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The Goldman Thing
From The Daily Capitalist
Since most of our legislators, bureaucrats, and White House residents have no idea what caused the Great Recession, they are itching to blame it on someone, and that "someone" is Goldman Sachs, the arch-capitalist of our time. As if fraud was the cause of all of our problems. It's like blaming greed.
Let me first get it on the table: I am not defending Goldman Sachs. The point of this article is to defend free market capitalism which has been incorrectly branded as the villain in our economic crisis. If Goldman defrauded their clients, they should pay the price.
The information on this case is too new to evaluate, and without further analysis of the complaint and the facts, I will withhold judgment. I would like to review the Abacus 2007-AC1 prospectus or PPM and the allegations of misrepresentation and fraud before I condemn Goldman. I have analyzed similar deals in the past and I would like to compare this one to what I believe was the norm for disclosure.
It sounds bad for Goldman now, and while it may very well be all true, the government loves to trot out the juicy bits for press conferences which the press loves, such as Mr. Tourre's email. As you all know, (i) you can't always trust what prosecutors say and (ii) there's always more to the story.
I also have a healthy suspicion of "economic crimes." These are crimes not based on ethics, traditional crimes, or a violation of someones rights by the perpetrator, but are crimes "against the people" as defined by legislators or some economic czar. Not to stir up a debate here, but insider trading is one example of the government trying to create a "level playing field." The distinguished economist Henry Manne has spent a lifetime showing why that is incorrect and irrelevant.
Yet today many pro-capitalism economic writers were quick to criticize Goldman. Mish Shedlock came out with an article today that blasted Wall Street ethics:
Sadly, this business screws the client for a fee time and time again because there is no ethics, no sense of fiduciary responsibility, and no walls on separation of duty to prevent fraud. ...
You might wish to read his piece since it's very critical.
I don't mean to be blasé about this or be overly critical of Mish because I think he's one of the best economics writers, but anyone who has ever worked on Wall Street knows that the first thing anyone thinks about is how much money they can make off of deals. That's the goal, the motive, the driving force. And it's not new. Of course that doesn't excuse civil or criminal wrongs. But what it does mean is that you've got to look out for your own position and your due dil better be more than good. Caveat emptor. That's just the way it is and everyone knows it. I am sure you are all shocked by this revelation.
Yes, there are many fine people in the business who do put their clients' interests before their own. But so what. Do I wish that ethics were better? Of course. But don't be surprised when in a world where people lie awake at night thinking about how to make more money, some very big players lose money in a deal.
Here is the gist of the complaint as reported in the SEC press release:
According to the SEC’s complaint, filed in U.S. District Court for the Southern District of New York, the marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. The SEC alleges that undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.
The SEC’s complaint alleges that after participating in the portfolio selection, Paulson & Co. effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure. Given that financial short interest, Paulson & Co. had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson & Co.’s short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors.
The SEC alleges that Goldman Sachs Vice President Fabrice Tourre was principally responsible for ABACUS 2007-AC1. Tourre structured the transaction, prepared the marketing materials, and communicated directly with investors. Tourre allegedly knew of Paulson & Co.’s undisclosed short interest and role in the collateral selection process. In addition, he misled ACA into believing that Paulson & Co. invested approximately $200 million in the equity of ABACUS, indicating that Paulson & Co.’s interests in the collateral selection process were closely aligned with ACA’s interests. In reality, however, their interests were sharply conflicting.
According to the SEC’s complaint, the deal closed on April 26, 2007, and Paulson & Co. paid Goldman Sachs approximately $15 million for structuring and marketing ABACUS. By Oct. 24, 2007, 83 percent of the RMBS in the ABACUS portfolio had been downgraded and 17 percent were on negative watch. By Jan. 29, 2008, 99 percent of the portfolio had been downgraded.
Investors in the liabilities of ABACUS are alleged to have lost more than $1 billion.
Today Goldman sent this email out to their clients explaining their version of the case:
NEW YORK, April 16, 2010 -- The Goldman Sachs Group, Inc. (NYSE: GS) said today:
We are disappointed that the SEC would bring this action related to a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact.
We want to emphasize the following four critical points which were missing from the SEC’s complaint.
- 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.
Background
In 2006, Paulson & Co. indicated its interest in positioning itself for a decline in housing prices. The firm structured a synthetic CDO through which Paulson benefited from a decline in the value of the underlying securities. Those on the other side of the transaction, IKB and ACA Capital Management, the portfolio selection agent, would benefit from an increase in the value of the securities. ACA had a long established track record as a CDO manager, having 26 separate transactions before the transaction. Goldman Sachs retained a significant residual long risk position in the transaction.
IKB, ACA and Paulson all provided their input regarding the composition of the underlying securities. ACA ultimately and independently approved the selection of 90 Residential Mortgage Backed Securities, which it stood behind as the portfolio selection agent and the largest investor in the transaction.
