The Case against Goldman Sachs (Did they sell securities that were designed to fail?)

I’d like to weigh in on this whole SEC securities-fraud action against Goldman Sachs. The feds have, of course, alleged that Goldman made materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (CDO) that was structured by Goldman and marketed to investors.

This is all very complicated. And I know some very smart people lining up on one side saying the SEC’s fraud action is weak. And I know some equally smart people on the other side saying this is an extremely serious matter that will be followed by numerous other SEC fraud charges against other Wall Street underwriters.

Look, I’m not a lawyer. I don’t know how this lawsuit will eventually play out. But let me make a couple of simple, straightforward, points that may help inform regarding the question of hedge fund manager John Paulson’s involvement in the securities selection for the Abacus CDO, and whether this is a material fact that Goldman should have disclosed to investors.

Here’s a very important timeline of the securities-selection process that was made by ACA management, the portfolio selector. This is from the actual SEC complaint:

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January 9, 2007 Goldman sends email to ACA, titled “Paulson Portfolio,” containing list of 123 RMBS selected by Paulson for the Abacus 2007-AC1 reference portfolio

January 22, 2007 ACA sends email to Fabrice Tourre & others at Goldman containing list of 86 RMBS, including 55 of the 123 selected by Paulson; 68 were rejected. This is very important. Goldman maintains that ACA was in fact the portfolio selector. ACA rejected 68 of Paulson’s recommendations. They accepted 55.

February 2, 2007 After meetings with Paulson & Tourre, ACA emails Paulson, Tourre & others at Goldman a list of 82 RMBS on which Paulson & ACA concurred, plus 21 others. So at this point, they are in agreement on 82, but they insert 21 others.

February 5, 2007 Paulson sends email to ACA & Tourre deleting 8 of the RMBS recommended by ACA and leaves the rest alone.

February 26, 2007 After further discussion, Paulson & ACA agree on a reference portfolio of 90 RMBS for Abacus 2007-AC1.

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Now, what I gather from all of this is that ACA management was most definitely the portfolio selector. There’s no question about it. This is Goldman’s single biggest defense in not mentioning hedge fund manager John Paulson’s name.

However, I’m looking at this and I’m thinking, with all these negotiations, all of this back-and-forth, that it’s quite clear that John Paulson played a pivotal role in the portfolio-selection process. That seems undeniable. So that raises the key question of whether Goldman Sachs’ decision not to disclose Paulson’s involvement was a correct judgment, or whether it was a material omission. It just seems to me that Goldman Sachs should have named Paulson in the offering circular for the CDO. They didn’t. Is it because they didn’t want investors to understand that this was a bear-market, short-the-bond CDO?

Second point: Some highly placed, senior Wall Street sources who have been deeply engaged in structured mortgage-based CDOs tell me that this CDO in question was weak and appeared designed to unravel quickly. They go on to say, in general terms, that this CDO constructed by Goldman Sachs lacked sufficient cash; its covenants were weak; and it afforded less investor protection than usual in order to provide higher yields. This troubles me enormously.

Creating something that’s designed to fail? Well, you know what? If it’s not illegal, it certainly appears unethical. So I must blame Goldman for this. Why sell it to customers if it’s going to fail? Why go there in the first place? What kind of brokerage service is this?

Now, there’s nothing wrong with creating a neutral security that will attract buyers and sellers. That’s called free-market capitalism. And the buyers and sellers do not have to know who the buyers and sellers are. But if, in fact, these Goldman CDOs were designed to fail, then there’s something seriously wrong with this system and it must be changed.

Whether Goldman lied about Paulson’s $200 million equity stake is another difficult issue. If they lied, then it’s a material misrepresentation and the SEC is dead right. But there are different opinions about this.

One final thought: Wouldn’t it be wonderful if Washington could somehow solve these issues without totally demonizing, demoralizing, and even destroying America’s great global banks? We need these banks for full-fledged economic recovery. We also need them for America’s full-fledged leadership in the global financial system and world economy. In other words, can we please figure out a way not to throw out the baby with the bathwater?

This is way too important a time for our recovering economy and financial system. Our future is at stake.

Here's one link egarding Magnetar and Goldman Sachs from The Economist:

MY COLLEAGUE at Free Exchange writes that he's beginning to feel a sense of "resigned cynicism" over financial reform, that effective policy responses may be out of the question and that the best we can hope for might be a cultural shift:

I'm increasingly of the belief that the best thing that might come out of the crisis would be the use of public anger to change the culture of Wall Street. It's hard to see how the world would be a worse place if outlandish bonuses were met with vocal public scorn, or if the brazen pursuit of financial wealth were looked down upon, or if regulatory weakness in the face of Wall Street pressure were greeted with hooting derision... If financial executives are going to behave as parasites, they should be shamed as parasites. Maybe nothing will change as a result, and they'll comfort themselves by drying their tears with gold leaf. But maybe it will have an effect.

