by Numerian posted by Michael Collins

Reading the SEC allegations against Goldman Sachs and Co., you get the impression the agency would prefer a simple world where you could charge a company with lying and be done with it. Lying to one’s clients is at the core of the suit against Goldman Sachs. Unfortunately there is apparently no law against lying in phone conversations and meetings, but there are laws against fraudulent written representations, and this is the legal foundation on which the SEC is basing its suit.

The meaty stuff in the SEC complaint is to be found in the behavior of Goldman Sachs and its employee who structured the transaction known as ABACUS 2007-AC1. Fabrice Tourre, now age 31, was a vice president on the structured product correlation trading desk. He put together the ABACUS deals and is said in the complaint to have left out pertinent information, or lied altogether, to the firm that helped set up the ABACUS deal and make it sellable to investors. No other Goldman Sachs employee is identified in the suit, and the management on the trading desk or in his department are described only in shadowy terms.

Goldman’s response this week to the suit says that they will defend themselves vigorously (and no doubt with many millions of dollars of legal expense), so they are not throwing Mr. Tourre to the wolves as some rogue trader. This would have been the logical thing to do since the allegations against Mr. Tourre are especially damaging. By embracing and defending him so readily, we therefore have to assume Mr. Tourre’s behavior is emblematic of the Goldman Sachs culture, and how he comported himself is how many others behaved at the firm. This in itself is very revealing about Goldman Sachs and its management.

The Transaction

The creation of the ABACUS-2007 transaction is certainly interesting and not too difficult to understand. We can follow the SEC complaint step by step.

• By early 2007, fissures were developing in the residential mortgage market in the US. A few months earlier, in the autumn of 2006, prices of homes had stopped climbing and in many markets had begun to fall. Defaults on home mortgages were beginning to rise sharply.

• Because of this, it was getting harder to sell collateralized debt obligations (CDOs) based on residential mortgages. This business was a specialty of Goldman Sachs, which set up the structured product correlation trading desk in 2005 to create and sell these CDOs. The CDOS were composed of one hundred or more Residential Mortgage Backed Securities (RMBS’s), which were themselves composed of over a thousand individual home mortgages. The RMBS market often structured their securities so that all the mortgages would be from California, for example, or all would be subprime or share some other commonality. This was convenient for creators of CDOs; they could devise sections, or tranches, with different risks, ranging from Aaa rated down to near-default risk, which was referred to as equity because it was tantamount to having no protection other than that of a shareholder.

• Investors who bought CDOs could choose which level of risk they would undertake; the higher the risk the greater the yield they could achieve. Because of this flexibility and the attractive yields, banks, mutual funds, pension plans, and endowments formed the customer base for these CDOs. These investors were getting a bit choosy, however, given the rising defaults in the mortgage market, and CDOs based on residential mortgage backed securities were getting harder to sell. Goldman had done several ABACUS deals in recent years, and this one under consideration by Fabrice Tourre was expected to generate up to $15 million in fees for the firm.

• What investors wanted to know was who selected the RMBS’s to include in the CDO? They were no longer willing to buy CDOs of this nature if Goldman Sachs selected the RMBS’s; they wanted the assurance that an independent third party had selected only the best securities for inclusion into the CDO. Despite the weakening residential mortgage market and rise in defaults, investors were not especially worried that the CDO tranche they were buying was going to deteriorate. Most everyone agreed housing prices in the US never declined on a national scale, and the CDO yields were still very attractive compared to US Treasuries.

• Not everyone agreed that the housing market was stable. In fact, John Paulson, owner of the Paulson & Co. hedge fund, believed the housing market was about to collapse. He wanted a way to bet against the housing market, and did a study of hundreds of RMBS’s that he thought were ultimately going to be downgraded and lose substantial value. He was particularly interested in those securities that featured mortgages from California, Nevada and Florida (where housing price appreciation had been the greatest), and subprime securities of the NINJA variety (no income, no job, and no assets verified for the home owner).

