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

[onyx1]

The problem was that the game was fixed...they knew the outcome and were betting on it.  

 

    This is the single biggest misunderstanding about the entire sad episode.  The structure was never guaranteed to crash. It was not engineered to fail.  The game was far from fixed.  The reference pool was populated with run of the mill Baa's that at the time were quoted upon request from 10-15 different dealers.   At the time, virtually the entire market (GS included) thought Paulson was wrong.  Ask yourself how could Paulson pull off the single most profitable trade in history?  Because he was alone against the entire market!!  Paulson spent month after frustrating month trying to get investors to agree with his theory.  Many dismissed him, others mocked and riduculed him.  Paulson was simply so far ahead of everyone that the market had not recognized his brilliant conclusion yet.   The SEC won't be able to show any evidence that GS knew what the outcome would be, because there is no way of knowing the future.  What I believe that GS will easily be able to demonstrate is that at the time, the overwelming consensus (including GS) in the market was that sub-prime RMBS were still legitimate securities for investment.

[cman]

This is nicely sums up my argument: http://online.wsj.com/article/SB10001424052702303491304575188352960427106.html?mod=WSJ_latestheadlines&mg=com-wsj

 

synthetic cdo requires both long and short positions; the main premise of the suit is totally asinine and easily refuted by a 12 year old

 

Obama has learned a lot from his pal chavez! Sam Zell sure is right about political risk in the US.

[txlaw]

Let's clear up a couple of issues here.  

 

First, nobody is getting prosecuted.  The SEC has filed civil fraud charges against Goldman Sachs, and Goldman Sachs only.  No complaints have been filed against Paulson & Co or any other investors who may have taken similar actions (for example, Magnetar).  

 

Second, the fact that we’re dealing with synthetic CDOs is irrelevant.  Nobody is faulting the investors who purchased credit default swaps from Goldman on the mortgage-backed securities referenced in the synthetic CDO.  The fact that there is a long and short side to a CDS trade is not the issue.  Of course the synthetic CDO investors knew that this was the case.  However, these investors did not know that the pool of short bets (CDSs) was assembled under the influence of someone whose incentives were not aligned with these purchasers.  The underwriter, GS&Co, specifically indicated that the portfolio was being assembled by a party, ACA, that clearly had the same incentives as the purchasers.  ACA was long the reference portfolio because they were guaranteeing the CDO bonds.  

 

Third, ACA’s incompetence is irrelevant to the claim that Goldman committed fraud by failing to disclose material information.  ACA put their stamp of approval on these CDOs as collateral manager and paid for it by entering runoff when the shit hit the fan.  There's no question that ACA has no excuse for their incompetence.  But many Goldman defenders seem to be focusing on the part of the SEC complaint that states that ACA was misled because it is the easiest allegation to rebut.

 

Fourth, who was on the right side of the trade is also irrelevant.  It doesn't matter how Goldman or anyone else thought the reference portfolio would perform.  The key is that Goldman failed to disclose info that may have given potential investors pause before buying these synthetic CDO securities.  Wouldn't you think twice about purchasing a portfolio of securities marketed to you if you knew that the portfolio was assembled by someone who was net short these securities (or similar securities)?  

 

The key issues are: (1) whether Paulson & Co was involved in the selection of the reference portfolio, and (2) whether this information – Paulson & Co’s involvement – was material to the point where it should have been disclosed to potential investors.  Whether the information was material depends on the context of the situation.

 

Paulson & Co states that ACA had "sole authority" over selection of the portfolio and that they did not sponsor the creation of the ABACUS program.  The SEC claims that Paulson was heavily involved in the selection of the portfolio and never states that Paulson had “authority” over selection.  Additionally, the SEC’s complaint only talks about Paulson being the sponsor of a particular ABACUS transaction, not the entire program.  The PR people and Paulson’s lawyers have carefully crafted their response to the complaint.  

 

In Goldman’s marketing material, they specifically talked about ACA’s role as the collateral manager and guarantor for the CDOs, implying that ACA and ACA alone would be involved in putting together the synthetic CDO.  Indeed, internal conversations indicate that Goldman wanted to leverage ACA’s credibility in order to sell more of this stuff.  But Goldman conveniently failed to mention that in this particular transaction someone other than ACA was also involved in selecting the reference portfolio.  

