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SEC Charges Goldman Sachs With Fraud in Structuring and Marketing of CDO Tied to


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SEC Charges Goldman Sachs With Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages

http://www.sec.gov/news/press/2010/2010-59.htm

 

"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.

 

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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."

 

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After reading the charges it appears that Goldman if it has any sense will settle with the SEC ASAP for an amt of double the losses and promise never to do it again. This is certainly the track record of the SEC they have had a history of punishing individuals harshly, however never firms or certainly not large ones. The particulars are abhorent if the charges are true which I have no doubt are .

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Now if they were doing this the old fashioned way, the fed reserve would also be suggesting to Goldman that they make a minor show & cave. After all, how much is your primary dealer status worth to you? .... & how could we possibly be seen to be upholding "market fairness" - when one of our primary dealers is being sued by the SEC on very serious charges?? 

 

Don Corlieone's world might be messy at times, but there's no doubt that it works.

 

We live in interesting times.

 

SD

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    I agree this will most likely end in a settlement for expedition, but IMO the SEC's case depends way too much on 20/20 hindsight.  In early 2007, Paulson was far from the visionary he is often credited today.  If fact, we was often mocked and riduculed as a reckless newcomer by those who had been operating in the structured RMBS for two decades.  ACA prided themselves on their expertise and reputation.  Having dealt first hand with the decision makers at ACA, I strongly believe they would not have been scared away from what they considered their circle of competence by a macro hedge fund "outsider".  ACA reviewed line-by-line and put their reputation behind the reference pool and their capital behind the $909mm super-senior tranche because of their own research, not whether Paulson was net long or net short.

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     I agree this will most likely end in a settlement for expedition, but IMO the SEC's case depends way too much on 20/20 hindsight.  In early 2007, Paulson was far from the visionary he is often credited today.  If fact, we was often mocked and riduculed as a reckless newcomer by those who had been operating in the structured RMBS for two decades.  ACA prided themselves on their expertise and reputation.  Having dealt first hand with the decision makers at ACA, I strongly believe they would not have been scared away from what they considered their circle of competence by a macro hedge fund "outsider".  ACA reviewed line-by-line and put their reputation behind the reference pool and their capital behind the $909mm super-senior tranche because of their own research, not whether Paulson was net long or net short.

I do not know ACA at all  I am shocked however that by early 2007 there was any one foolish enough to gaurantee any tranch of a pool which consisted of a bunch of junior tranches of subprime mortgages. My own experience is that in many firms NO-ONE was driving the bus you had employees taking on all kinds of unkown risks that senior mgmt was unaware of. I know  first hand that the CEO of one bank became aware of his firms exposure to triple A tranches of subprime when a hedge fund which was short his companies stock called and started asking him lots of questions about one particular traders positions which ended up costing this company many billions of dollars.It is interesting that it basically the British tax payer that paid for this as RBS ended up with the ultimately liability on the CDS which were sold to Paulson.

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I do not know ACA at all  I am shocked however that by early 2007 there was any one foolish enough to gaurantee any tranch of a pool which consisted of a bunch of junior tranches of subprime mortgages.

   It certainly seems foolish now, but at the beginning of 2007 the RMBS industry (investors, rating agencies, banks, originators, etc.) were enjoying the fourth-year of a housing-based party where everyone one was getting rich.  There were strong signals that the system was cracking, but the industry consensus maintained (wrongly, of course) that Baa2's backed by sub-prime mortgages were still good investments.  (Without this broad consensus, Paulson would never had the opportunity to make so much money.)   In this transaction, the risk wasn't just on ACA.  What is not clear to many is that at closing GS retained the risk of $1.65bln of the $2.0bln reference pool of Baa2 subprime mortgages.  Their motivation was a fee and the belief they could lay off the risk.  Would GS have taken this risk if not for the belief that the pool would maintain its credit health?