The offering documents for the transaction included every underlying mortgage security. The offering documents for each of these RMBS in turn disclosed the various categories of information required by the SEC, including detailed information concerning the mortgages held by the trust that issued the RMBS.
Any investor losses result from the overall negative performance of the entire sector, not because of which particular securities ended in the reference portfolio or how they were selected.
The transaction was not created as a way for Goldman Sachs to short the subprime market. To the contrary, Goldman Sachs’s substantial long position in the transaction lost money for the firm.
Goldman isn't going to role over on this one so the SEC has a huge fight on its hands.
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Professional courtesy.
great point...them wondrous municipal finance IR Swap trades are too easily forgotten. More along the lines of "bad news for GS = good day for others"
Paulson and Co made $4 billion on the CDO meltdown, with Paulson's personal gains being $1 billion. So obviously this was a big one, but where did his hedge fund make the other $3 billion? Follow the trail.
Hedge funds love to do deals where they have more information than anybody else, sometimes dipping over into inside information, sometimes as in this case, playing with a marked deck.
Goldman was the house, winking at the crook at the table, collecting fees from the sheep.
+1. i might be wrong, but Paulson & Co could come off a bit foolish for even being involved. The mechanisms existed already to short those selected MBS without even bothering with the CDO structure.
Gosh, the Wall St shills are out in number, even on ZH.
Can't even read an article seeking to explain "their side".........prolly makes me unacceptably "unfair".........so be it.
I want em in jail ! the sooner the better.
Goldman is a repeat offender with the same MO each time. This isn't an isolated case but a pattern of fraud. They've blown a hole in the financial system and robbed the US taxpayer on a grand scale at least twice. They defraud their own clients in return for a side-bet from Paulson. Their entire business model is supposed to be based on their superior knowledge, judgement and understanding of finance. It turns out a street thug's understanding is all that was required. And they are responding to this and all charges as you would expect a street thug would.
This is nothing but a publicity stunt. The purpose is to ignite public opinion against the Banksters. With enough public outrage Obama hopes to enact Financial Reform (of some sort). He needs public outrage to counter the ENORMOUS war chest and lobbying efforts against reform. GS is a sideshow, it doesn't matter what happens to them, the real action is in DC.
Yes. And it is imperative that we keep our eyes - and everyone else's eye - on the ball.
A total clean out of Congress is what they don't want. So that is exactly what we must do starting in November.
I agree it is a publicity stunt but really you think Obama wants to "reform" the banking industry? More like reform the laws so that they can garnish my wages without court permission.
Fannie & Freddie, the Congress and Bush decided to push home ownership for poorer people so they could become mainstream Americans.
Eventually, the small town mortgage writers wrote mortgages to anyone, because there was demand from GS --- because GS found a way to slice & dice the junk mortgages into "safe" traunches and then "insure" these traunches. GS became the driving force.
A relatively bland and historic part of Americana ---- mortgage writing -- became a hot investment.
Did the the premier banker GS see the sub primes for what they were? ---- very risky ---- Yes as evidenced by the traunches and insurance.
A)Did the premier banker say to American investors and World Wide investors and Freddy and Fannie ---- No Way --- No Sales --- No monkey business ---Did they do what was right? Right in a moral and responsible sense?
B)Did they peddle the mortgages as they were -- "Sub Prime Mortgages for Sale -- Step right up and get your risky mortgage paying a ,well ,rather low interest rate"
Would doing A & B have stopped the Socialist --- Central Planners --- Sub Prime Debacle --- in it's tracks. If you can't get a buyer for the mortgage --- what local morgage writer would write a new sub prime mortgage.
We will never know
Because the banksters (and Jim Cramer) wear their amoral badge with honor -- their only creed is to make money regardless of whether you are peddling worthless paper ( a deed to the brooklyn bridge)
And if they, The Banksters, can convince the SEC that selling stock that you do not own or have possesion of (Naked Shorting) is necessary for "liquidity" -- And the SEC regulators, captured and looking out for their own individual interest down the road --- passed the Madoff exemption --- then it is not illegal. It may be wrong to sell something you do not own ---but not illegal.
The money changers are as bad as the socialist planners --- and they even voted for OBAMA --- Soros being Obama's largest contributor (thank you Tyler Gruden)
Both want to fleece the public of their hard earned money and hard earned freedom. So I say GS does not deserve a fair trial --- and they will be pilloried in the public before the trial.
I would like GS to prepare their defense along the line of -- "What could we do--- We did not pass this law pushing sub prime loans --- What could we do --- we only reacted to the Socialist --- to the initiators of this crime upon American Freedom
I really believe you have a point here, YellowDog. Apparently, there are some politicos out there that take offense to the logic.
