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The Goldman Thing

Courtesy of Econophile

From The Daily Capitalist

Since most of our legislators, bureaucrats, and White House residents have no idea what caused the Great Recession, they are itching to blame it on someone, and that “someone” is Goldman Sachs, the arch-capitalist of our time. As if fraud was the cause of all of our problems. It’s like blaming greed.

Let me first get it on the table: I am not defending Goldman Sachs. The point of this article is to defend free market capitalism which has been incorrectly branded as the villain in our economic crisis. If Goldman defrauded their clients, they should pay the price.

The information on this case is too new to evaluate, and without further analysis of the complaint and the facts, I will withhold judgment. I would like to review the Abacus 2007-AC1 prospectus or PPM and the allegations of misrepresentation and fraud before I condemn Goldman. I have analyzed similar deals in the past and I would like to compare this one to what I believe was the norm for disclosure.

It sounds bad for Goldman now, and while it may very well be all true, the government loves to trot out the juicy bits for press conferences which the press loves, such as Mr. Tourre’s email. As you all know, (i) you can’t always trust what prosecutors say and (ii) there’s always more to the story.

I also have a healthy suspicion of “economic crimes.” These are crimes not based on ethics, traditional crimes, or a violation of someones rights by the perpetrator, but are crimes “against the people” as defined by legislators or some economic czar. Not to stir up a debate here, but insider trading is one example of the government trying to create a “level playing field.” The distinguished economist Henry Manne has spent a lifetime showing why that is incorrect and irrelevant.

Yet today many pro-capitalism economic writers were quick to criticize Goldman. Mish Shedlock came out with an article today that blasted Wall Street ethics:

Sadly, this business screws the client for a fee time and time again because there is no ethics, no sense of fiduciary responsibility, and no walls on separation of duty to prevent fraud. …

You might wish to read his piece since it’s very critical.

I don’t mean to be blasé about this or be overly critical of Mish because I think he’s one of the best economics writers, but anyone who has ever worked on Wall Street knows that the first thing anyone thinks about is how much money they can make off of deals. That’s the goal, the motive, the driving force. And it’s not new. Of course that doesn’t excuse civil or criminal wrongs. But what it does mean is that you’ve got to look out for your own position and your due dil better be more than good. Caveat emptor. That’s just the way it is and everyone knows it. I am sure you are all shocked by this revelation.

Yes, there are many fine people in the business who do put their clients’ interests before their own. But so what. Do I wish that ethics were better? Of course. But don’t be surprised when in a world where people lie awake at night thinking about how to make more money, some very big players lose money in a deal.

Here is the gist of the complaint as reported in the SEC press release:

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.

Today Goldman sent this email out to their clients explaining their version of the case:

NEW YORK, April 16, 2010 — The Goldman Sachs Group, Inc. (NYSE: GS) said today:

 

We are disappointed that the SEC would bring this action related to a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact.

 

We want to emphasize the following four critical points which were missing from the SEC’s complaint.

  • Goldman Sachs Lost Money On The Transaction. Goldman Sachs, itself, lost more than $90 million.  Our fee was $15 million. We were subject to losses and we did not structure a portfolio that was designed to lose money.
  • Extensive Disclosure Was Provided. IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities.  The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side.
  • ACA, the Largest Investor, Selected The Portfolio. The portfolio of mortgage backed securities in this investment was selected by an independent and experienced portfolio selection agent after a series of discussions, including with Paulson & Co., which were entirely typical of these types of transactions.  ACA had the largest exposure to the transaction, investing $951 million.  It had an obligation and every incentive to select appropriate securities.
  • Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor. The SEC’s complaint accuses the firm of fraud because it didn’t disclose to one party of the transaction who was on the other side of that transaction.  As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor.

Background

In 2006, Paulson & Co. indicated its interest in positioning itself for a decline in housing prices.  The firm structured a synthetic CDO through which Paulson benefited from a decline in the value of the underlying securities.  Those on the other side of the transaction, IKB and ACA Capital Management, the portfolio selection agent, would benefit from an increase in the value of the securities.  ACA had a long established track record as a CDO manager, having 26 separate transactions before the transaction.  Goldman Sachs retained a significant residual long risk position in the transaction.

 

IKB, ACA and Paulson all provided their input regarding the composition of the underlying securities.  ACA ultimately and independently approved the selection of 90 Residential Mortgage Backed Securities, which it stood behind as the portfolio selection agent and the largest investor in the transaction.

 

The offering documents for the transaction included every underlying mortgage security.  The offering documents for each of these RMBS in turn disclosed the various categories of information required by the SEC, including detailed information concerning the mortgages held by the trust that issued the RMBS.

Any investor losses result from the overall negative performance of the entire sector, not because of which particular securities ended in the reference portfolio or how they were selected.

 

The transaction was not created as a way for Goldman Sachs to short the subprime market. To the contrary, Goldman Sachs’s substantial long position in the transaction lost money for the firm.

Goldman isn’t going to role over on this one so the SEC has a huge fight on its hands.

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