So if you heard the news at all on Friday you no doubt heard about a suit filed by the SEC against Goldman Sachs. The suit alleges that Goldmand Sachs (GS) mislead investors with a collateralized debt obligation (CDO) they were selling. The suit claims that GS sold the product knowing full and well that the mortgages backing the security would fail. Imagine buying a house from a builder that knew it would burn down in 8 months. It’s obvious to me and the rest of the investment community that this is a bunch of crap, but we’ll get to that.
Most people don’t really know what Goldman Sachs or an investment bank of any kind is. Investment banks (IBs) are mostly foreign to people like you and me. We don’t ever encounter them, because we aren’t their clients. Much of what GS does is business to business. When Google went public, GS was one of the banks involved in making that happen (they were dumped before the IPO though). When a government needs to raise $100 million to build new schools, it’s banks like Goldman Sachs that are facilitating the transaction by finding investors and pricing the bonds. They are a broker of sorts. IBs also do a lot of institutional investing, providing services for other banks, pensions, and hedge funds. Investment banks range in size from the very small (5 or so people) to tens of thousands of people.
So let’s look at this transaction in greater detail. Goldman was packaging together a CDO that would be called ABACUS. As a part of the deal, an independent party would pick the mortgages that went into it. This party is called ACA Management. They selected the actual mortgages that would be in the portfolio of this CDO. Another person, John Paulson, who runs his own hedge fund, made some suggestions to add or take out certain mortgages. ACA was free to comply with Paulson or ignore the requests all together. ACA had the final call.
The issue comes in around Paulson. This was in early 2007, and he’d been shorting mortgages for a while now (he later made billions doing this). ACA asked the Goldman Sachs banker, Fabrice Tourre, if Paulson was long or short on this CDO. Tourre, in a roundabout way, may have tried to convince ACA that he was long, as in he was expected to buy part of the CDO expecting the values to increase. In reality, he was short. This is the central issue here, whether or not Tourre told ACA and other investors that Paulson was short.
In the end of course the CDO performed miserably and investors lost a lot of money on the whole deal. Paulson made a lot. The SEC is claiming that Goldman and Tourre committed fraud by misleading investors in the ABACUS CDO. The courts will have to decide that one. But there a number of facts that may make this a weak case in court.
- The Department of Justice won’t touch this case. There isn’t enough in it to warrant a criminal case. This is a civil lawsuit.
- Goldman was the broker of this deal. They made a fee on the transaction ($15 million) whether the CDO did well or not. They had no reason to lie about Paulson’s position.
- For the SEC to stand a chance, they’ll have to get ACA to admit that one tiny dude (Paulson) would have actually impacted their decision making process. They would have to say that despite the fact that they employ dozens of MBAs and pay millions of dollars to make the right decisions, they weren’t smart enough to see what what going on. Remember this isn’t grandma and grandpa getting frauded, ACA and the investors of ABACUS were sophisticated bankers themselves.
- Goldman had no reason to design a portfolio that would lose money. Because they owned part of ABACUS themselves (it’s not uncommon for an IB to invest in their own deal). All told, they lost $90 million on the deal.
- ACA, which was also the biggest investor, had done 26 such transactions prior to this one. They were hardly amateurs even in the CDO market.
- Paulson was known throughout Wall Street as a short investor of mortgages. It should be assumed that he will be short on this one. If ACA wanted clarification, they could have asked for a plain english answer from Tourre instead of the financial jargon response he gave.
But none of this matters. Again this is a civil case. Goldman will claim innocence and negotiate a settlement that will set them back the same way you’re set back by gas prices going up 3 cents. The SEC and Obama will claim victory, having finally beat down the one bank that managed to profit from the financial crisis. I’m not kidding, people hate GS simply because they made money when we all lost it.
But even that doesn’t matter. What does is the timing of the announcement of this case. See, the SEC had some bad press on Friday. But, no one was paying attention to it. Do you remember the Stanford guy who was running a Ponzi scheme in Texas? Well, the inspector general of the SEC announced yesterday that his investigation into the SEC’s handling of Stanford has shown some serious issues with the SEC. As it turns out, the SEC knew about Stanford back in 1997! But because the culture of the SEC at the time supported quick cases that were open and shut, the SEC examiners were unable to get the enforcement group to investigate further.
Was it a coincidence that the SEC announced their biggest attempt at looking like a hero the same day another agency announced they found the SEC to be an incompetent bureaucracy. I’m no conspiracy theorist, but that’s pretty convenient.
There a lot of sources in this post, but I don’t have them all. I’ll just list a few at the bottom if you want more reading.
WSJ
Business Insider
BusinessWeek
Goldman Sachs PR
 By The Weakonomist |
The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice. |
