The unstated but implied guilt/incompetence of the ratings agencies in this transaction is nauseating.

        1. Marshall Auerback says

          Yes. But it’s not the arrest — it’s the conviction, on felony charges, of major cases (not a teller who embezzled $40K). You see how stark the contrast is.

          1. stendahl says

            Two other observations…

            The charges show a detailed understanding of the facts and mechanics involved in these transactions. This suggests the investigation must have been in the works for some time. Some of the details make one wonder whether their case benefitted from someone inside feeding them information – ACA? Paulson? Someone at Goldman? A ratings agency? A competitor?

            The fact that Paulson was willing to take the equity piece makes Goldman’s omission of Paulson’s involvement that much more glaring. Paulson’s willingness to purchase this piece shows that his conviction was so high, he was willing to lose 10% on the equity and the cost of the CDS to bet against these instruments.

            I suppose in the heady days of the mid-00s that might have even been a selling point for investors.

          2. Marshall Auerback says

            These bankers are like someone who finds a market for nuclear waste in Yuca Mountain, only to find out that the end buyer is a terrorist who constructs a dirty bomb with the materials. It’s like turkeys voting for Thanksgiving.

  4. George Kesarios says

    I think there are good chances that Goldman will turn into Drexel.

    Not only is this sub prime mess even worst than the Junk Bond scandal, but now everyone who ever lost money in these instruments will have their day in court!!

  5. greg says

    I am presently in litigation with Fremont Reorganizing, Goldman Sachs dba Litton Loan Servicing, et al., (2 different cases) for about 2 years now. The main issue with the complaint is a fraudulent loan originated by Fremont in June 2006. This in turn produced an array of other
    issues: unsigned deed of trust, over billing issues, lost payments, excessive balloon payment, back dated assignments, illegal non-judicial foreclosure documentation, missing documentation, illegally reporting to my credit, falsifying declarations, 6 week TRO’s, court procedures not followed, judges wait until the courtroom is cleared to rule against a TRO (both times); retired (78 year old) judge ruled against a seated judges TRO where the retired judge took 30 minutes to read a 300 page brief. The whole time they have been ignoring my request and failing to give me the required documentation so that I can rescind the loan. Goldman Sachs dba Litton Loan Servicing has been aggressively trying to foreclose on my property. I believe to cash out for insurance reasons. (It’s over a million dollar loan) I have invested over $400,000 into this property for the past 5 years and if I had known about this mortgage meltdown game played by Wall Street I would have never proceeded with this Real Estate transaction. The Media and the Government has not once addressed or helped the borrower, namely me, who also has been damaged by these defaulted CDO’s.

    A Time line of what’s going on with Goldman Sachs to show how they are scheming to pursue foreclosures for the insurance by acquiring distressed, shelled fraudulent companies which will eventually or haven’t already gone BK…

     Oct 26, 2005 Litton Loan Servicing Class Action – mishandling loans, servicing over 400,000 borrowers – case settled Feb 17, 2009 for $537 (limited due to class status)
     Feb 27, 2007 FDIC Cease and Desist – Fremont Reorganizing for illegal loan practices, et al., (largest predatory lenders who heavily solicited brokers for their schemes)
     Oct 16, 2007 Massachusetts Lawsuit vs Fremont and Goldman Sachs – Predatory Lending Practices – settled May 11, 2009 for $60 mil
     Dec 11, 2007 – Goldman Sachs Acquires Litton Loan Servicing
     June 2, 2008 Litton (Goldman Sachs) Acquires Fremont Reorganizing Servicing Rights
     June 19, 2008 Fremont Reorganizing files BK
     Apr 16, 2010 – SEC vs Goldman Sachs – Securities Fraud

    Here is the link to my blog if you want to download court documents pertaining to my case.

    Note: My wife is pursuing individuals who are interested in joining her in a class action lawsuit with regards to violation of her community property rights in a wrongful foreclosure. If you are in a community property state and a spouse is not on title you may have grounds for legal action.

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