The SEC: it’s a WAR!! Against Goldman Sachs!!
Fear!! Fire!! Foes!! Awake!! PANIC!!!!!
In an absolutely stunning development, Wall Street titan Goldman Sachs, whose influence is so pervasive that it’s been accused of being virtually a branch of the federal government unto itself, has been sued by the federal government — specifically the Securities and Exchange Commission — for alleged securities fraud.
And not just any securities fraud. The allegations sound an awful lot like — indeed, virtually identical to — the Magnetar deals exposed this past weekend on NPR, and discussed yesterday on this blog. As the song says:
Step One! We write a check to a Wall Street bank for 10 million dollars, and ask them to make us a CDO!
Step Two! They create the CDO using risky stuff! Very risky stuff! Extremely risky stuff!
Step Three! Other investors commit hundreds of millions of dollars to the CDO.
Step Four! We bet AGAINST the CDO, using a credit default swap!
Step Five! The housing market crashes, the CDO’s value drops to zero, our bet pays off and we make hundreds of millions of dollars and before you can say “Step Six”… We’re rich!We’re gonna bet against the American Dream.
We’re gonna be on the winning team.
Purchase risky debt on a massive scale
Then place a bet that the debt will fail! …
Here’s how the New York Times describes the Goldman case:
[The SEC] claims [Goldman Sachs] created and sold a mortgage investment that was secretly devised to fail. …
The instrument in the S.E.C. case, called Abacus 2007-AC1, was one of 25 deals that Goldman created so the bank and select clients could bet against the housing market. Those deals, which were the subject of an article in The New York Times in December, initially protected Goldman from losses when the mortgage market disintegrated and later yielded profits for the bank.
As the Abacus deals plunged in value, Goldman and certain hedge funds made money on their negative bets, while the Goldman clients who bought the $10.9 billion in investments lost billions of dollars.
According to the complaint, Goldman created Abacus 2007-AC1 in February 2007, at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst. [“And all we’ve gotta doooo / To make our dreams come truuuue / Is bet against the American Dreeeeeam!” -ed.]
Goldman let Mr. Paulson select mortgage bonds that he wanted to bet against — the ones he believed were most likely to lose value — and packaged those bonds into Abacus 2007-AC1, according to the S.E.C. complaint. Goldman then sold the Abacus deal to investors like foreign banks, pension funds, insurance companies and other hedge funds.
But the deck was stacked against the Abacus investors, the complaint contends, because the investment was filled with bonds chosen by Mr. Paulson as likely to default. Goldman told investors in Abacus marketing materials reviewed by The Times that the bonds would be chosen by an independent manager.
“The product was new and complex, but the deception and conflicts are old and simple,” Robert Khuzami, the director of the S.E.C.’s division of enforcement, said in a statement. “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.”
Mr. Paulson is not being named in the lawsuit. In the half-hour after the suit was announced, Goldman Sachs’s stock fell by more than 10 percent.
Here’s the Wall Street Journal‘s explanation:
The Securities & Exchange Commission charged Goldman Sachs Group Inc. and one of its vice presidents for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages.
The SEC said Goldman Sachs structured and marketed a synthetic collateralized-debt obligation, or CDO, that hinged on the performance of subprime residential mortgage-backed securities.
The CDO was structured and marketed by Goldman in early 2007 when the U.S. housing market and related securities were beginning to show signs of distress, the SEC complaint said.
According to the SEC, 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.
“Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc. [“Paulson”], with economic interests directly adverse to investors in the [CDO], played a significant role in the portfolio selection process,” the complaint said.
Stocks are down across the board, and particularly in the financial sector, because of the news. Which, of course, proves that this is a terrible idea and that Obama is a socialist who hates free markets. [/sarcasm]
Actually, it will be very, very interesting to see how Republicans react to this. (Caveat: I haven’t read any external commentary on this yet; these are just my first-blush reactions based on the bare-bones news of what has happened.) The SEC’s decision will surely be very popular with the public at large, given the broad populist rage against Wall Street. I’d imagine that would include the Sarah Palin / Tea Party crowd, as well as the Left and the center. But it will be deeply unpopular with Wall Street and financial types, who are big funders of the Republican Party (and the Dems too, in fairness — but certainly, their interests are generally more aligned with the GOP), and more generally with fiscal conservatives, many of whom (I would think) will see this as an unfair, heavy-handed attempt at an ex post facto federal crackdown on a practice — namely the secret, no-lose double-dealing on these types of financial products — that, while arguably unethical and certainly very destructive to the financial system and the economy, was, on the face of it, perfectly legal.