I hope he's wrong, but if he's right (or, in fact, either way) we should all be doing more reporting like the extraordinary piece "This American Life" aired the week before last on the Magnetar trade. The piece, reported by Jesse Eisinger and Jake Bernstein of ProPublica, describes how a Chicago hedge fund named Magnetar entered the market for collateralised debt obligations (CDOs) in 2006, helped inflate the subprime bubble an extra year or two, and then cashed out by shorting the very bubble it had helped to create, to the tune of billions of dollars. Aside from Annie Lowrey at the Washington Independent, and James Kwak, few people in the blogosphere seem to have picked up on the ProPublica story; I can't understand how I missed it. It's fantastic. It's horrific. It's like a really good South Korean monster movie. Except that it really happened, and in the end, after watching all that destruction of value, you, the taxpayer, have to pay for it.

As Messrs Eisinger and Bernstein tell it, the essence of the Magnetar strategy was simple. As the subprime real-estate market slowed in 2005, it became increasingly difficult to put together CDOs. Investors could still be found to buy the supposedly less-risky senior and mezzanine tranches, but the bottom tranche containing the riskiest loans, known as the equity tranche, was becoming unmarketable. Without a buyer for the equity tranche, it was impossible to put together the CDO deal. But in late 2005, Magnetar, a new hedge-fund startup, began buying up large quantities of high-risk equity tranches, making huge numbers of new CDOs possible. At the time, few could figure out what Magnetar was up to. But at the same time, Magnetar was betting (or hedging, depending on how you look at it) heavily against the failure of the CDOs they were buying into. And according to Messrs Eisinger and Bernstein, Magnetar was also systematically intervening with CDO managers, who selected the mortgage-backed securities that were bundled into the tranches, and pressuring them to include higher-risk securities in the equity tranche. Messrs Eisinger and Bernstein contend that Magnetar was setting up the entire CDO to fail, so that all the tranches would collapse, and it could collect on the credit-default-swap bets it had placed against the CDOs it was putting together. In almost every case, that was what happened; Magnetar made billions of dollars in 2007 and 2008, as the CDO market was collapsing.

In principle, the CDO manager had a fiduciary duty to disclose to investors that Magnetar had persuaded them to include riskier securities in the CDO. But few did. Most of their earnings, millions of dollars a year in some cases, came from fees for closing CDO deals. They had no personal incentive to undermine their prospects of closing a deal. Magnetar, predictably, denies it tried to influence CDO managers; it claims it was neutral on the housing market, and would have made money whether housing rose or fell. Messrs Eisinger and Bernstein say the evidence belies the claim:

Magnetar invested in 30 CDOs from the spring of 2006 to the summer of 2007, though it declined to name them. ProPublica has identified 26.
An independent analysis commissioned by ProPublica shows that these deals defaulted faster and at a higher rate compared to other similar CDOs. According to the analysis, 96 percent of the Magnetar deals were in default by the end of 2008, compared with 68 percent for comparable CDOs.

And with that I will stop summarising their work, because you should all go read the rest of it at ProPublica, and/or listen to it on "This American Life". But beyond Magnetar, Brad DeLong refers us to James Kwak's take on the Goldman Sachs fraud filing. As Mr Kwak writes of the Goldman case:

The type of transaction involved—in which a hedge fund makes a CDO as toxic as possible in order to then short it—is similar to the Magnetar trade, which I discussed earlier. One thing we learn from paragraph 5 is that Paulson sure knew how to pick ‘em:
“The deal closed on April 26, 2007. Paulson paid GS&Co approximately $15 million for structuring and marketing ABACUS 2007-AC1. By October 24, 2007, 83% of the RMBS in the ABACUS 2007-AC1 portfolio had been downgraded and 17% were on negative watch. By January 29, 2008, 99% of the portfolio had been downgraded. As a result, investors in the ABACUS 2007-AC1 CDO lost over $1 billion. Paulson’s opposite CDS positions yielded a profit of approximately $1 billion for Paulson.”

But people want liquidity, and they have to be willing to pay for it! Or something. What exactly was the purpose of the financial sector supposed to be, again? Because I'm pretty sure "inflating bubbles so as to bet on their collapse, thus forcing the taxpayers to bail out your counterparties" wasn't it. Anyway, if it's outrage you want, come and get it.

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