Saturday, April 17, 2010

SEC v. Goldman Sucks

The US Securities and Exchange Commission on 16 April 2010, filed a complaint in the Southern District of New York, a US district court against Goldman Sachs &Co, and Fabrice Tourree, currently working for Goldman in London. The complaint charges civil claims of fraud. This claim was brought by the newly established enforcement division of the SEC that focuses on structured and new products. This specialised Unit within the SEC Enforcement division focuses on complex derivatives and financial products, which include credit default swaps. Collateralised debt obligations and securitised products. This claim is an amazing development in securities regulation enforcement as it targets a leader in Wall Street and a firm that prides itself on disclosure and legal compliance. It is my opinion that this action is the SEC’s shot across the bow for firms that underestimated the political fallout from the Global Financial Crisis. Also, this cause of action is an opportunity for the SEC to re-establish itself as a cop on the beat rather than a tool of Wall Street.

The complaint by the SEC describes an arrangement facilitated by Goldman that misled investors to believe they were investing in quality debt obligations while another Goldman client participated in the set-up and then sold short. A simplistic explanation follows but first let me quote the SEC . “The product was new and complex but the deception and conflicts are old and simple,” SEC Enforcement Director Robert Khuzami said. “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.” (see citations below)

The players
Goldman, and employee Fabrice Touree
John Paulson, and the Hedge Fund, Paulson & Co.

The played
ACA Capital Holdings
IKB Deutsche Industriebank AG
maybe you and me

Very, very simplistically, Goldman asked a well respected bond insurer, ACA Capital Holdings, to assist in creating a portfolio of mortgage backed debt. ACA had expertise in residential –mortgage backed securities so they would select the assets in the portfolio. Included in the meetings where assets were selected was Paulson & Co. Allegedly, ACA was informed by Goldman that Paulson was an equity investor in the deal. (see SEC Complaint section E, para’s 25-35) In reality, according to the complaint, Paulson & Co from the beginning believed that the residential mortgage market was about to have a ‘credit event’ and tank. Paulson & Co intended to short the deal.

Once the portfolio had been selected by ACA and Paulson, Goldman marketed it to clients. IKB Deutsche Industriebank AG bought in to the deal because ACA, a reputable bond insurer, had chosen the debt vehicles. There is some evidence to show that during negotiations in the early stages, Paulson & Co did not approve of some Wells Fargo debt that would be better performing. ACA questioned this. (see SEC Complaint section E, para 24)

Regardless of any doubts, the deal was concluded and IKB invested in the portfolio. Paulson & Co shorted it and 2 months later all of the assets were worthless. ACA went bankrupt and IKB is now majority owned by the Royal Bank of Scotland.

In many of the stories regarding this complaint the name of Warren Buffett comes up. Buffett invested in Goldman in 2008 when there were questions about Goldman’s integrity. Buffett staked his reputation on Goldman. Uh, well, how is that workin’ for you Warren???

Money does funny things to people. I learned this when I worked on an equity trading desk in the late 80’s. We need cops like the SEC to get everyone’s head out of the sand particularly given the devastating effect of he Global financial crisis here and abroad. I hope the SEC shows some leadership.

As always we wait with interest to read Goldman’s well crafted and expertly written response to this complaint. We all know this is the tip of the iceberg. Let’s see if the SEC, and Goldman for that matter, has what it takes to see this through.

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