• Paulson approached Goldman Sachs in early 2007 with an idea for shorting the housing market. He would buy from Goldman Sachs an insurance policy, called a Credit Default Swap (CDS), based on the very RMBS’s he thought would likely lose value. He would pay a one-time fee for this CDS, and if he was right, Goldman Sachs would pay him as much as a billion dollars. Normally CDS’s are sold to clients who are using them to hedge the credit risk in assets they already own, but in the discussions with Goldman Sachs, Paulson made it clear he owned no residential mortgage securities, and was interested in the CDS as a pure speculative play against the housing market.

• The first question that came to Goldman Sachs’s mind was: how do we hedge this transaction? They needed cash flow equal to a billion dollars to pay to Paulson if the housing market did indeed collapse. It was Paulson who suggested Goldman Sachs create a CDO that would bring in a billion dollars; under the right terms a CDO could still be made attractive to investors who believed the opposite of Paulson, in other words that the housing market would not deteriorate. This is where the services of Fabrice Tourre came in to the picture, as he was assigned the task of creating another in the ABACUS series of CDOs.

• To solve the problem of the independent third party, Goldman Sachs approached the collateral management firm ACA Capital, which specialized in selecting and managing the securities in CDOs and had done 22 previous transactions. Tourre told ACA that Goldman was acting on behalf of a sponsor – Paulson & Co. – and that Paulson wanted to contribute to the initial selection of the RMBS’s to be included in the CDO. Paulson sent a list of 123 securities he wanted in the CDO, all of them from his own list of the weakest securities in the market according to his research. ACA accepted only 55 of them for inclusion.

• Several meetings were then set up among Paulson, Tourre and ACA to refine the group of RMBS’s that would ultimately be selected for the CDO. At no time in any of these meetings did Tourre mention that Paulson was going to enter into a side contract with Goldman Sachs to short these securities by purchasing a CDS from Goldman. In other words, it was never revealed to ACA that Paulson had a serious conflict of interest; in fact he had a reverse interest: he wanted the CDO to fail and to do so as quickly as possible. His real interest was getting the worst possible securities included in the CDO package.

• ACA was concerned about Paulson’s desire to include the weakest securities in the CDO. For example, he refused to allow any mortgages from Wells Fargo to be included, because Wells Fargo was known to have a more careful credit review process for mortgages than other lenders. Privately, Tourre assured ACA that Paulson’s financial and economic interest was entirely aligned with theirs, because Paulson and Co. was going to invest $200 million in the equity portion of the CDO. This was demonstrably a lie; Paulson never invested in any portion of the CDO.

• ACA has told the SEC that they would never have put their firm’s reputation at stake and acted as collateral agent for the ABACUS-2007 CDO had they known that Paulson was not going to invest in the CDO, or had they known that he was going to short portions of the CDO by buying a credit default swap from Goldman.

• When it came time to approach investors, Tourre put together a term sheet, prospectus, and other documents describing the ABACUS-2007 CDO. Great prominence was given to the fact that ACA was the collateral agent and had chosen the securities included in the CDO. There was never any mention that Paulson & Co. had participated in selection of these securities or was a sponsor of the CDO. Several investors have told the SEC they would never had bought the CDO had they known that the selection process was compromised and not entirely independent.

• The CDO closed on April 26, 2007. By late October, 2007, 83% of the securities in the portfolio had been downgraded, and by late January, 2008, 99% of the securities had been downgraded and lost substantial value. Investors lost hundreds of millions of dollars, and several bank investors had to be rescued by their governments because of these and similar losses.

• Meanwhile, Paulson’s credit default swap soared in value, and he eventually earned $1 billion in profit on his short of the mortgage securities market. This money came directly from the investors who lost at least at much on the CDO. For example, one investor, the Dutch bank ABN, negotiated with Goldman Sachs in late 2007 to get out of their tranche of the CDO, and paid Goldman $841 million to unwind their deal. This money ultimately went to Paulson.

