Original posted on FT Alphaville by Joseph Cotterill:
The weekend produced a veritable Eyjafjallajökull ash cloud of blogging and bloviating on the SEC’s filing on Friday against Goldman Sachs and its structured products trader Fabrice Tourre. Here’s the best we’ve read.
Getting shorty in CDOs
First — the key SEC charge is that Tourre allowed John Paulson to pre-select bonds in a proposed CDO and then to short them, without informing its other investors, ACA Capital included.
In a stand-out post, Steve Waldman questions the role of shorting in CDOs overall, arguing that CDOs are more akin to securities than derivatives, in terms of disclosure:
Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO. They no more thought they were trading “against” short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio. Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors. That’s inexcusable. Was it illegal? I don’t know, and I don’t care.
In a separate post, Steve mulls a more abstract view of whether Goldman did indeed act as a ’secret agent’ for one client to the disadvantage of another.
And was that pragmatic, let alone legal?After reading the filing, Bond Girl is cutting:
Seriously, why the hell would anyone want to be a client of Goldman Sachs after reading this?
Why would you work with a firm where employees mock the transactions they are arranging for you to purchase in emails?
Why would you work with a firm that would let someone that it knows is going to have a short position in the investment – because it helped them attain it – help structure that investment for you?
Why would you work with a firm that sees your multi-million-dollar business relationship as nothing more than collateral damage in its ultimate pursuit of fees?
This is not what investment bankers do. This is what backstabbing sociopaths do.
ACA and due diligence
Meanwhile, Henry Blodget and Felix Salmon squared off over whether Paulson’s prior involvement did indeed materially affect ACA’s position — or whether a ’sophisticated investor’ should have known better. Quite the ding-dong, this.
Blodget argues that there is a difference between control and influence:
Paulson did NOT have control over which securities were selected for the CDO.
This is critical. It’s also a fact that is clearly visible in the evidence the SEC provided.
The firm that DID have control over which securities were selected, ACA, was a highly sophisticated firm that analyzed securities like this for a living. It had FULL CONTROL over which securities were included in the CDO. We know this because, of the 123 bonds that Paulson proposed for the CDO, ACA only included 55 of them. In other words, ACA dinged more than half of the bonds Paulson wanted in the CDO, presumably because they did not meet ACA’s quality hurdle.
Now, did Paulson influence which securities ACA selected? Yes, he probably did. But any time someone says or does anything with respect to a security, there are lots of things that influence decisions.
Salmon calls this argument ‘pathetically unconvincing’:
Let’s remember here that in the end there were 90 securities in the CDO. Of those 90, it seems that 55 were chosen by Paulson. In other words, more than 60% of the securities in the CDO were picked, essentially, out of a stacked deck. It didn’t matter which securities ACA chose; Paulson had come up with his longlist of 123 securities precisely because all of them were particularly toxic. That’s a material fact which, if ACA had known it, would surely have sufficed to get them to exit the deal entirely.
Paul Kedrosky has the original flipbook for the ill-starred CDO, for reference.
Pivoting from that flipbook, Erik Gerding of The Conglomerate zeroes in on the SEC’s case over disclosure:
My guess is that a reasonable investor would indeed want to know that Paulson was involved in selecting the deck. What’s the support for this beyond the SEC’s Complaint? Look at the “flipbook” for the transaction provided to investors by Goldman…
It goes on at length of why ACA is a good collateral manager for the CDO. On p. 27, it includes a bullet point “Alignment of Economic Interest.” The SEC complaint zooms in on this little nugget (see Complaint Para. 38). (Note to law students: bullet points in “powerpoint” style are not only bad devices to communicate ideas, they have some itty bitty securities law problems when used to market securities. If you can’t formulate something in a complete sentence, try again.) Nowhere does the flipbook mention that the Paulson hedge fund was involved in selecting the collateral for the CDO.
But it’s far from a slam dunk, he notes. Still, Salmon has raised a wider set of questions about the Abacus deal — so this aspect will no doubt run and run as a point of bloggy contention.
Financial reform, post-Goldman
Barry Ritholtz has some questions too — more geared to the fallout on the current debate on US financial reform, however, as the Dodd bill lands on the Senate floor:
2. How endemic is this practice on the Street? Did other big derivative underwriters — Merrill, Morgan, Lehman, Deutsche, etc. — engage in similar (alleged) fraudulent practices when they were constructing and marketing these derivatives?
4. What does this say about the White House and Wall Street? Are the gloves off? Has the public outcry now reached the point where we might see vigorous prosecution of Wall Street wrongdoing?
7. How does this impact the Financial Reform legislation snaking its way through Congress? Will this add momentum to the call for stronger regulation of the Street? Of Hedge Funds?
8. Will this finally move derivative reform — exchange traded, full transparency/open interest, counter party disclosure, reserve requirements, perhaps even overturning CFMA — forward?
We might well ask — given some nifty Democratic capitalisation on the case already.
When you deliberately withhold adverse material information from customers, that is fraud. When you do this on a grand scale, the full weight of the law will come down on you and the people who supposedly supervised you. And if the weight of that law is no longer sufficient to deal with – and to prevent going forward – the latest forms of very old and reprehensible crimes, then it is again time to change the law.
Hmm. That would really put the cat among the Senate pigeons.
