Goldman’s Abacus lies | Analysis & Opinion | The SEC suit against Goldman Sachs (full complaint here, and well worth reading) is explosive stuff. Essentially the SEC seems to have nailed down the kind of behavior that ProPublica was looking for in its story on the Magnetar Trade — a hedge fund which was short mortgages, in this case Paulson, was carefully picking nuclear waste to put into synthetic CDOs, unbeknownst to the final investors in those deals. From the complaint: GS&Co marketing materials for ABACUS 2007-AC1 – including the term sheet, flip book and offering memorandum for the CDO – all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management LLC (“ACA”), a third-party with experience analyzing credit risk in RMBS. Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. It seems here that ACA was somewhere between a useful idiot and an outright victim of Goldman’s Fabrice Tourre: I think that the SEC has the right defendant here.
SEC Charges Goldman with Fraud. By James Kwak Press release here. Complaint here. The allegation is that Goldman failed to disclose the role that John Paulson’s hedge fund played in selecting residential mortgage-backed securities that went into a CDO created by Goldman. Here’s paragraph 3 of the complaint: “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.”
The problem is that the marketing documents claimed that the securities were selected by ACA Management, a third-party CDO manager, when in fact the selection decisions were influenced by Paulson’s fund. And I don’t think this action contradicts my general point. “The deal closed on April 26, 2007. Goldman Sachs SEC Charges: Translated for Humans - MarketBeat - By Matt Phillips So here’s how we understand it. The crux of the charges against Goldman Sachs relate to a financial instrument the firm developed through discussions with hedge fund Paulson & Co. (Paulson & Co. was not named as a defendant in the SEC charges.) According to the complaint, Paulson paid Goldman Sachs approximately $15 million for structuring and marketing this security — called ABACUS 2007-AC1 — in early 2007. The security let Paulson & Co. make bets against the residential real estate market, which the hedge fund believed was going to tank.
Now, ABACUS 2007-AC1, was a complex form of investment vehicle known as a “synthetic collateralized debt obligations,” or synthetic CDO, here’s how the Journal explained them, back in 2005: [Sythetic CDOs] provide income from a pool of corporate bonds, [in the Goldman situation the synthetic CDO was based on subprime residential mortgage backed securities.-- ed] without anyone’s needing to actually purchase bonds. SEC: Goldman Is Actually a Vampire Squid - The Curious Capitalis. A few weeks ago, I did a blog post questioning whether the mega-profitable, much-hated investment bank Goldman Sachs really methodically set about putting together mortgage-backed securities that would fail.
I pointed to a Michael Lewis endorsed college thesis that seemed to suggest Goldman’s mortgage CDOs had actually done better than the rest. I then asked people to vote on whether Goldman was actually a vampire squid or not. Well the Securities and Exchange Commission casts their vote today and the winner is: VAMPIRE SQUID. The SEC is alleging Goldman committed securities fraud by colluding with a hedge fund to create bonds that were filled with home loans sure to default. Goldman then sold those bonds to invests as regular-old good investments, knowing the hedge fund that conceived the bonds planned to bet against them.
“The product was new and complex but the deception and conflicts are old and simple,” said Robert Khuzami, Director of the Division of Enforcement. The Magnetar Trade: How One Hedge Fund Helped Keep the Bubble Go. The hedge fund helped create mortgage-based securities, pushed for risky things to go inside them and then bet against the investments, resulting in billions in losses for investors and ultimately making the financial crisis worse. It’s a story of the perverse incentives and reckless behavior that characterized the last days of the boom. Update October 29, 2010: This story has been corrected in response to a recent letter from Magnetar. Read their letter, along with our response [2]. In late 2005, the booming U.S. housing market seemed to be slowing. At just that moment, a few savvy financial engineers at a suburban Chicago hedge fund [3] helped revive the Wall Street money machine, spawning billions of dollars of securities ultimately backed by home mortgages.
When the crash came, nearly all of these securities became worthless, a loss of an estimated $40 billion paid by investors, the investment banks who helped bring them into the world, and, eventually, American taxpayers. Paulson Goldman Sachs Fraud Case. Paulson & Co. worked to allay investors' concerns over the hedge fund's involvement in the Goldman Sachs fraud case. Although Paulson & Co. is not being charged with fraud, the SEC has charged that Goldman Sachs defrauded investors by not telling them that Paulson was betting against a subprime debt product. The hedge fund is trying to reassure investors that the lawsuit does not directly involve Paulson & Co. and that it did not act unlawfully. Paulson, in a conference call on Monday and followed up with a letter to investors late on Tuesday, says neither he nor anyone else at the firm had received a so-called Wells notice indicating that charges might be filed against the fund, several investors who listened to the call said.
No one had yet notified the $32 billion fund of their intentions to pull money out, they said. A spokesman at Paulson & Co, which earned $15 billion by correctly betting in 2007 that the U.S. housing market would collapse, declined to comment. Source.