S.E.C. Comes Out Swinging Against Goldman Sachs

By Justin Gardner | Related entries in Law, Money

Between this and their “high frequency trading”…are we seeing karma coming back around on GS?

From NY Times:

Goldman Sachs, the Wall Street powerhouse, was accused of securities fraud in a civil lawsuit filed Friday by the Securities and Exchange Commission, which claims the bank created and sold a mortgage investment that was secretly intended to fail.

The move was the first time that regulators had taken action against a Wall Street deal that helped investors capitalize on the collapse of the housing market.

The suit also named Fabrice Tourre, a vice president at Goldman who helped create and sell the investment.

Of course Goldman is claiming this is unfounded, but I find it hard to believe that the S.E.C. would make such a specific, public pronouncement if they didn’t have some pretty iron clad evidence.

And when you look at the S.E.C.’s claims…it’s pretty damning stuff…

The focus of the S.E.C. case, an investment vehicle called Abacus 2007-AC1, was one of 25 such vehicles that Goldman created so the bank and some of its clients could bet against the housing market. Those deals, which were the subject of an article in The New York Times in December, initially protected Goldman from losses when the mortgage market disintegrated and later yielded profits for the bank.

As the Abacus portfolios in the S.E.C. case plunged in value, a prominent hedge fund manager made money from his bets against certain mortgage bonds, while investors lost more than $1 billion.

According to the complaint, Goldman created Abacus 2007-AC1 in February 2007 at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst. Mr. Paulson is not named in the suit.

Goldman told investors that the bonds would be chosen by an independent manager. In the case of Abacus 2007-AC1, however, Goldman let Mr. Paulson select mortgage bonds that he believed were most likely to lose value, according to the complaint.

Goldman then sold the package to investors like foreign banks, pension funds and insurance companies, which would profit only if the bonds gained value. The European banks IKB and ABN Amro and other investors lost more than $1 billion in the deal, the commission said.

“Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio,” Robert Khuzami, the director of the commission’s enforcement division, said in a written statement.

In short (heh!)…while Goldman was selling investments that the housing market would go up, they were betting that the housing market would go down.

But, regardless of whether or not Goldman will ever have to answer for this (buyer beware clauses, etc…), the good news about this announcement is that the S.E.C. is back and doing what they should have been doing all along…policing the market and the players within it.


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20 Responses to “S.E.C. Comes Out Swinging Against Goldman Sachs”

  1. Tweets that mention Donklephant » Blog Archive » S.E.C. Comes Out Swinging Against Goldman Sachs -- Topsy.com Says:

    [...] This post was mentioned on Twitter by Justin Gardner, Donklephant. Donklephant said: DONKLEPHANT: S.E.C. Comes Out Swinging Against Goldman Sachs http://ow.ly/175Mv9 [...]

  2. SpkTruth2Pwr Says:

    I was shocked when I read the story because it really was a very pointed and targeted claim by the SEC and more important, it will reshape the way in which we looked at the collapse of the financial market in 2008, as something more of deliberate reckless abandon rather than naive optimism.

  3. Chris Says:

    sacrificial lamb.

  4. Josh Cowan Says:

    For a really interesting look at how one company made a FORTUNE making the crisis worse, check out: http://www.thisamericanlife.org/radio-archives/episode/405/inside-job

  5. Josh Cowan Says:

    Sorry for the double post but for those who wish a more in depth and text version of the Magnetar story, check out: http://www.propublica.org/feature/the-magnetar-trade-how-one-hedge-fund-helped-keep-the-housing-bubble-going

  6. Mike A. Says:

    more of a sacrificial wolf

  7. gerryf Says:

    Let the buyer beware! Free markets! Let them fail (but not really)! If only we had fewer regulations! Socialist!!!!!!

  8. Frank Hagan Says:

    We’ll have to wait to see if the charges are unfounded or have some meat attached to them. The SEC is not a divine agency, and has been known to overextend (ask Martha Stewart).

    The populist rhetoric about shorting a market causing it to fail is superstition. It is not a cause and effect relationship in the normal course of things. A short is simply a bet that the stock or security will fall; a long term stock strategy is simply a bet that the stock price will rise. If more people had shorted the mortgage market, those mortgage backed securities would have looked less attractive, and the market would have cooled. Instead, we had a government influenced expansion of a market that was – in retrospect – bound to fail because of other reasons.