I am impressed with your testicular fortitude. While I have a negative opinion of Goldman Sachs, it is nice to hear their side of the story. I would like to hear some sort of rebuttal to their story from someone more knowledgeable in this area if they can provide one.
I pretty much agree with you though, if Goldman is guilty of fraud they should be prosecuted. Fraud should be illegal and ENFORCED. However, stuff like insider trading laws are nothing more than an illusion, a deception of protection for the average joe and in fact average joe would be much better off without such laws because then they would be forced to face the truth, which is that insiders ALWAYS have the advantage. There is no perfectly level playing field in this respect, and never will be. The best way to protect the consumer is for them to understand the concept of "buyer beware", do your own damn research and stop depending on a completely impotent and captured regulatory body to "protect" you.
Edit: Also.. I do disagree with you in one respect. I think fraud did play a large part in the financial crisis. I'm not sure how you can say that it didn't. Unless I am misunderstanding you? I think it was:
#1 Low Interest Rates
#2 Fraud
#3 Community Reinvestment Act
#4 Repeal of Glass-Steagall (keep in mind I'd have no problem with the repeal of this law if it wasn't for the fact we have a stupid federally subsidized deposit insurance, but since we do this is a prudent measure to prevent the socialization of losses)
(in order of importance)
I added to my original comment a bit, so re-read it please...
You call this PR BS their side of the story like it has anything resembling the truth? I love this part:
"ACA had a long established track record as a CDO manager, having 26 separate transactions before the transaction."
BFD. 26 trades is hardly a long established track record. Additionally, the elite Goldman sales desk surely sold it well.
If we go back to the Orange County debacle in 1994, buying inverse floaters and other toxic waste in the REMIC's of that time, you will find they had a long track record too--of being suckers. History has been rewritten on that one...but I was in the business at that time and I know how it worked. Find the ninnies stupid enough to buy the junk and stuff it down their throats. Call Mike Vranos for further information...the king of stuffing the most toxic traunches from Kidder.
CMO's were launched in the early 80's with 4 traunches, REMIC's were launched in the late 80's seemingly simple at first and then ramping up to deals with 110 traunches by 1992 all mostly FNMA/FREDDIE vanilla backed. By 1994 they were just as fucked up as what was coming in the future. But your sales buddy at Merrill or GS was happy to wine and dine you and get you in on a great yield. Funny thing is, most sales guys didn't know shit about these things but acted like they did. Portfolio managers acted like they understood them because who wants to be stupider than your buddy on the Street? But the truth is, unless your duration was 3 years or under, you were in for a load of pain if prepayments accelerated or decelerated at a rapid rate. All prospecti had prepayment bands for each traunche--assuming other traunches behaved (lol)--that would determine your yield. But when you have 70-110 traunche deals--chances of an accrual bond jumping in front of your payment were always there, not to mention the fact that some of these things were tied to the most absurd interest rate indices in the world!
In 1999 we had the first CDO's--seemingly benign at first, but they could put everything but in the kitchen sink in them by 2004. A repeat performance of the REMIC market.
It's all just repackaging mortages (and then the CDO's where they were able to throw in more) and having to change the name periodically because they became more arcane, complex, and totally impossible to analyze given the parameters set forth within the prospecti. The only difference with CDO's is that they weren't my generation's MBS. They were heading straight towards toxic waste to begin and with a different structural edge, even more byzantine trash. Ah, the wonders of financial innovation.
If you really believe that these prospecti are read through and analyzed with a fine tooth comb before buying pieces of a deal--especially after a great night out on the town with your favorite Goldman salesman--you are beyond naive.
I never said I trusted them, which is why I wanted a response such as yours. ;)
Duly noted! :)
Great post Howard...Don't you see this entire sorry fiasco as predicated on "reaching for yield?" There were so many institutional investors who were desperate for fixed-income product with yield that they would do ANYTHING to get it. Of course the ratings agencies helped by stamping the AAA brand on all this shit. But isn't this the result of "zero" (pun intended) interest rates for a prolonged period of time when pension fund managers and other institutions were caught of guard? Where's Leo K on this issue?
Absolutely it was reaching for yield--and it always has been. In the beginning (god I sound old) CMO's were to allow everyone a choice of maturity thus giving the MBS market a wider audience. Note--the Japanese got so fucked in the early 1980's when they were holding plain vanilla GNMA 15% that they wouldn't touch them for years. They got vaporized on those pups.
CMO's were the ticket to get them back in with the shorter durations and first to be paid traunches. They had a pleasing yield of 20-30 bps over tsys. The structured market also allowed a host of other institutions to play in the MBS arena without dealing with as much of that nasty negative convexity. And for the longer traunches, the Drexels, First Bostons, etc. always found a client willing to buy. Seeking yield, you betcha.
See my response to your other comment below please..
I responded...I was in early morning fantasy land post revolution.