    As it turned out, GS laid off some risk to IKB who took comfort from the Aaa rating and the reputation of ACA.  GS laid off the super senior to ACA who took comfort in their own ability to select good credits and that fact that their attachment point was 45% (ACA's first $ of loss would not happen unless 45% of the pool defaulted with no recovery).  GS wasn't able to transfer the remaining risk and ended up loosing millions on the risk they retained.  I see no conspiracy here.  

   The SEC assumes that because GS is "smart" they could predict the future and must have known these were bad assets, and in order to get their $15mm fee and get the deal done they had to defraud ACA.   The SEC gives too much credit to GS.  GS was just enjoying the party.

 

Disclosure: Went long GS due to percieved market overreaction.

 

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I agree there was risk but the Goldman e-mail reminded me of the dot com companies they and others brought to market.  This liability is part of the reason they get the fees they do.  Although at times their business appears to print money, there are risks.  I wonder how this will play with other sub-prime deals.  If you watched the Mike Lewis piece on 60 minutes, it appears GS sold AIG a good amount of short CDS contracts that the gov't had to make good on.  In that case, M. Burry asked GS to put together a security he could make money on if sub mortgages went bad.  If their are similar trash e-mails about this deal, then they may have a case.  In addition, GS has deep pockets and they have not engraciated themselves to the public by reducing their salaries and taking more stock.   

 

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From the SEC complaint:

http://online.wsj.com/public/resources/documents/secgoldman2010-04-16.pdf

 

18.    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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I find it interesting that Paulson is not prosecuted by SEC. Apparently because he did not promote or sell the products. He designed the product, then bet against it, making $1 billion. It would be like designing a pill to make you happy (richer whatever), knowing that it is poison, and blaming the pharmacy for selling it and having no accountability at all.

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I find it interesting that Paulson is not prosecuted by SEC. Apparently because he did not promote or sell the products. He designed the product, then bet against it, making $1 billion. It would be like designing a pill to make you happy (richer whatever), knowing that it is poison, and blaming the pharmacy for selling it and having no accountability at all.

 

The best analogy I can think of is this:  It's late 2006 and you see a big imbalance in home supply in CA, AZ, NV, and FL.  You are an institution and want to make a bet that the housing market will crumble (against prevailing opinion).  You approach Vanguard (or any other similar institution) and say you would have interest in shorting an institutional ETF populated with home builders, mortgage originators, developers, REITs, building suppliers, etc. who do a lot of business in these states.  Vanguard responds that due the recent bull market they have also recieved interest in a housing ETF from other institutions who think the boom will continue.  Vanguard says they will create a housing ETF but they want a set of nationwide companies.  You say your interest is primarily these states.  You negotiate back and forth and agree on a regional housing ETF that includes CA, NV, AZ, & FL, plus TX, NM, LA, MS & GA.  All ETF holdings are fully disclosed in a prospectus and the deal closes.  You make your bet and within the next year make you a lot of money.  Are you a candidate for prosecution by the SEC?

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Paulson & Co and other hedge funds shorted RBS and other UK banks during the credit crunch. Guess he took advantage of them twice, 2nd time around I bet he was thinking about what incompetence for RBS to acquire ABN with all the toxic assets they held on their books.

Goes to show you shouldn't trust your broker for anything, research, trade ideas ... especially if they're on the other side.

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You say your interest is primarily these states.  You negotiate back and forth and agree on a regional housing ETF that includes CA, NV, AZ, & FL, plus TX, NM, LA, MS & GA.  All ETF holdings are fully disclosed in a prospectus and the deal closes.  You make your bet and within the next year make you a lot of money.  Are you a candidate for prosecution by the SEC?

 

 

Difference between this example, and what Paulson/GS did was that Paulson actually had meetings with ACA (Vanguard in your example), and gave the impression that he was going to go long, not short. And then ACA (Vanguard) had meetings with Mr. Tourre and he mislead them saying that Paulson was going to go long. Tourre and GS had a motive to mislead on two counts; 1) for the fee and 2) to offload risk onto ACA, ABN and IKB.

Then ACA (Vanguard) got other investors in the vehicle (ETF) - ABN and IKB - also on the marketing / selling of the premise that Paulson was going long.