    When you want to place a bet on who loses a game, the bookie gives you odds. After the initial setting of the odds of win-lose, the odds are adjusted by the “market” of bets … if more people “vote” by choosing the team you did, the odds become less favorable. But if you are alone in your assessment, the odds are more favorable for you.

    There is no cause and effect with the bet against the mortgage market unless GS is manipulating things behind the scenes to induce failure in it. The investors who bought the short position were the smart people; they saw the government induced disaster coming.

    There may be malfeasance here, and the SEC may be right. But we need to be careful about assuming that government prosecutors must have iron clad evidence because they brought a case.

    The mortgage crisis has several villains, all of them political. The republicans who allowed banks to sell risky investments and then colluded to bail them out when they failed (you do one, or the other, but not both). The democrats who pushed for the end of “red lining” and had regulatory agencies hover over brokers to make sure they weren’t discriminatory against poor people. President Bush, with his “ownership society” rhetoric.

    There’s plenty of blame to go around in DC; that’s why they are looking at someone else to blame.

  9. Justin Gardner Says:

    Frank, fair enough, but there’s plenty of smoke here.

  10. Josh Cowan Says:

    I wonder if anyone would be willing to share their perspective on a “hypothetical” scenario with a couple of alternatives. I ask because I genuinely am not sure how I feel about it.

    Scenario:

    If an investment bank were to create a product that they believe would likely fail and the bank secretly bets against the instrument while at the same time selling the instrument to people who believe the instrument will succeed. Has the bank done anything wrong?

    Alternatives to Scenario 1:

    What if the Bank isn’t sure if the product will fail so they just hedge their bets. Is the amount of the hedge indicative of their real intentions? INOWS, if the hedge makes a lot more money than the bet does that tell us something?

    Alternative 2: The bank does everything laid out about above, but the bet against the instrument is openly and fairly disclosed. Has the bank done anything wrong?

    I tend to feel that if there is transparency to the situation, (which of course there wasn’t but transparency was not legally mandated) then it is O.K. The one caution is that these instruments are so complicated that it is not clear to me that anyone could really tell what they were buying. After all, they consist of a huge amount of finely sliced financial instruments. Further, the rating agencies are too co-opted to provide much guidance.

    But I’m curious what others think.

  11. gerryf Says:

    No, no, no—not fair enough, Justin! Not fair enough at all!

    I was certainly being glib with my response, but DO NOT let Frank get away with changing the issue being discussed, which is all to common whent he right needs to defend one of their fair-haired stepchildren.

    This is not about Goldman Sachs CAUSING the mortgage crisis. No one said it was.

    Hedge fund manager John Paulson saw the mortgage crisis coming just like a lot of people did (like, for example, heck, ME–and as Kranky Kritters likes to say, I’m not even that smart.)

    Paulson was so sure that many of those CDOs would default that he wanted to short them, or bet against them paying off. OK, as much as a I find shorting deplorable, that’s what hedge fund managers do — they look for inefficiencies in the market and exploit them.

    Nothing illegal there, even though perhaps it should be.

    But Paulson, if the SEC charge is accurate, wasn’t just a passive investor. Armed with the almost certainty the mortgage market is going to tank, Paulson goes to Goldman Sachs and asks the investment bank to CREATE mortgage-backed bonds WITH THE EXPRESS INTENT OF HIM SHORTING THEM.

    Goldman Sachs agrees, taking a $15 million payment from Paulson for doing so. AND THEN GOLDMAN SACHS GOES A STEP FARTHER.

    It allows Paulson to pick the mortgages that would be bundled into bonds — the mortgages that Paulson thought would be most likely to fail.

    And it get’s better!

    Goldman then sold those tainted, Triple A-rated (LOL–they knew they were not truly triple a because the picked them!) bonds to unwitting Goldman clients, collecting another hefty fee in the process.

    And then, like Paulson, GOLDMAN SACHS placed secret bets that the bonds it had sold to IT OWN trusting clients that the bonds would fail.

    In effect, Paulson and Goldman had inside information that the CDOs they were creating would more than likely fail, because they had designed those instruments to do exactly that (within a year of their creation, 99 percent of bonds in question had indeed been downgraded). But Goldman’s clients that bought those CDOs were not privy to that knowledge.