 

And that’s where the SEC will get them because I think the failure to disclose that info was material.

 

Note: I am neither long nor short GS.

 

[txlaw]

This is nicely sums up my argument: http://online.wsj.com/article/SB10001424052702303491304575188352960427106.html?mod=WSJ_latestheadlines&mg=com-wsj

 

synthetic cdo requires both long and short positions; the main premise of the suit is totally asinine and easily refuted by a 12 year old

 

Obama has learned a lot from his pal chavez! Sam Zell sure is right about political risk in the US.

 

Actually, the idea that the SEC doesn't understand the difference between a cash CDO and synthetic CDO is truly asinine.  As I have noted above, that's a red herring argument.

 

The Journal is predictably espousing an opinion aligned with those on the wrong side of financial reform because of the upcoming elections.  Don't get me wrong, I read the WSJ every day for its news content -- but the opinion page is shit, just like the NYT's. 

[ubuy2wron]

If anyone has read Mr Lewis,s newest book the big short he deals with the abolute stupidity and venality of many of the paricipants. Mr personal favorite villan has to be Stan Oneal who personaly has to take responsiblitiy for blowing up Merriil Lynch where I spent almost half of my career I sometimes think the BOD were so out of touch that they appointed Stan CEO because the felt he represented  an extension of their proud Irish Catholic leadership heritage.

[arbitragr]

 

 

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.

 

 

The problem was that the game was fixed...they knew the outcome and were betting on it.  

 

    This is the single biggest misunderstanding about the entire sad episode.  The structure was never guaranteed to crash. It was not engineered to fail.  The game was far from fixed.  

 

You will be surprised how fixed the game is. I have worked for a broker/top 10 investment bank in the past, and market makers regularly take advantage of their clients b/c they have more information.

Example: if you have a stop loss on your position, it's registered on the system. with a bit of searching and maybe some technology, your broker will hunt for these stop losses, and especially if its a small volume position, will clear out all the stop losses with their own capital, and then buy it back and on sell that in a rising market or to buyers ('ask' side of the book) who are willing to pay a higher price. They can do this b/c they can see all the orders on the system, and see the market depth of volume.

 

this i found especially happened in the forex markets where the markets are unregulated without a central exchange. Brokers and market makers are talking to each other every day in the forex markets. Market makers have all the power in unregulated markets.

 

Another example is in a highly volatile market, brokers/market makers will increase the spread you pay just as you are about to put a trade in, especially if you have a limit order registered on the system.

 

My feeling is that b/c the CDS and CDO markets were unregulated the same sorts of advantages and behavior occured in those markets to/from the market makers.

 

If you think the game isn't fixed, then you are either inexperienced or naive. Market makers, especially ones that have smart, greedy and energetic people working for them (i.e. Goldman Sachs) always win ... or always try and fix the markets in their favor. The markets are not a casino, however the behaviour is similar to how the house always tries to fix the game in their favor with activity + insight.

You think that GS with their position in the market place, wouldn't have been able to see Paulson's positions? and his thesis/reporting materials?

Fabrice Tourre was well aware of the fact that there was a housing bubble in place as early as 2005/06 (it's a long read but NYT reporter Gretchen Morgenson was in the loop way before everyone else: http://www.nytimes.com/2009/12/24/business/24trading.html)

 

 

[txlaw]

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.

 

The problem was that the game was fixed...they knew the outcome and were betting on it.  

 

    This is the single biggest misunderstanding about the entire sad episode.  The structure was never guaranteed to crash. It was not engineered to fail.  The game was far from fixed.  

 

You will be surprised how fixed the game is. I have worked for a broker/top 10 investment bank in the past, and market makers regularly take advantage of their clients b/c they have more information.