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Difference between this example, and what Paulson/GS did was that Paulson actually had meetings with ACA (Vanguard in your example), and gave the impression that he was going to go long, not short. And then ACA (Vanguard) had meetings with Mr. Tourre and he mislead them saying that Paulson was going to go long. Tourre and GS had a motive to mislead on two counts; 1) for the fee and 2) to offload risk onto ACA, ABN and IKB.

Then ACA (Vanguard) got other investors in the vehicle (ETF) - ABN and IKB - also on the marketing / selling of the premise that Paulson was going long.

 

OK fair.  Lets change the scenario slightly.  Now what if you approached Vanguard without stating your position one way or the other, but Vanguard simply assumed you are a long investor (because of the overwelming bullish consensus in the market). If you make no effort to clarify your intentions, are you subject to prosecution?

 

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I find this charge to be outrageous political thuggery.  If you read closer, this is not a CDO but a synthetic CDO.  With a synthetic CDO the underlying securities are not mortgage bonds but credit default swaps.  I buy cds indexed against certain reference securities and the premiums I pay for insurance go toward paying the yield on the cdo to the investors.  Therefore it is 100% impossible for the investing parties to be unaware there was a short side of the trade.  The real criminals are the stupid investors stretching for an extra few pennies of yield- they deserved to lose money on the trade.  Just because some young kid sends out stupid boastful emails to friends doesn't mean fraud was committed. This deal was obviously cherry picked because it looks bad and it involves GS (deutsche bank was the main player in this market and there is no doubt they've done more questionable stuff).

 

With that said, GS and other banks did shameful things in the creditj boom, but so did the politicians running GSEs, speculators flipping houses and familiesnof modest means purchasing McMansions and investors fueling the boom with dumb money.

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I would agree with you if the US and other tax payers did not have to bail the folks out who bought the securities that others shorted.  In addition, one of the risks Goldman Sachs took when it facilitated this deal with "trash" bonds is that it may be held partially responsible.  This is not simply facilitating a bad deal but doing the deal knowing the bonds were trash and someone else would buy them.  Part of Goldsman fees must include a certain level of due diligence associated with deals that have their name on it. 

 

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Guest ValueCarl

I don't know when this former "Fast Money" addict became a good guy-great car analogy he uses-a man who I often poked fun at for his short sighted program, one where degenerate gamblers would be duped in order to bolster his audience ratings and personal pay, but he's sure got it SPOT ON here. At the same time, having a GEICO commercial lead him off with Warren's personal homage having been PAID to GOLDMAN IMAGES at the same time bowing down to their GOLDEN CASH COW, seems funny at a minimum. What a TANGLED WEB, WEB spins.  8)

 

http://www.msnbc.msn.com/id/21134540/vp/36604057#36604057

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Yeah, I really hate the whole broker/market maker argument that Blankfein and the Goldman PR department keep repeating over and over again. 

 

When I buy a stock through my online discount broker, the broker doesn't make any representations regarding the prospects of the underlying business -- they merely act as a conduit for the transaction between the individuals who are either long or short on the trade.  My broker does offer some research tools and opinions from third parties, but the broker itself makes no representations regarding the stock.

 

This situation is different.  Goldman actually underwrote these investment vehicles, playing the part of a manufacturer/assembler.  In order to offload their assembled product, they selectively and inaccurately disclosed information about the selection of the underlying reference collateral.  They made it appear that  this third party financial guarantor, ACA, was the only entity involved in selecting the underlying reference collateral.  But in reality, the sponsor of the SPE, Paulson & Co, was quite involved in the selection of the reference collateral.  Furthermore, Goldman omitted the fact that the sponsor was actually net short the underlying reference collateral -- they may have even given the buyers the impression that Paulson was long only.  This was a truly despicable and material misrepresentation/omission on Goldman's part.

