For months now and by way of several articles, I have written extensively on what I called the financial weapon of mass destruction, the credit default swap (CDS), a form of credit derivative. Today the SEC brought a civil suit against Goldman Sachs alleging fraud.
“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 certainly is bringing the concerns into mainstream media finally. However, I think it is sad and even criminally negligent that both in this case and the case brought by Bloomberg against WAMU are both private actions brought by private entities. My question is where is our government and our government regulators? Where is the Department of Justice? Where is the Department of the Treasury? Where is CONgress?
While I am certainly happy to see some action being taken against the banksters, I can only wonder why there aren’t criminal indictments. Trillions of dollars are involved here. Millions of people have been ripped off and our government is silent!
The action today clobbered the markets with the DOW dropping over 125 points. That alone can be calculated in additional losses in the tens of millions of dollars. What is interesting also is that the hedge funds and others such as JP Morgan Chase are still untouched. Are they untouchable and why are they untouchable.
I suspect this is the tip of the iceberg and I hope our government will get their act together. I don’t think they can play stupid any longer and I don’t think anybody that is breathing doesn’t know what’s up. Our government must act now and act forcibly. It’s time to start the process of dealing with the real issues. Those issues are fraud, greed and the lack of meaningful and necessary regulatory reform. It also offers some hope that duped investors may at long last have a legal vehicle and opportunity to recoup some of their lost investments. Alas as always, lawyers are going to make a ton of dough but the world is far from perfect and just. At least these arrogant, greedy Wall Street boys are finally about to get the spanking they need and are long overdue in getting. I must admit I am getting these very humorous mental images of Biff, the Wall Street darling meeting Bubba, king of cell block B!