Of course, the charge is fraud, which is always illegal, but arguably the real target is the underlying practice. Anyway, this all presents a minefield for Republican politicians to navigate, or so it seems to me. The fact that the SEC’s action was announced on a Friday, traditionally the day when administrations “dump” news they don’t want to get much play in the media, strongly suggests that the political side of the administration had little if any influence on the decision; surely Obama and Rahm would have preferred this be announced on a Monday or Tuesday. It’s political gold for them, and political kryptonite for the GOP. At least that’s my sense.
Another interesting question is how Matt Taibbi, the Rolling Stone polemicist whose lengthy, scathing piece about Goldman Sachs last year got wide play in the blogosphere, will react to this news. I’m thinking that he’s either jumping for joy, sitting at his desk in stunned silence, or lying on the floor and in need of medical attention after fainting from the shock. I mean, the federal government actually sued Goldman Sachs?!? Really?!?!?!
Anyway, I’ve had very little time to read about this or digest it, but it’s a fascinating development, and I’m sure there will be much more to say about it. For now, here’s the SEC press release, with a link to the complaint.
P.S. Meanwhile, so much for this, one would think:
In his self-styled war against Wall Street, President Obama appears to have a powerful ally: Goldman Sachs.
That was published this morning. Heh.
P.P.S. Naked Capitalism: “Oooh, things are starting to get interesting.”
The Awl: “What the SEC is doing, it seems to me, … is recasting a rather common business practice as a crime—which is, quite likely, how it should have been considered all along.” (Bonus: Goldman as the Eye of Sauron. Heh.)
The scandal here is not that Goldman was short the subprime market at the same time as marketing the Abacus deal. The scandal is that Goldman sold the contents of Abacus as being handpicked by managers at ACA when in fact it was handpicked by Paulson; and that it told Abacus that Paulson had a long position in the deal when in fact he was entirely short.
Goldman Sachs has lost more than $10 billion in market capitalization today, in the wake of these revelations. Good. It can go long markets and it can go short markets. But it can’t lie to its clients. That’s well beyond the pale.
More reactions after the jump.
The Atlantic‘s Daniel Indiviglio:
The idea is that Goldman structured securities that were designed by an interested manager to go bad, but didn’t represent them that way to investors. If the facts of the case are proven to be accurate as depicted above, then it should be very easy for the SEC to prove fraud. Cherry picking bad assets and selling them to investors who thought they were chosen by an “independent manager” is illegal.
Up to now, Goldman has been arguing that it was just making markets in regard to the securities it created and sold that went bad. That isn’t generally fraud. Investment banks are free to unite buyers and sellers of securities — so long as they don’t misrepresent what they’re selling. But if it worked with a hedge fund to intentionally create a garbage fund and misrepresented that to investors, then that is fraud.
Yet suing Goldman is a slam-dunk for headline grabbing. This point raises the question: is it just a lucky coincidence that the SEC chose the investment bank most demonized by the media to finally sue? It’s plausible that many banks engaged in questionable behavior as the housing market began to sink in 2007, so it’s curious that the SEC chose to sue Goldman, and only Goldman. There is some chance that the SEC has a weak case, but looks to enjoy some public praise for finally appearing to crack down on Wall Street’s much-criticized actions during the housing market’s collapse.
So if the evidence described above is there, then the SEC should succeed. But even a win here won’t necessarily open the floodgates to lots more lawsuits. This could be an isolated situation where Goldman misrepresented how the securities were designed. If, in fact, an independent manager had chosen the assets in question, then there would be no case.
Given the charges, I can’t imagine that Magnetar will be able to escape the now emboldened SEC because the allegations against Magnetar’s cherry picking collateral for CDOs are identical. It seems the regulators have finally awakened from their slumber.
Get ready. The perp walks are finally coming.