- SEC charges Goldman Sachs with subprime fraud
- The case involving ABACUS 2007-AC1
- Markets Live transcript - Goldman/SEC special - 16 Apr 2010
- Formerly The Greatest Trade Ever
- Paulson: 'It's our money now'
- SEC/Goldman linkfest
- Introducing Fabrice "fabulous Fab" Tourre
- 'Goldman Sachs is disappointed...'
- This CDO is a Democrat
- ACA's rather disastrous CDO forays
- The analysts react
- A Goldman blogger round-up
Both the traditional media and the blogosphere have taken an almost obsessive interest in the suit the SEC filed against Goldman last week with regard to one of its synthetic real estate related CDOs, Abacus 2007 AC1. Goldman’s shares and the stock market in general traded down, presumably seeing this suit as a turn in the tide, an end of the US government’s supine stance on questionable practices in the financial service sector.
Although the Wall Street Journal is reporting that the SEC is widening its investigation, so far it appears to be going only after very low hanging fruit. While the Journal notes that the SEC is looking into specific CDOs issued by Merrill, UBS, and Deutsche Bank, in all the examples mentioned, there is an existing private lawsuit against the investment bank. As we discuss in detail below, we think this initial salvo falls well short of the universe of possible miscreants.
So the big question remains: how aggressively will the SEC pursue these cases? As John Bougearel noted in an earlier post, it is too early to tell whether this suit is indeed the beginning of a concerted initiative (with the initial litigation allowing the SEC to perfect its legal arguments and uncover more information through the discovery process) or simply an effort to address (as in appease) to a public mad as hell about no-questions-asked bank bailouts and continuing subsidies to the financial services industry.
And while many commentators have focused on the quality of the SEC’’s apparent case, the truth is it is far too early to tell. The claims do look strong enough to survive summary judgment, which means the SEC will be able to seek more information from Goldman, Paulson, former ACA staffers, and various counterparties. It can add claims if it wants to as the case progresses.
And as other have noted, the odds are high that even if Goldman wins (or more likely, settles), it comes out the loser. When Procter & Gamble and other large companies sued Bankers Trust over losses they sustained on derivatives trades gone bad, many observers argued they didn’t have much of a case. Procter in particular had a sophisticated treasury operation; how could experienced market players claim they had been duped? The litigation appeared to be an effort to stem losses on bad bets.
But when P&G obtained access to taped conversations of BT staff discussing their and others’ trades, public opinion shifted dramatically. The bank’s posture was openly predatory (the most infamous quote was “Funny business, you know? Lure people into that calm and then just totally fuck ‘em.”). BT never recovered from the scandal, but it took a second run-in with the authorities (failing to turn abandoned client assets over to the state) that led to the bank’s sale to Deutsche Bank.
Assuming that the Goldman suit is the first step in a bigger initiative, where might the SEC and private claimants go next? There would seem to be at least three obvious channels: other John Paulson-related CDOs; non-Paulson Goldman Abacus trades; synthetic CDO programs like Abacus, apparently for the banks’ own accounts (the most notable example being Deutsche Bank’s Start program) and the Magnetar CDOs, which were structurally different than the Paulson program but appear to have been designed with the same intent, namely using a CDO to gain access to credit default swaps on particularly drecky subprime debt at cheap price (since the use of a CDO lured some counterparties into accepting AAA prices for at best BBB risk).
Greg Zuckerman’s book The Greatest Trade Ever discusses the origin of the synthetic CDO, and depicts Paulson as the moving force behind them, attributing $5 billion of CDOs to him. According to Zuckerman, Paulson approached Goldman, Deutshce Bank, and Bear Stearns in 2006 about launching synthetic CDOs that he would sponsor in return for taking down the ENTIRE short side (as in all of the CDS used to provide the cash flow for the CDO). Bear Stearns found the idea to be unethical (!) while Goldman and Deutsche went ahead.
Various commentors, including this blog (and later in an extensively researched New York Times story) have observed that Goldman’s Abacus program (25 deals, totaling over $10 billion) appeared to be designed to serve Goldman’s desire to put on a short position, yet presented to customers as no different than other CDOs. Deutsche Bank’s less widely discussed Start program appears to be along the same lines.
Although one of Magnetar’s deals is also on the list of cases the SEC is probing, this CDO (Norma) has been in the press since 2007, when it was the focus of one of the very first stories on dodgy CDOs, this one published by the Wall Street Journal. Magnetar’s program was far and away the largest of all the subprime short strategies that used synthetic or heavily synthetic CDOs as a major component. Our tally of the trades (more complete than ProPublica’s) puts the total at 29 transactions with a total par value of over $37 billion.
We’ve sorted the deals by banker, since the winks and nods that might have occurred between the dealer and the hedgie sponsoring the deal could have operated across multiple transactions. The list shows that some major CDO players have not yet received much critical scrutiny for their role in working with CDO sponsors who appear likely to have designed the deals to fail, namely Calyon, Mizuho, Citigroup, Lehman, and Wachovia. We’ve also put Calyon and Mizhuo together on our spreadsheet, since the team at Calyon decamped to Mizhuo (while any legal action would presumably target the bank-issuer, plaintiffs might want to examine the conduct of the professionals at both firms).
In other words, there is a lot of dirt if the SEC chooses to dig. And it is far too early to tell whether they have the Administration support and the bloodymindedness to do so.