Example: if you have a stop loss on your position, it's registered on the system. with a bit of searching and maybe some technology, your broker will hunt for these stop losses, and especially if its a small volume position, will clear out all the stop losses with their own capital, and then buy it back and on sell that in a rising market or to buyers ('ask' side of the book) who are willing to pay a higher price. They can do this b/c they can see all the orders on the system, and see the market depth of volume.

 

this i found especially happened in the forex markets where the markets are unregulated without a central exchange. Brokers and market makers are talking to each other every day in the forex markets. Market makers have all the power in unregulated markets.

 

Another example is in a highly volatile market, brokers/market makers will increase the spread you pay just as you are about to put a trade in, especially if you have a limit order registered on the system.

 

My feeling is that b/c the CDS and CDO markets were unregulated the same sorts of advantages and behavior occured in those markets to/from the market makers.

 

If you think the game isn't fixed, then you are either inexperienced or naive. Market makers, especially ones that have smart, greey and energetic people working for them (i.e. Goldman Sachs) always win ... or always try and fix the markets in their favor. The markets are not a casino, however the behaviour is similar to how the house always tries to fix the game in their favor with activity + insight.

You think that GS with their position in the market place, wouldn't have been able to see Paulson's positions? and his thesis/reporting materials?

Fabrice Tourre was well aware of the fact that there was a housing bubble in place as early as 2005/06 (it's a long read but NYT reported Gretchen Morgenson was in the loop way before everyone else: http://www.nytimes.com/2009/12/24/business/24trading.html)

 

 

Well, you won't find me arguing against the notion that market makers/brokers are front running or taking advantages of spreads to the detriment of their customers or whatnot.  My point was that the specific conduct of Goldman at issue should not be analogized to a broker/market maker because they were actually making representations regarding an offering in their marketing materials.

 

And in this case, there is no question that Goldman understood Paulson's thesis.  I mean, he specifically told them that he was bearish on the reference portfolio and that the data proving his case was readily available.

[SharperDingaan]

For every trade there has to be both a buyer & a seller. Prospectus rules restrict the primary sale of complex securities to only sophisticated investors, who have both the knowledge & ability to assess the risks. It is both common practice, & a desirable thing to create an underwriting overhang; & a seller will pay the underwriter a fee for the price support that the overhang provides. Had the gain/loss not been so extreme it could be put down to ‘market risk’; because it is so extreme the loss making party is now forced to go the legal route.

 

Sell anything & you’ll incur reputational risk, & the more your involvement in the products distribution or manufacture the more risk you take on.  But to make money you need to expose your reputation, & if everyone else is as reckless as you are, isn’t there safety in numbers? Goldman made an error in judgement; & to avoid making another one, they will be forced to cave.

 

This could not have occurred were there a better, & more flexible, investment act. To get there you need ‘notches on a stick’; you start at the top, & you work your way down by ‘rank’ – & let the school yard work for you, in what is a very ‘ego’ driven business. At around the 5th notch the practice changes to ‘stepping back’ from named institutions, & letting fear operate. Healthier institutions, quicker, & ‘entitlement’ earned the old-fashioned way.

 

We think this is the beginning of a fundamental rewrite of securities laws.

 

SD 

 

[txlaw]

For every trade there has to be both a buyer & a seller. Prospectus rules restrict the primary sale of complex securities to only sophisticated investors, who have both the knowledge & ability to assess the risks. It is both common practice, & a desirable thing to create an underwriting overhang; & a seller will pay the underwriter a fee for the price support that the overhang provides. Had the gain/loss not been so extreme it could be put down to ‘market risk’; because it is so extreme the loss making party is now forced to go the legal route.

 

Sell anything & you’ll incur reputational risk, & the more your involvement in the products distribution or manufacture the more risk you take on.  But to make money you need to expose your reputation, & if everyone else is as reckless as you are, isn’t there safety in numbers? Goldman made an error in judgement; & to avoid making another one, they will be forced to cave.

 

This could not have occurred were there a better, & more flexible, investment act. To get there you need ‘notches on a stick’; you start at the top, & you work your way down by ‘rank’ – & let the school yard work for you, in what is a very ‘ego’ driven business. At around the 5th notch the practice changes to ‘stepping back’ from named institutions, & letting fear operate. Healthier institutions, quicker, & ‘entitlement’ earned the old-fashioned way.

