Friday, April 16, 2010

Goldman Busted on This One

Today, the SEC filed a complaint alleging that Goldman Sachs, and employee Fabrice Tourre, defrauded investors by failing to disclose that the party that picked the securities underlying a CDO was doing so to short it (Paulson & Co.). Their stock is down some 20%. In general, investment banks were caught up in the housing delusion with everyone else, which is why they too suffered so much in the meltdown. This transaction, however, is quite different.

As laid out in the SECs brief, Goldman and Tourre knew that Paulson was trying to create a CDO Paulson could then short. In effect, Goldman was the clearing house, taking merely a fee, while Paulson and the CDO buyers would have a future's type payoff. So, Goldman didn't really care what happened, they just wanted a deal done, to get fees. What makes this so special is that this deal was constructed when the first cracks were showing in the market, as the ABX Subprime CDO index started to falter in November 2006, and fell precipitously in February 2007. Internal emails indicate they were well aware the market was going down, and this was one of the last deals (the deal was presented to the relevant parties in January, and closed on April 26, 2007). On March 7, 2007, there was a BusinessWeek article on how Paulson & Co was making a fortune off shorting subprime CDOs, which were then showing massive signs of danger.

Goldman and Tourre got another company with a solid reputation, ACA, to be the official sponsor, because they knew no one would buy a CDO assembled by a short--too much opportunity to cherry pick the bad bonds. You don't need to do as much due diligence when you think the other parties involved have a consistent interest in your portfolio, so a sponsor with long-only interest is rather essential for such complex deals. Goldman told ACA that the collateral was picked by Paulson which would then hold the equity stake in the transaction. In fact Goldman knew Paulson had no such plans and wanted a vehicle to short, and as mentioned, there were articles discussing Paulson's shorting of subprime CDOs, so ACA was incredibly deaf. Nonetheless ACA was mislead (ACA soon basically failed, so they got their just reward).

In securities markets, people often buy from those who think the price will fall. Yet in this case the seller's intention was material because when there is incomplete information, knowing the intentions of the parties involved makes a huge difference. I know from my litigation experience, that appropriate tactics are vastly different when dealing with parties who have good faith, versus parties with bad faith. Intentions, motivations, go a long way in explaining things, but the problem with blaming intentions is they are usually impossible to determine objectively, and so best ignored. In this case, the portfolio was constructed by a short seller so the intentions are pretty clear. Whether there's a law against this, I'm not sure, but it's pretty bad business.

While I think Tourre and Goldman deserve a smacking for this, it should be recognized that this kind of deal is not representative, and that most CDOs were created by people who sincerely, if stupidly, thought they were good deals. Note that Paulson is one of the few hedge funds that really cleaned up in this mess, most hedge funds missed it with everyone else. If shorts were primary drivers of CDO demand, this would suggest a giant conspiracy, so it's the proportion, not the principle, which leads me to think that understanding the 2008 credit crisis via these kind of deals is misleading.

Note: Goldman fires back, disputing the main point of evidence for the SEC, that Goldman told Abacus manager ACA that Paulson was the equity owner. I think that is the most important fact in the case, and is either true or false. Goldman does note that since they lost $90MM on the deal, and ACA lost almost $1B, they actually did think it was a good deal, which makes sense. Even if they are not guilty, they were really short sighted, and Fab Tourre is either an idiot or a scumbag, and Goldman is stupid or scumy for hiring guys like that.


Monetarius said...

"It's the proportion not the principle...." The Magnetar trade is at least one other example of the "principle" at work. We better find out how many others were done before discounting a conspiracy.

Patrick R. Sullivan said...

'In this case, the portfolio was constructed by a short seller so the intentions are pretty clear.'

It's more complicated than that. ACA consulted with Paulson about what to include in the CDO, but they rejected more than half of his suggestions. Everybody involved seems to be aninvestment professional. The SEC complaint seems to be pure hindsight.

BTW, why isn't Paulson being charged if there was fraud?

Anonymous said...

The issue with this one is that it is a synthetic CDO, which can only exist when there's a long side and a short side, so anyone investing in a synthetic CDO is well aware that someone else is betting against it, who the other side is irrelevant.

Patrick R. Sullivan said...

Digging a little deeper into the SEC complaint, if I'm understanding it correctly, Goldman introduced Paulson to ACA and Paulson sent them a list of 120+ bonds he'd like to see included.

ACA discovered that they'd already purchased 60 or so of them, thus those were fine with them, eventually 55 of them were in the CDO. Also, ACA added enough others to come up with 90. Goldman then marketed that portfolio.

Hard to see a lot of 'significance' (the SEC's term) for Paulson there. However, it would be interesting to know if Paulson's 55 were worse than ACA's 35.

And, according to the SEC complaint Paulson's hedge fund was known to be betting against MBS as early as 2006. Isn't there some requirement for a firm like ACA, that had a track record of creating these kinds of portfolios, to clean out the wax from their ears and listen to who Paulson was.

Patrick R. Sullivan said...

Goldman speaks,

and says the SEC is full of it.

Both Goldman and ACA had long positions in this portfolio--with ACA having the biggest exposure (almost $1 billion)--and thus no incentive to construct a portfolio disadvantageous to the long position. Goldman lost $75 million, net, on its side.

IKD, the German bank playing the widow and orphans according to the SEC, also offered its advice to ACA on what to include in the CDO. ACA had worked with IKD many times before, so if they didn't expect IKD to be long--and by default Paulson to be the short party--they could have simply asked either one.

This all looks like a political ploy to add fuel to the fire currently in congress to extend regulation of banks and financial firms.

Anonymous said...

"You don't need to do as much due diligence when you think the other parties involved have a consistent interest in your portfolio, so a sponsor with long-only interest is rather essential for such complex deals."

This is utter crap. As the manager of the CDO, ACA had a fiduciary responsibility to the long buyers of the entity to investigate the creditworthiness of each security and not just "take Paulson's word for it" because of his supposed involvement as a long. Besides, ACA's whole buiness was assessing structured product credit risk (their core business was wrapping these products - just as AMBAC and MBIA were doing) and they had a side business managing CDOs. So who were the experts, ACA or Paulson?