The Goldman Sachs subprime scandal

Wall Street kingpin Goldman Sachs was last week charged with investor fraud by America’s financial referee, the Securities and Exchange Commission (SEC).

The shock announcement rattled nerves across the stock markets, with Goldman’s own share price falling by 13%.

But the bank has come out firing, saying the charges have no basis in fact or law and it will vigorously defend both the firm and its reputation.

The alleged fraud occurred in 2007 – about the time the US housing market was faltering.

The SEC says Goldman Sachs advised two of its clients to accept a US$1 billion bet over sub-prime mortgage bonds that they knew were going to fail.

They say Goldman did not tell the clients that the person they were betting against, John Paulson, had actually fixed the odds in his favour.

The bet

Multi-billionaire John Paulson is the head of Paulson & Co, one of the world’s largest hedge funds (Paulson is no relation of ex-Goldman CEO and Treasury Secretary Henry Paulson).

In 2006, he told Goldman Sachs that he wanted to bet on sub-prime mortgage bonds collapsing. He needed someone to take that bet and Goldman agreed to act as the middleman.

Goldman knew that one of their clients, German bank IKB, would potentially be interested in taking the exposure, but that they would want someone else to choose which mortgage bonds to bet over.

So in January 2007, Goldman asked ACA Management to select them and they agreed.

For the next two months ACA worked on choosing the bonds – but with the help of Paulson, at Goldman’s request.

Goldman never told ACA or anyone that Paulson wanted to bet against the mortgage bonds he was helping to choose. In fact, ACA thought he was accepting some of the exposure himself.

In February 2007, Paulson and ACA agreed to a group of about 90 bonds, many of which were handpicked by Paulson for weakness.

Once they were chosen, Goldman packaged them all into a betting vehicle named Abacus 2007-AC1 (a synthetic collateralised debt obligation).

IKB accepted $150 million of the $1 billion-plus Abacus bet and Dutch investment bank ABN Amro accepted $909 million.

Paulson paid the bet to them via some (fairly cheap) credit default swap insurance. Goldman Sachs collected a $15 million fee for the deal.

By 2008, the Abacus mortgage bonds had defaulted and were basically worthless.

IKB and ABN Amro had to pay $1 billion to Paulson.

(Paulson & Co made a whopping $13 billion in 2007 betting against the US housing collapse).

The charges

The SEC is charging Goldman Sachs with failing to disclose “vital information” about Paulson’s conflict of interest: that he helped select the mortgage bonds and was betting against them.

Goldman said they couldn’t do this because market practice is that “they do not disclose the identities of a buyer to a seller and vice versa.”

They are also charged with failing to tell IKB and ABN Amro that they thought the Abacus bonds were going to default.

Goldman claims they were under no obligation to point out the risks because both IKB and ABN Amro were ‘qualified institutional buyers’, meaning they were legally recognised as sophisticated, well-informed investors who need less protection than individuals.

Goldman also points out they lost $90 million on the deal by taking part of the bet with Paulson.

The SEC’s proof of Goldman’s knowledge are several emails sent prior to the deal from the only person charged in the case, Fabrice Tourre – a then 27-year-old vice-president and one of the architects of the Abacus product.

The emails say things like “The whole building is about to collapse anytime now...Only potential survivor, the fabulous Fab[rice Tourre]” and “I am at this aca paulson meeting, this is surreal.”

The SEC has taken this to mean that he knew the bonds had been selected to fail and that Paulson was planning on betting against their success.

Despite this, some industry experts believe that while Goldman’s behaviour may have been unethical, it probably wasn’t illegal. They were just the middleman and it was up to the parties to do careful research into what they were buying.

Indeed, many feel the real villains in this case are the credit rating agencies.

They believe IKB and ABN Amro would never have bought into Abacus without its top triple-A ratings from Standards & Poors and Moody’s rating agencies.

Abacus turned out to be one of the worst performing mortgage deals of the housing crisis, with 100% of its bonds getting a rating downgrade in its first year. It’s currently rated near the lowest possible.

When asked why the SEC is not going after Paulson, they said bluntly: “It was Goldman that made the representations to investors. Paulson did not.”

It’s a difficult case and analysts are predicting a tough fight. But a betting man would go with Goldman.

By The Casual Truth

Photo – John Paulson