Wow, I never thought this day would come. It has long been an open secret that Goldman Sachs had a role in defrauding subprime mortgage investors, but due to their specific government connections and the general state of the financial sector it was assumed nothing would come of it. However the SEC has filed civil (for now?) charges against Goldman to recoup their ill-begotten gains. …
It is obviously too early to tell where this case will go, let alone whether it is a precursor to more suits, but hopefully it is the beginning of accountability and a necessary step for true economic recovery.
We haven’t had time to review the SEC’s fraud allegations…in detail yet, but we’ve scanned them.
Based on the scan, we have not seen any screaming smoking guns. There is certainly evidence that Goldman and Tourre said one thing internally and another externally. It also appears that the information that was omitted in the external marketing materials would likely have been of interest to investors.
That’s not proof of fraud, but, as represented by the SEC, it looks bad. …
Goldman will likely say the charges have no merit and then, in a month or two, settle with the SEC for a few hundred million dollars (chicken feed). Goldman will then defend itself against the civil lawsuits that arise from this and probably settle those as well. There may also be follow-on lawsuits for other CDOs and products Goldman created. Those, too, will likely be settled or dismissed. Bottom line: This will cost Goldman some money, but not enough to matter to investors. …
Fabrice Tourre will be placed on administrative leave or fired (a.k.a., thrown under the bus). He will then spend the next couple of years testifying in this and other follow-on civil lawsuits. The SEC will probably demand a cash settlement from him, too, and boot him out of the industry. … Tourre will likely want to fight the charges, especially if he thinks they’re b.s., but it will be too risky and expensive for him to do so, so he’ll likely settle. Having made such public allegations, the SEC will make sure that any settlement produces an appropriately tough-looking headline (thus the fine and industry dismissal).
I don’t have much to add — I think you’ve cherry-picked some great quotes that explain the issue isn’t playing both sides of the fence, it’s about lying and defrauding investors. If one part of the market thinks real estate values are going to go up, GS is free to sell securities to those investors that will rise in value based on that outcome. Simultaneously, GS is free to sell competing securities to those investors who take the opposite view. This isn’t that different from casino operations, which facilitate all sides of the bet but take a piece of everybody’s pie. If these allegations are true, this is like the dealer encouraging the table to raise the ante and after the flop, while signaling to the guy with pocket aces that the other two aces are not yet dealt and are increasingly likely to be the turn card or the river.
As for this damaging Republicans, I am not particularly worried about that. Despite the imaginations of folks like Paul Krugman and Thomas Frank, corruption in companies like Enron and GS do not tend to be seen as partisan issues — especially when it is documented that those companies are well into the pockets of both parties. Vocal support for free markets and less regulated financial institutions does not signal support for fraud and insider games any more than vocal support for more regulation and socialistic principles signals support for the practices of bribery and favoritism.
Where there is an interesting political angle on this, is that this news just broke at the same time as the financial regulatory bill is making its way through the Senate. Coincidence? I’m inclined to think not.
Also, while GS is trading down 13% or so, the overall market impact has been far less damaging.
Seems to me this might be a tricky one for the Republicans to spin. Been thinking lately that, in the era of the insta-media, partisan politics has mostly been reduced to taking complex, difficult issues and reducing them to bite-size, happy memes (e.g. – Tea Partiers who hate government spending but love electing war heroes to make sure our brave soldiers get their share – heard that yesterday on a famous Right Wing radio show).
Anywho, I picked up a bit of Rush Limbaugh discussing Goldman at lunch today, and speaking of heads asploding – that poor bastard started with the “what Goldman did was not ‘unfettered capitalism'” and then quickly veered to the problem being that the regulation-loving Dems won’t let Goldman do what they want, which things Goldman wanted to do apparently being good now.
Channeling our earlier conversation about the Catholic church, the problem with Goldman’s behavior is that it is reflective of a poor controls environment for financial firms. You could argue that there are two broad views of regulation: in one (the good one), regulation essentially involves a governing body imposing controls on markets to ensure they function effectively (e.g. penalties for false advertising). The second version of regulation, the bad one, is pernicious government interference.
So getting back to memes, the MSM Republicans have for the most part set themselves up as opponents of regulation, for the arguably good reason that they oppose government interference. But the Goldman disaster sure looks like it was a result of a poor controls environment for financial mega-firms.
