Securities and Exchange Commission (SEC) has charged Goldman Sachs and one of its vice presidents for defrauding investors by mis-stating and omitting key facts about a financial product tied to subprime mortgages as the US housing market was beginning to falter.
The SEC alleged that Goldman Sachs structured and marketed a synthetic collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS). Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO.
The SEC also alleged that Paulson & Co, a hedge fund manager, paid Goldman Sachs to structure a transaction in which Paulson could take short positions against mortgage securities chosen by Paulson based on a belief that the securities would experience credit events.
According to the SEC’s complaint, filed in US 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 (ACA), a third party with expertise in analyzing credit risk in RMBS.
The SEC alleged that undisclosed in the marketing materials and unbeknownst to investors, the Paulson hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.
After participating in the portfolio selection, Paulson 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 had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson’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 alleged that Fabrice Tourre, vice president of Goldman Sachs, was principally responsible for ABACUS 2007-AC1. Mr Tourre structured the transaction, prepared the marketing materials, and communicated directly with investors. Mr Tourre allegedly knew of Paulson’s undisclosed short interest and role in the collateral selection process. In addition, he misled ACA into believing that Paulson invested approximately $200m in the equity of ABACUS, indicating that Paulson’s interests in the collateral selection process were closely aligned with ACA’s interests. In reality, however, their interests were conflicting.
According to the SEC’s complaint, the deal closed on April 26, 2007 and Paulson paid Goldman Sachs approximately $15m for structuring and marketing ABACUS. By October 24, 2007, 83% of the RMBS in the ABACUS portfolio had been downgraded and 17% were on negative watch. By January 29, 2008, 99% of the portfolio had been downgraded.
Investors in the liabilities of ABACUS are alleged to have lost more than $1bn.
Robert Khuzami, director of the division of enforcement at SEC, 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.”
Kenneth Lench, chief of the structured and new products unit at SEC, said: “The SEC continues to investigate the practices of investment banks and others involved in the securitization of complex financial products tied to the US housing market as it was beginning to show signs of distress.”
In reply to the charges by SEC, Goldman Sachs has stated that it is 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.
Goldman Sachs has said that it has lost more than $90m, and the fee was $15m in the transaction. Moreover, it was subject to losses and it did not structure a portfolio that was designed to lose money.
IKB, a German Bank and 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. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side.
Goldman Sachs added that ACA, an investor, had 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, which were entirely typical of these types of transactions. ACA had the largest exposure to the transaction, investing $951m. It had an obligation and every incentive to select appropriate securities.
Goldman Sachs also said that it had never represented to ACA that Paulson was going to be a long investor. The SEC’s complaint accused the firm of fraud because it did not 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.