Goldman Sachs Fraud Case
As readers are likely aware by now, Goldman Sachs was yesterday charged with fraud by the Securities and Exchange Commission. I’ve resisted comment thus far, as I’ve been tied up with a minor crisis at work and don’t have any especial expertise in the vagaries of securities law, anyway. But here’s what we know thus far.
WaPo (“SEC accuses Goldman Sachs, Fabrice Tourre of defrauding investors“):
The Securities and Exchange Commission filed fraud charges against Goldman Sachs on Friday, alleging that the famously successful but vilified Wall Street bank sold investors a subprime-mortgage investment that was secretly designed to lose value.
In filing the civil suit, the agency targets one of the few banks that, with the help of taxpayer bailouts, emerged from the financial crisis stronger than before. The case strikes at a main cause of the financial crisis: the creation of investments derived from home loans made to borrowers who couldn’t afford the houses they were buying.
But the suit, which alleges that Goldman Sachs misled its clients, goes beyond, raising the possibility that the bankers who devised these investments knew they were selling toxic financial products that could endanger the financial system but were concerned only with the fees they would earn by doing so.
Months before the mortgage investment was marketed, a senior Goldman Sachs executive recognized in an e-mail that the implosion of the housing market was imminent. “The whole building is about to collapse anytime now,” concluded Goldman Sachs vice president Fabrice Tourre, who allegedly created the investment at the core of the case.
The SEC suit also drags into a legal maelstrom the legendary hedge fund manager John Paulson, who personally earned billions of dollars as his firm Paulson & Co. bet against the housing market as it went bust. The fund was a central actor in the alleged fraud, but officials say Paulson did nothing wrong.
Goldman Sachs denied the SEC’s allegations. “The SEC’s charges are completely unfounded in law and fact, and we will vigorously contest them and defend the firm and its reputation,” the bank said in a statement.
In its case, the SEC alleges that Goldman Sachs created and marketed a financial product known as a collateralized debt obligation, often referred to as a CDO, whose value was linked to that of home loans. The agency claims that Goldman Sachs didn’t tell investors that Paulson & Co. helped the bank assemble the CDO while the hedge fund at the same time placed bets that it would lose value.
“The product was new and complex, but the deception and conflicts are old and simple,” SEC enforcement director Robert Khuzami said in a statement. “Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party.”
WSJ (“Goldman Sachs Charged With Fraud“):
The civil charges against Goldman and one of its star traders, 31-year-old Fabrice Tourre, represent the government’s strongest attack yet on the Wall Street dealmaking that preceded, and some say precipitated, the financial crisis that gripped the nation and the world. Goldman’s shares fell 13%, one of the steepest slides since the firm went public in 1999, erasing some $12 billion of market capitalization.
Mr. Paulson and his firm aren’t named as defendants. The hedge-fund firm said in a statement that it wasn’t involved in marketing the bonds to third parties. “Goldman made the representations, Paulson did not,” Mr. Khuzami said.
The deal at the center of the SEC suit came as Goldman and other firms were deeply involved in making, buying and building complex investments out of subprime loans, just as the market for those loans was beginning to weaken perilously. Critics of such deals say they enriched the firms but magnified what became the worst financial crisis since the Great Depression.
Goldman has issued a press release attempting to rebut the charges. Their topline arguments:
• Goldman Sachs Lost Money On The Transaction. Goldman Sachs, itself, lost more than $90 million. Our fee was $15 million. We were subject to losses and we did not structure a portfolio that was designed to lose money.
• Extensive Disclosure Was Provided. IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities. The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side.
• ACA, the Largest Investor, Selected The Portfolio. The portfolio of mortgage backed securities in this investment was selected by an independent and experienced portfolio selection agent after a series of discussions, including with Paulson & Co., which were entirely typical of these types of transactions. ACA had the largest exposure to the transaction, investing $951 million. It had an obligation and every incentive to select appropriate securities.
• Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor. The SEC’s complaint accuses the firm of fraud because it didn’t disclose to one party of the transaction who was on the other side of that transaction. As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor.
Steve Bainbridge, who knows a little something about corporate law, has the cynical take that, “It was inevitable that the government would go after one of the big investment banks for their conduct during the run up to the credit crisis. Someone must be thrown to the lions so that the polis are distracted from the role their government played in the fiasco.” But he rounds up reactions from three others who think the SEC has a pretty solid case here. Which seems reasonable enough, in that the SEC gets to choose its cases and isn’t likely to go after an adversary with enormously deep pockets unless it thinks it can win.
Leaving aside the law for now — again, this is complicated and well outside the legal coursework I had as a political scientist — and looking at the ethics, it wasn’t entirely clear to me from reading the press accounts what Goldman did that was wrong. I get why people are angry at Goldman Sachs, of course. They’ve behaved arrogantly and profited from a massive financial collapse that’s caused widespread devastation and to which they contributed.
But at first blush it sounds like they acted in precisely the manner we’d expect from a massive investment bank: hedging their bets, ensuring that they’d come out ahead regardless of whether the subprime market crashed. Yes, they had more information than did the average investor but, then again, when doesn’t an investment firm? Yes, Tourre seemed to think the whole thing was going to blow up. But, surely, he’d have been better off simply getting out of the subprime business if he were sure of that? Instead, he made a side bet the old fashioned way: With other people’s money.
UNM lawprof Eric Gerding explains why that’s probably not right.
The allegations are that a large hedge fund, Paulson & Co., pushed Goldman to sell a CDO to investors. The hedge fund allegedly (a) played a large behind-the-scenes role in helping Goldman structure and select the assets (collateral) that backed the CDO, and then (b) bought a number of credit default swaps that “shorted” the CDO. The SEC alleges that Goldman told neither investors nor the CDO’s collateral manager (akin to the investment manager for the CDO) of Paulson’s role in selecting assets or its short position — which would suggest a conflict of interest. It is hardly shocking that a securities law case boils down to disclosure.
Kevin Drum‘s explanation makes some sense in this regard:
Goldman claimed that the securities bundled into Abacus had been chosen by independent managers, but in fact they’d been carefully cherry picked by hedge fund manager John Paulson, who selected the crappiest mortgage bonds possible because he wanted to bet against them. Goldman apparently thought that was a fine idea, because they wanted something to bet against them too. So a synthetic CDO purposely designed to do poorly seemed like a great idea.
But I gather that Paulson isn’t being charged with diddly. Why is he allowed to establish and market an intentionally bad investment vehicle and walk away with billions, while Goldman is held liable?
Gerding makes a good point, too, that we’re all well served to heed:
It is important to note that all of the foregoing are from the SEC’s statements. Let’s see if the SEC’s version of the facts holds up. Everybody should get their day in court, even institutions Rolling Stone writers hate.
Everyone’s behavior looks worse in the charging document than in reality, as it’s designed to state the absolute strongest case against the accused and omits every shred of exculpatory evidence.