So how does the right-wing MSM play it, keeping in mind that the partisan mass media is specifically set up to take one side of an issue and gin up the base’s outrage from that perspective? Hell, unless you’re talking Glen Beck and his trusty chalkboard, I don’t know how the other right-wing talking heads tease out iterations of regulation without losing their cred as emotion-stokers.
Jazz, you’re incredibly good at pontificating meandering threads of semi-reasonable-sounding rubbish, but everything about this case boils down to this: fraud and misrepresentation is illegal. No more and no less financial regulation of complex financial instruments is going to change that fact. The complexity of the deals might make it more difficult to spot and untangle the fraud, but drawing up regulations to simplify financial instruments makes about as much sense as drawing up regulations to simplify how a VCR should work. By the time you’ve got it figured out, the technology and innovation will make your overly burdensome rules unnecessary and empty of purpose. In a worst-case scenario, you kill the market for the instruments completely and drive the financial sector to other places of the globe where they have more tools at their disposal (e.g. Dubai).
As for the political ramifications, again, you’ve created a false association between opposition to regulation and acceptance of fraudulently corrupt profiteering. Neither requires the other.
I think the regulation-related argument is that, fraud or no fraud, it should be illegal for a company to, on its own behalf (not on behalf of an arm’s-length client), bet against a financial instrument whose creation (and high risk level) the “betting” company is itself responsible for, particularly when the success of such a strategy depends quite clearly on other investors being duped (whether or not through technical “fraud”). Unlike a regular short sale, such a transaction has no redeeming value from the perspective of the market at large, and in fact can be incredibly destructive, as we’ve seen here. It seems to me that this particular example of “financial innovation,” unlike many other examples of financial innovation, is unequivocally bad.
As you rightly point out, the SEC’s case is predicated on Goldman not merely doing the above-described transaction, but doing it while committing fraud. However, the case shines a light on the overall practice, which arguably ought to be illegal on its own merits. I mean, really: what is the argument in favor of allowing such shenanigans?
To be clear, if I understand the facts correctly, the actor making the referenced no-lose double-bet “on its own behalf” is actually Paulson & Co., with Goldman as the facilitator of that bet. Paulson isn’t being sued, because they aren’t the ones who allegedly committed fraud; Goldman is. But there is no redeeming market value to what Paulson wanted Goldman to do in the first place, regardless of Goldman’s specific methods, and in fact it almost certainly could not be accomplished unless other investors were misled, whether or not misled to the point of “fraud.” Hence my argument that the whole transaction should be illegal (going forward, of course).
You’re confusing yourself by over-complicating the transaction. GS was setting itself up to make money in either outcome.
Consider Southwest Airlines. A few years ago, SWA began buying a significant portion of jet fuel on long-term contracts to hedge against sharp rises. Sure enough, when fuel costs went up, SWA made gobs of money on cheaper-than-market fuel while the rest of the industry had to deal with spot purchases fuel based on oil prices of 70, then 90, then 110 dollars a barrel. Had prices dropped in half instead of doubling, SWA would have been squeezed on cost while their competitors would have been able to undercut SWA ticket prices and still make good profits. But SWA didn’t commit all of its purchases to these long-term contracts; they still bought a significant portion of their fuel on the spot as well. This limited the upside and the downside and gave them a more predictable baseline for planning.
Similarly, there is nothing wrong with GS or other firms saying to themselves, “Gee, I’m making gobs of money on selling these securities, but if the markets turn on us, we’re going to go bankrupt real fast and/or see a significant market for our instruments disappear, so we better start buying default swaps as well.” What should happen, however, is that there should be some basic COI disclosures, such as if GS has any direct stake in the securities which it was marketing, failing, or if its internal analysts are predicting a fall in the value of these securities.
The crime in this particular case is not that GS and Paulson collaborated to market a tranche of securities they expected to go sour under faltering real estate market conditions — that is and should be totally legal, so long as the buyers are aware of the sellers’ positions. This is NO DIFFERENT than any other equity transaction, and usually the information is implicit: I am selling my property or stock to you because I think the value is going to drop; you are interested in buying my house or stock because you think I am wrong and that values will actually go up. If GS and Paulson had said to these investors, “We are in a short position here, but this is a great deal — you should take it!” That would’ve been perfectly legal. The investors might have hesitated and turned down the offer, but they might also have thought they had a better read on the real estate market and on these particular securities and in fact saw this as a great deal. Instead, the allegations are that GS conspired to trick the investors into thinking Paulson was long on the deal when he was in fact short. That, if true, is simply fraud.
