Note: James writes in TV Doubleheader: "Simon [Johnson] and I are both on Bill Moyers (first half) tonight [4/16]. Then Simon is on Real Time with Bill Maher. Enjoy." Simon and James are authors of the newly released book "13 Bankers: The Wall Street Takeover and the Next Financial Meltdown
SEC Charges Goldman with Fraud
Courtesy of James Kwak at Baseline Scenario
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. Goldman had a duty to disclose that influence, especially since Paulson was simultaneously shorting the CDO. (According to paragraph 2 of the complain, he bought the credit default swaps from Goldman itself. I used to wonder about this; if he bought the CDS from another bank, then Goldman could claim it didn’t know he was shorting the CDO, implausible as that claim might be. But in this case Goldman must have known.)
It seems like the key will be proving that Paulson influenced the selection of securities enough that it should have been in the marketing documents. Paragraphs 25-35 include quotations from emails showing that Paulson was effectively negotiating with ACA over the composition of the CDO, so it’s pretty clear he had influence. The defense will presumably be that ACA had final signoff on the securities, and Paulson was just providing advice, so Paulson’s role did not need to be disclosed. (I don’t know what kind of standard will be applied here.)
The complaint also alleges that Goldman misled ACA into thinking that Paulson had a long position in the CDO via the equity tranche, while in fact Goldman knew all along that he would short the debt tranches. It seems pretty clear that that’s what ACA believed. The implication is that had ACA realized that Paulson was shorting the CDO, they would not have gone along with the deal.
] were enough to do the job.And I don’t think this action contradicts my general point. I would love it if the SEC could nail banks for some of the CDOs they created, but I’m still betting that the vast majority will not create legal liability for them.
The type of transaction involved — in which a hedge fund makes a CDO as toxic as possible in order to then short it — is similar to the Magnetar trade, which I discussed earlier. One thing we learn from paragraph 5 is that Paulson sure knew how to pick ‘em:
“The deal closed on April 26, 2007. Paulson paid GS&Co approximately $15 million for structuring and marketing ABACUS 2007-AC1. By October 24, 2007, 83% of the RMBS in the ABACUS 2007-AC1 portfolio had been downgraded and 17% were on negative watch. By January 29, 2008, 99% of the portfolio had been downgraded. As a result, investors in the ABACUS 2007-AC1 CDO lost over $1 billion. Paulson’s opposite CDS positions yielded a profit of approximately $1 billion for Paulson.”
And once again, no doubt to the annoyance of many, I don’t blame Paulson. It’s Goldman that had the duty to its investors, not Paulson.
Fabrice Tourre of Goldman, however, who is named as a defendant? Well, he will forever be identified by the email quoted in paragraph 18, whatever it means:
“At the same time, 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.’”
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Simon Johnson, former chief economist of the International Monetary Fund, is a professor at the MIT Sloan School of Management, a senior fellow at the Peterson Institute for International Economics, and a member of the CBO’s Panel of Economic Advisers. He is a co-founder of The Baseline Scenario.
James Kwak is a former McKinsey consultant, a co-founder of a successful software company, and currently a student at the Yale Law School. He is not, never has been, and never will be a member of the Yale Law Journal. However, on December 11, 2009, he was named Grand Heresiarch of the Ancient, Hermetic, and Occult Order of the Shrill by Brad DeLong. He is a co-founder of The Baseline Scenario.
13 Bankers: The Wall Street Takeover and the Next Financial Meltdown
“The best explanation yet for how the smart guys on Wall Street led us to the brink of collapse. In the process, Johnson and Kwak demystify our financial system, stripping it down to expose the ruthless power grab that lies at its center.”
— Elizabeth Warren, Leo Gottlieb Professor of Law, Harvard Law School; and Chair, TARP Congressional Oversight Panel