 

We think this is the beginning of a fundamental rewrite of securities laws.

 

SD 

 

 

I completely disagree that this is a fundamental rewrite of securities law.  I am not a securities lawyer, but from what I know of the Securities Exchange Act, it is written very broadly to catch all sorts of fraudulent behavior. 

 

Furthermore, to rebut any charges of fraud by noting that there is always two parties to a transaction is preposterous.  If you do a deal with someone where you are long and they are short the underlying asset, if they fail to disclose material information or affirmatively misrepresent the nature of the transaction, that is grounds for claiming fraud in many cases.  Indeed, that happens all the time in Main Street transactions.

 

If anything, this is a fundamental change in the enforcement behavior of the SEC, which has grown fat and lazy over the last couple of decades (or perhaps it never was that great an enforcer).  Underwriters will no longer be able to get away with as much as they have in the past when marketing their offerings.  The "everybody's doing it" excuse will no longer hold any water with this SEC, which has to restore its own badly damaged reputation.  Also, remember that at the moment, it is the government, not any buyers who suffered losses, who is suing, although those suits will surely follow. 

 

Reputational risk has become less and less important of a factor in regulating the behavior of the investment banks because the employees have been able to offload all the risk onto their shareholders.  All the employees who created this mess were able to cash out to some degree before the crisis.  There was no partnership at stake.  It's the whole argument over the partnership versus public company nature of investment banks.  The "old school" rules don't apply in this new world of publicly held investment banks.

[txlaw]

Here is a much better WSJ article on the real issues involved with the case.

 

http://online.wsj.com/article/SB20001424052748703594404575192473240271764.html

[SharperDingaan]

 

The legal references are to the US Investment Advisers Act of 1940, the US Securities Act of 1934, & the US Securities Act of 1933. The acts have served very well but you cant regulate effectively when you`re stuck with 70 yr old relics. The 1990-2010 `Gatsby`era is over, & the greatest legacy those passing can leave behind is sophisticated & state-of-the-art regulation.

 

We dissagree on reputation. If the fed no longer finds them reputable they`ll lose their primary dealer status & the fees & feedstock that the access generates. If the SEC accusations were criminal, all financial institutions would immediately have to back away from them - & Goldmans would follow Lehman by the end of the week. Goldman thought that if you could not go elsewhere, & they were no worse than anyone else, they were safe. They were wrong.

 

SD 

[txlaw]

 

The legal references are to the US Investment Advisers Act of 1940, the US Securities Act of 1934, & the US Securities Act of 1933. The acts have served very well but you cant regulate effectively when you`re stuck with 70 yr old relics. The 1990-2010 `Gatsby`era is over, & the greatest legacy those passing can leave behind is sophisticated & state-of-the-art regulation.

 

Agreed on the need to update the statutes and regs for modern finance.

 

We dissagree on reputation. If the fed no longer finds them reputable they`ll lose their primary dealer status & the fees & feedstock that the access generates. If the SEC accusations were criminal, all financial institutions would immediately have to back away from them - & Goldmans would follow Lehman by the end of the week. Goldman thought that if you could not go elsewhere, & they were no worse than anyone else, they were safe. They were wrong.

 

SD 

 

They were definitely wrong. 

 

Not so sure though that many of the bad actors who worked at Goldman would ever be concerned with the firm's reputation.  Management would certainly be concerned, but the employees who were only looking to strike it rich in a short amount of time wouldn't necessarily care that much about the firm's primary dealer status. 

 

That's the problem with having so many different types of business housed under one "investment banking" roof.  There are inherent conflicts of interest, and the culture of some subsidiaries -- prop trading desks -- can infect the more client-centric subsidiaries.

 

[beerbaron]

If some of you read "Short History Of Financial Euphoria" you must know that after each bubble there needs to be some scapegoats. GS seems like a easy choice as a scapegoat, especially with the public opinion on of compensations.

 

BeerBaron

[Myth465]

Here is an update of the case with Charlie Ross, Sorkin, Micheal Lewis, and a Lawyer.