Some Observations

Goldman Sachs has issued a brief statement in defense of their conduct, saying that their job has always been to match the interest of parties with different views about the market. In this case, Paulson & Co. thought the mortgage securities market was going to collapse, while investors in the CDO did not. Goldman gives you the impression they are a disinterested middleman matching buyers and sellers. This is exactly how a trader thinks, and it is traders like Lloyd Blankfein who run Goldman Sachs and have done so ever since the firm went public in the 1990s. This is not what Goldman Sachs used to be like when it was a private firm. Then, it operated only in the interest of one client at a time, and if there was any potential conflict of interest with another client, it would decline the transaction. This culture has died out on Wall Street, and this deal, created as it was on a trading desk, displays the consequences of the new culture where the most important thing is getting the deal done at the maximum amount of profit to the firm.

The behavior of Fabrice Tourre, if proven in court, is indefensible. Goldman Sachs will have to throw him over at some point and claim he did not act within the standards of the firm. They will probably do so in a negotiated settlement with the SEC, after stalling the settlement with legal tactics for a few years so everyone can forget about it. The SEC is demanding a jury trial and disgorgement of all profits, plus an assessment of penalties, so this is going to cost Goldman Sachs a hundred million dollars or more, but in this environment Goldman would rather pay this privately than risk a jury trial.

Notwithstanding whatever Goldman ultimately will say about Fabrice Tourre, he is being defended at the moment because the firm cannot afford to quickly jettison him without affecting morale at the company. He is also a typical Goldman employee – full of himself (he egoistically refers to himself in emails as “fabulous Fab”), aggressive with the facts, and unconcerned about conflicts of interest. Perhaps he lied more overtly than most employees would, but stretching the truth a bit must be common when the firm has to spend nearly every transaction skirting over and hiding the conflicts of interest involved.

Very little is said in the lawsuit about Goldman Sachs management. There is a Mortgage Capital Committee that approved the deal. They were made aware of the fees earned and the involvement of Paulson & Co. and the CDS he would undertake with Goldman. Apparently none of these senior executives were the slightest bit concerned about the conflict of interest or whether ACA needed to be misled about Paulson for them to enter into the deal. Management obviously did not insist that the written material be clear about Paulson’s role. These are obvious reasons to include Goldman Sachs & Co. as a defendant in the lawsuit.

John Paulson is given credit for being one of the few who saw disaster coming in the housing market. Readers here at The Agonist and at other blogs have long known about this potential, even as early as 2004. The difference between us and John Paulson is that we had no way to profit from this event, other than selling our house and renting. As a billionaire hedge fund manager, Paulson has access to the financial power structure and used it to his advantage. In fact, with this lawsuit we see his behavior is not entirely commendable. He certainly kept his mouth shut about his desire to short the mortgage securities market when he was meeting with ACA, and it is hard not to believe that he had an understanding in advance with Fabrice Tourre that his true role would never be revealed.

Paulson is not the only hedge fund manager who shorted the housing market. A Chicago firm called Magnetar has recently been revealed to have engaged in very similar transactions with other big Wall Street banks. Their true position was never revealed in these deals as well, so theoretically the SEC has lawsuits it can file against JP Morgan Chase, Bank of America and others.

It should also be remembered that a few weeks ago the chairman of JP Morgan Chase testified to Congress that not once in any of the executive meetings at the bank did someone postulate that the housing market might collapse. Yet this bank was at the time doing huge transactions with hedge fund managers who certainly did believe this to be case and were actively betting against the housing market. It is simply preposterous to believe that bank managements “didn’t see it coming.”

The SEC suit exposes Goldman Sachs to more civil lawsuits from the investors who can now claim they were defrauded into buying the ABACUS CDO. This would include the German bank IKB, which collapsed because of such investments.

, ABN of The Netherlands, and AIG, now owned by the US government. Goldman is facing serious problems with these tangential lawsuits.

Finally, when all is said and done, we are just getting a tiny peek at the culture of corruption that is Wall Street. Will there be more such revelations, or is this all we are going to be allowed to see?