    If the SEC is correct, GOLDMAN SACHS and PAULSON colluded to DEFRAUD Goldman Sachs investors!

    That is what we are talking about!

    To take Frank’s lame apologist analogy further, this would be like the bookies taking bets and then going out and breaking the leg of the star player on one team so they could win the most money.

    Sorry if I seem irate about this, but letting Frank change the subject to make it sound like Goldman Sachs was just caught up in something is utter nonsense.

  12. Jim S Says:

    Another reason Frank’s critique isn’t fair is that the bad actors in this are not solely political. Telling institutions they can’t discriminate is not the same thing as telling them to make bad loans. That particular lie has been disproved already.

  13. Nick Benjamin Says:

    There is no cause and effect with the bet against the mortgage market unless GS is manipulating things behind the scenes to induce failure in it. The investors who bought the short position were the smart people; they saw the government induced disaster coming.

    This is fraud because they lied to investors. Period. Regulation, deregulation, etc. are irrelevant. Goldman designed a product that was virtually worthless because it had a high risk of failure. They knew that because they’d helped design it that way. Then they told investors it was AAA.

    Don’t get me wrong. I’m not blaming Goldman et al. for the mortgage crises. A widespread market failure in something as highly regulated as financial agreements must ultimately be blamed on the regulators. There are always idiots doing stupid things, it’s a regulators job to make sure their stupidity only a brings themselves down and not the entire dang economy.

    But this particular case is only tangentially related to the crisis. The issue is simple: Goldman designed a shitty product, and then claimed it was absolutely perfect. That’s fraud. Period. They’re lucky they’re Goldman-Sachs, because if anybody else pulled this kind of crap they’d be in criminal court.

  14. Frank Hagan Says:

    Nick, you could be right. GS may have indeed committed fraud. My concern is that populist rhetoric throws the babies out with the bathwater. Its never as simple as “big bad rich people”.

    And I don’t consider a prosecutor filing a lawsuit as ever evidence of a clear cut case … especially in a politically charged atmosphere. The only thing more powerful than a huge financial institution, with more potential for corruption, is a huge government agency trying to salvage its reputation.

    The cozy relationship between the top banking people and our Presidents (even President Obama) should cause us all concern. It may be time for a little trust busting in the style of TR.

  15. Nick Benjamin Says:

    @Frank
    It’s possible the SEC is wrong on this case. But given that Goldman has not denied these claims, and the SEC isn’t going after the obvious political target (Paulson & Co. is a hedge fund, and they profited handsomely from the transaction), IMO the SEC is probably right.

  16. the Word Says:

    @Frank
    you said
    Its never as simple as “big bad rich people”.

    Having worked for years in that industry, don’t ever say never. You’d be surprised how many people will do anything for money and some will do even more for lots and lots of it.

    Unions could easily teach ethics to most of the people I encountered in that field.

  17. blackoutyears Says:

    I’m always bemused by the idea that the housing collapse was all due to the evils of gov’t. It’s almost as if the crisis occurred without lenders making spurious loans to un- or under-qualified borrowers. Or like it’s not the fault of the lenders/borrowers? And anyway, Frank’s defense of Wall Street’s role in the crisis (an increasingly popular one on the right thanks to the effrots of the WSJ and other financial opinion makers) is being misapplied here…

  18. Chris Says:

    That industry is the sociopath’s method of getting rich.

  19. kranky kritter Says:

    GS (or any other investment firm) has an obligation to market any securities it creates/ packages in good faith. Whatever they are selling gets sold with some sort of explanation of why it’s a sound investment. And morally and legally, they have to believe what they are saying.

    If they don’t really believe it’s a sound investment and are at the same time taking direct actions that demonstrate that they as an entity in fact believe it’s a foolish investment, then they are committing fraud.

    Caveat emptor doesn’t free them, not when they have positioned themselves as knowledge professionals with particular expertise.

  20. medlaw Says:

    “In short (heh!)…while Goldman was selling investments that the housing market would go up, they were betting that the housing market would go down.”

    As gerryf stated in his elucidative comment, Goldman did not generally bet against the housing market. They placed bets against the very mortgage derivative securities they themselves had created and promoted. It’s very ugly. Obviously the ratings agency had to be in on the scam as well. I’m wondering why this is not a criminal matter.

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