 

http://www.charlierose.com/view/interview/10973

 

Listen to Micheal Lewis' repeat of the facts. When he says the people were wonder why Paulson was in the room, and then Goldman told them he wanted a piece of the action says alot. The rebuttal using Buffett though is interesting and is a good counter argument.

[txlaw]

Thanks for posting that, Myth. 

 

The lawyer, David Boies, is a very famous American trial lawyer.  He represented the DOJ in the Microsoft antitrust suit, Napster when they were sued by the RIAA, and Al Gore in Bush v. Gore.  I believe he also represented Andy Fastow in the Enron debacle (Fastow, the most culpable person in the room, got off easy by singing like a canary).  You have to be very careful listening to what David Boies says because he's a genius and because he's probably choosing his words carefully in order not to lose potential business.  He likes taking on hard (and lucrative) cases like this.

 

I have a couple quibbles with some of the things that were said by the guests. 

 

Andrew Ross Sorkin repeats the "two sides of the trade" argument, and Boies talks about how everyone likes to hate on short sellers.  But as I have argued previously, this is a "hide the ball" argument.  (I found a pretty good post by a blogger that more fully articulates my position; see http://www.interfluidity.com/v2/784.html).  The real problem is that there was an implication in the marketing material that the reference portfolio was being selected solely by a long only investor when, in fact, a short investor was also involved in picking and choosing what to include.

 

Andrew Ross Sorkin also brings up an example with WEB that is misleading.  First, I don't think the SEC case is based on the particular identity of the individual who helped select the reference portfolio at issue.  That's an argument that's being thrown out there so that Goldman and others can argue that the whole suit is based on hindsight bias.  The key is that there was a person who allegedly helped select the reference portfolio and who was short the porfolio but who was not disclosed to the investors.  When I say investors, I mean investors other than ACA. 

 

Second, Sorkin's WEB example is an extension of the "two sides of the trade" fallacy.  In Sorkin's example, there is no long-only selection agent who is selecting the portfolio.  His example would be more appropriate for a trade where Goldman was the intermediary brokering an OTC credit default swap contract.

 

David Boies also briefly mentions that the case is about "affirmative misrepresentation."  But I'm not so sure that's the case -- I believe omissions can also be actionable.  So the question is whether nondisclosure in the context of the deal was enough to violate the securities laws.  It is always easier to prove fraud when there is an affirmative misrepresentation; when culpability rests on omission of a material fact, it is usually a more difficult case to prove. 

 

The guests are all absolutely right about the politics involved, though. 

[Myth465]

TX those are some good points. I didnt know how prominent the lawyer was, and that detail helps.

 

I find alot of straw mans in this discussion. It seems like a simple case to me relating to discloser.

 

- Zealous Government.

- Shorting Seller Hatred.

- Sophisticated investors / we are all big boys now.

- and my personal favorite, the SEC doesnt know what a synthetic CDO

 

are all straw mans.

 

The case seems to center around the fact that Goldman didnt disclose Paulson's involvement. Lewis saying he wouldnt want someone to do that to him, and asking is that anyway to treat a client gets to the heart of the matter. He says if its not illegal shouldnt it be?

 

----

 

Politically this was a brilliant move, like his politics or not Obama is more than just a great speaker. I chuckled a bit Emanuel was on Charlie Rose a few days ago and said the SEC is independent and the timing was just coincidental.

[Myth465]

Here is a great post worth reading.

 

"10 Things You Don’t Know (or were misinformed) about the GS Case"

 

http://economistsview.typepad.com/economistsview/2010/04/10-things-you-dont-know-or-were-misinformed-about-the-gs-case.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+EconomistsView+%28Economist%27s+View+%28EconomistsView%29%29&utm_content=Google+Reader

[ERICOPOLY]

Warren Buffett offered his strongest defense yet of Goldman Sachs, saying he doesn't believe the investment bank acted improperly in a sale of subprime-related securities at the heart of a Securities and Exchange Commission fraud case.

 

http://money.cnn.com/2010/05/01/news/companies/buffett_goldman.fortune/index.htm