Thursday, April 22, 2010

The SEC vs Goldman Sachs: an instructive court case

The SEC lawsuit against Goldman Sachs is not all that complicated. The SEC is alleging that G/S worked with an investor, John Paulson, to design Collateral Debt Obligations (CDO's) that were designed to fail. Paulson then bought derivitaves on those CDOs that paid large sums if the CDOs failed. Goldman Sachs then went out and sold investors the CDOs telling them that the CDOs were solid, safe investments. The allegation made by the SEC is that Goldman Sachs committed fraud by failing to inform the investors that the individual who was betting the CDO's would fail had also selected many of the mortgages that were included in the CDO.

Here is a very readable explanation from Business Week.
The SEC chose this case because it is comparatively stark. In early 2007, at the request of Paulson & Co., the hedge fund run by billionaire John Paulson, Goldman structured a deal called Abacus 2007-AC1, designed to let Paulson wager that the subprime-mortgage industry would collapse. Goldman lined up two counterparties for a fee of $15 million: ACA, a bond-insurance company, lost about $950 million (with the banks backstopping it), and a German bank called IKB lost $150 million. Goldman's offense, according to the SEC, was telling IKB that the portfolio of mortgage bonds used for the deal was "selected by ACA," when in fact Paulson was deeply involved in the process, cherry-picking the worst bonds it could find. Goldman didn't tell IKB who was on the other side of the trade, or the extent to which Paulson influenced selections. As a result, the SEC claims, Goldman's statement to IKB was false, misleading, and fraudulent.

The issue in the case hides the complexity. Paulson and Co is not being charged by the SEC. Nor is the investor, IKB. Business Week goes on, however, to describe everyone involved as being a great deal less than angels. And what about the rating agencies which gave the CDO's very good ratings?
The Abacus case is of course far more complex and nuanced than the SEC complaint lets on. This is a cast of characters without a single hero. Not even the supposed victims are sympathetic. IKB sold commercial-paper IOUs to investors in mid-2007 that were worthless by year's end. Its former CEO, Stefan Ortseifen, went on trial last month in Germany for allegedly lying about IKB's financial condition before its near-collapse.

The credit-rating merchants, whose incompetence cannot be overstated, make their usual cameo, as well. And while Paulson didn't get sued, because the SEC said he made no misrepresentations, he did make $1 billion on the deal. Having his name associated with this alleged fleecing carries its own unknowable reputational risk.
The other major player in this case is the SEC. The SEC has also been reported to have known of the ponzi scheme by the Texan, Allen Stanford, since at least 1997 but failed to act because it was a large, messy and complex case and their statistics would look better if they took on many smaller, simpler cases.

The final villain in this case has to be the Bush Administration and Congress, both of whom strongly believed the conservative myth that regulation of financial firms should not be done because it would hurt business.

This case seems quite clear. Goldman Sachs told those who they sold the CDOs to that one of the investors (ACA) had selected the mortgages included in the CDO but failed to inform anyone that John Paulson, who was betting the investments would fail, was instrumental in getting many of the mortgages in the CDO included. Did Goldman Sachs know the CDO's were likely to fail? That's the allegation. They were selling bad product to investors and misrepresenting it. The market was totally unregulated, so there was no transparency in the transaction. The brokers and Paulson (who was betting the mortgages would fail and made billions when they did) were fully aware that the product Goldman Sachs was selling was a bad investment.

For anyone puzzled why the intentionally unregulated US and World economies came so close to collapsing into Great Depression II in the fall of 2008, this case is a microcosm of the reasons.

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