In summary, hedging your bets and betting against your clients can and should be legal so long as you’re disclosing your position. The resultant stability from hedging your risk is obviously of great “redeeming value from the perspective of the market at large”, but that ceases to be the case when such hedging comes at the expense of duped and misled clients.
I’m not confusing myself. I am merely suggesting that there is probably a gray area in between “fraud” and “full disclosure,” and because these particular deals (unlike some of your hypotheticals) were pretty clearly not going to work unless there was some level of deception occurring, the best-case scenario for the deals’ authors is that they fall into that gray area… in which case they are both legal and horrible for the economy/market at large.
Out of curiosity, have you listened to the previously-blogged This American Life episode about the Magnetar Trade, or read the above-linked ProPublica article? Not that you’re obligated to, of course, but it explains where I’m coming from far better than I can.
So – learning from history, just how much of this will turn out to have the same root causes as the Keating debacle, whereby the regulators were in place, yet were told to keep away by powerful politicians like those of the so-called Keating 5 – where the GOP involved was exonerated, and the Dems involved were held as having been at fault …
Goldman Sachs believed that they had powerful protectors … I’m currently wondering just how much of what is happening is a pre-emptive ‘strike’ before an anticipated change of House (and possibly even Senate) control due to the upcoming November election …
From the ProPublica article:
I’m all for throwing in jail persons who deserve to be thrown in jail, but this article buries the lede. The housing bubble and the financial crisis were not caused by bad actors like Magnetar, they were caused by a Fed policy of easy money and a congressional mandate on Fannie Mae and Freddie Mac to open up the spigots to encourage low-income minority (read: unqualified) homeownership.
Another damning nugget:
Translation: The government-created oligopoly on credit-rating agencies backfired disastrously and investors paid the price — just like in 2001 with Enron.
Bottom line: What Magnetar did was ethically despicable, but in all likelihood, entirely legal. Unlike GS, they actually went in on the deal, so the investors weren’t betting against Magnetar, they were betting alongside them. But Magnetar understood the risk and bet heavily in CDS’s such that it would make money even beyond what it had invested in these CDOs.
One thing in this article I did not understand is, the article says this:
Then elsewhere, it suggests that Magnetar focused on buying the most risky tranche, the equity of the CDO. Both cannot be true, unless what they’re trying to say is that Magnetar bought portions of the CDO in both tranches in order to jumpstart the CDO creation. But again, that is not made clear or explained very thoroughly.
I see two things that would have helped the overall market in response to this type of bold subterfuge:
One, all CDOs and CDS’s should be a matter of public record; the light of day should shine on the investors in these instruments. That way, if Magnetar approaches a bank about starting up a risky CDO, the bank can look at the public record of Magnetar’s trades and decide if its a smart deal or not.
Two, to the extent CDS’s are intended to be an insurance and hedging mechanism, vs.a tool to ledger outsized bets, it is probably a good idea to limit your ability to invest in a CDS to the size of the bond you are invested in, and you should not be allowed to invest in CDS’s that cover CDOs and bonds in which you have no stake at all. The fact that you don’t have to own anything to invest in CDS’s is a synthetic multiplier on the underlying securities and equities supposedly being “insured”.
Bottom line: True fault likes with the Fed and gov’t policy makers; Magnetar took advantage and danced in the gray to make billions; and GS made the fatal mistake of (allegedly) actually perpetrating fraud to keep their shell game going.
I was confused by the mezzanine vs. equity contradiction (or apparent contradiction) too, but I think what they’re saying is this: the CDOs that Magnetar “sponsored” (by buying the “equity” tranche of the CDO) were themselves made up entirely of the “mezzanine” tranches of other bonds (namely mortgage-backed securities). All CDOs, after all, are made up of other bonds, or portions thereof. I think in Magnetar’s case, their CDOs — including all three CDO tranches — were made up entirely of mezzanine MBSs (or “synthetic” mezzanine MBSs or whatever the hell).
I could be wrong, though. That particular point certainly is not explained well, unlike most of the piece.
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