 

This enforcement action brings up the philosophical question about whether it's a good idea to allow a prop trading operation, broker/market maker, asset management company, and investment bank to be housed under one roof.  Essentially, the client agnostic operations get the good reputation of the investment bank division, and the investment bank no longer has any skin in the game because their exposure can be hedged out across the entire company.  The incentives are even more perverse because the client agnostic operations dominate in terms of providing the firm's profits.  I think we want a system where the investment banks are concerned about the quality of their offerings and are not merely trying to maximize the volume of and spread associated with these transactions. 

 

At the very least, these companies should give the buyers of their assembled products full and complete disclosure.

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I find this charge to be outrageous political thuggery.  If you read closer, this is not a CDO but a synthetic CDO.  With a synthetic CDO the underlying securities are not mortgage bonds but credit default swaps.  I buy cds indexed against certain reference securities and the premiums I pay for insurance go toward paying the yield on the cdo to the investors.  Therefore it is 100% impossible for the investing parties to be unaware there was a short side of the trade.  The real criminals are the stupid investors stretching for an extra few pennies of yield- they deserved to lose money on the trade.  Just because some young kid sends out stupid boastful emails to friends doesn't mean fraud was committed. This deal was obviously cherry picked because it looks bad and it involves GS (deutsche bank was the main player in this market and there is no doubt they've done more questionable stuff).

 

    Agreed.  I doubt there would be as much indignation if people understood the nature of a synthetic CDO.  In every synthetic, someone (or sometimes many) must be short.  In the institutional arena, this is an accepted fact and it is not required information for disclosure.  If it were required, where would it end?  Did Prem's motivation get disclosed when his handpicked CDS contracts were placed in corporate synthetic CDO's?  Did WEB's motivation get disclosed to the sellers when he bought back his customized put options on the S&P?  How about PIMCO selling Treasuries they think will underperform to mutual funds, would that need to be disclosed too?  How about any institution that had input into the construction of a specialized ETF that intended to short it, should that be disclosed also?  The answer is no because the counterparties are institutional investors with research capabilities, not babes in the woods. 

    The institutional investors involved in the ABACUS deal were experienced, savvy, and had executed billions of these types of trades for years.  The SEC claim of their victimhood doesn’t pass the laugh test. The refence pool was not a blind pool.  GS made a line-by-line disclosure of every item in the reference pool so that all investors could perform the necessary credit work.  This is full and complete disclosure when dealing on an institutional level.  Sadly for ACA and IKB, their credit work was not as good as Paulsons.  But that is not GS fault, and I suspect ACA and IKB know this too.  If ACA and IKB felt defrauded, you have to ask why have they not brought suit on their own by now?

 

Disclosure : Long GS

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Agreed.  I doubt there would be as much indignation if people understood the nature of a synthetic CDO.  In every synthetic, someone (or sometimes many) must be short.  In the institutional arena, this is an accepted fact and it is not required information for disclosure.  If it were required, where would it end?  Did Prem's motivation get disclosed when his handpicked CDS contracts were placed in corporate synthetic CDO's?  Did WEB's motivation get disclosed to the sellers when he bought back his customized put options on the S&P?  How about PIMCO selling Treasuries they think will underperform to mutual funds, would that need to be disclosed too?  How about any institution that had input into the construction of a specialized ETF that intended to short it, should that be disclosed also?  The answer is no because the counterparties are institutional investors with research capabilities, not babes in the woods.

 

I could understand your analogy if they were going after Paulson...they are not.  They are going after Goldman, who was the bookie.  The problem was that the game was fixed...they knew the outcome and were betting on it.  There is a very clear ethical dilemma in what they did...even back when they were actually doing it, not just in hindsight.  The federal government believes that the context of their argument is in the best interest of investors.  I couldn't agree more!  Are they the only ones guilty?  Of course not.  Should the counterparties and other investors be held responsible for their losses?  Yes, and they have lost fortunes.  Cheers! 

 

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While you may be right in the details and the letter of the law the big picture and intent of allowing an intermediary play both sides of a transaction and structure a deal they new was not prudent is poor management and supervision much like Solomon when WAB had to take over for awhile.  This would be water under the bridge if these banks imposed some type of self-disciple on these transactions.  Absent this, the gov't will gladly take on the regulatory responsibility. 

 

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