Saturday, April 17, 2010 2 comments ++[ CLICK TO COMMENT ]++

SEC charges Goldman Sachs with fraud

Most of you are likely aware by now that the SEC has made a civil charge* against Goldman Sachs for a CDO that they sold. I wasn't going to comment on this story, since it has been covered by others and you can get better information from those sources; but I changed my mind and thought I would just say something just for historical record-keeping purposes. The more I thought about the situation, the more I realize how significant this event may end up.

To recap the situation, it seems Goldman Sachs sold a synthetic CDO called ABACUS 2007-AC1 in 2007 and the SEC is charging that Goldman Sachs made misrepresentations. Basically, it seems that Goldman Sachs didn't disclose material information. The material information centers on the fact that the CDO appears to have been constructed with the input of the hedge fund run by John Paulson. This is important because Paulson was attempting to short the CDO (for those not familiar, Paulson rose to fame after shorting the subprime mortgage market and making several billion during the bust.)

The Fabulous Fab

The SEC probably has a good chance of winning the civil suit. It appears a European executive (Vice President) at Goldman Sachs, Fabrice Tourre, boasted openly of his incompetence and lack of understanding of what he was doing. The Globe & Mail quotes the SEC complaint:

Portions of an e-mail in French and English sent by Mr. Tourre to a friend on January 23, 2007 stated, in English translation where applicable:
“More and more leverage in the system, The whole building is about to collapse anytime now…Only potential survivor, the fabulous Fab[rice Tourre]…standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!”

Talk about ego bringing down someone. It's not clear if senior management was aware of Tourre's actions but it is probable that Tourre is the one that will end up paying the price.

One interesting thing about Fabrice Tourre's e-mail is how early (Jan 2007) he was aware of the potential for the collapse of the CDOs. The crisis started unfolding with the unusual loss taken by HSBC in early 2007 but the real signal was the collaspe of the two Bear Stearns hedge funds in March of 2007 (if I remember the date correctly.) If Tourre's knowledge was shared by others at Goldman Sachs, it kind of makes sense how Goldman Sachs avoided getting killed in the bust. I always wondered how Goldman Sachs avoided the mess and it seems that they really had people who understood the situation better than their competitors and the general public.

One thing that is becoming clearer to me is that European bankers, investors, and other financial players are less competent and less skilled than American ones. I probably insulted all the European readers with that comment, but come on, who played the worse role in this crisis? On top of this incompetent Fabulous Fab fellow, don't forget that AIG was brought down by a small 100-employee division in Britain. A lot of the massive losses were also due to the lack of skill by European investors from various banks, pension funds, and the like.

Initial Monetary Damage Likely Limited

The monetary damages to Goldman Sachs from any legal outcome is likely to be limited. Goldman Sachs only earned around $19 million and it has suggested it ended up losing $90 million in the end on this deal. So even if a court makes Goldman Sachs pay back what it earned on the deal, it wouldn't be much.

The real question, though, is whether Goldman Sachs will be liable for the entire loss of the CDO. The main buyers, two European banks, ABN Amro and IKB, took around $1 billion in loss on the deal (conversely, it appears Paulson probably made $1 billion on the deal.)

The Bond Insurer Angle

Thanks to Felix Salmon for pointing me to the initial sales document for Abacus 2007-AC1. It looks like Abacus was managed by ACA Capital. Long time readers may recall ACA was one of the weakest monoline bond insurers and the first one to go bust.

ACA was acting as the manager here but think about the cases where they were an independent insurer. If Goldman Sachs loses this case, I wonder if it will end up being liable for losses paid out by the bond insurers. Insurance companies have been trying to claim that the CDOs they insured were fraudulent with little success so far but I wonder if this case completely changes the outcome.

In fact, the market is betting that some bond insurers may recoup some of the money they have paid out. MBIA shares rallied 5% on Friday on this news. I think almost all the bond insurers, and certainly someone like Ambac, is likely insolvent but if they recoup a billion here and there, the outcome could be radically different. Some of the surviving ones, such as AIG, may live to see some money being sent their way. It remains to be seen if AIG will sue Goldman Sachs and others.

Other CDO Sellers Vulnerable

This civil charge against Goldman Sachs likely means that other banks who were sellers of CDOs and similar products may be vulnerable. The SEC will probably bring civil charges in other CDO cases where short sellers played a role in constructing them. According to MarketWatch, Scion Capital and Magnetar were two prominent firms that profitted from selling short and it's not clear how similar those deals are to the Paulson deal.

Long-term Implications

Assuming the monetary damages are contained, the biggest loss for Goldman Sachs will be the damage to its reputation. Customers may end up losing faith in a company that seems to be dealing against their interests. There is already some dislike of Goldman Sachs by the public, usually the jealous types and conspiratorial types that hang out at websites like Zero Hedge, but losing face to customers is a grave threat.

The reputational damage is such a great risk that I have read some reports suggeting that some key employees have suggested taking the company private.

I suggested earlier how Warren Buffett tarnished his reputation by becoming an owner of Goldman Sachs and I suspect his reputation is going to get hit even more, given all the dirt that is likely to come out of this case.

I think John Paulson's reputation probably weakened a little bit too, given how he profitted off a product that was misrepresented to the buyers. I don't think Paulson did anything wrong but the public will continue to question his profits. Other firms that profitted from short-selling, such as Scion Capital and Magnetar Capital will also be under a cloud, even though they didn't really do anything wrong (if anything their whole business is centered on profitting from these situations so I don't think they did anything wrong.)


* My understanding is that the SEC can only lodge civil charges. Criminal charges, if any, would have to be brought up by the DOJ. It's not clear if the DOJ will be bringing forth any criminal charges. According to a Bloomberg report, it appears the SEC indicated to Goldman Sachs of a potential charge 9 months ago so I'm not sure if the DOJ has been attempting to cut a deal behind-the-scenes over the last 9 months or not.

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2 Response to SEC charges Goldman Sachs with fraud

April 18, 2010 at 3:10 PM

Hmm, I really have to take issue with the idea that USian bankers are smarter then their Euro counterparts. Not because it might be insulting to Europeans (hell, we do have plenty of idiots this side of the pond and they are very heavily employed in banking and politics) but because it simply doesn´t match the record.

Consider, how many Eurobanks blew up over subprime CDO/RMBS? very few in fact and all very small (IKB has about $80B in assets, a piker by Eurobank standards) Eurobanks off course didn´t need much US help in blowing themselves up the oldfashioned way:

 Icelandic banks killed themselves relying excessively on expensive wholesale funds and noncore deposits
 The UK, Ireland and Spain all had massive property bubbles of their own and plenty dodgy loans to go with that
 Fortis killed itself overpaying for ABN Amro and borrowing heavily to do it

So yes, our bankers are idiots, but CDO exposure wasn´t their big stupidity

 Compare this to the US. In the US:

Citi blew up on subprime CDO exposure (and was given massive amounts of government aid to make up the difference)
AIG blew up on subprime CDO exposure (and the London based AIG FP was mostly USian staffed)
Merrill Lynch blew up on subprime CDO exposure (and was merged into BofA effectively sinking that one as well but for massive government assistance
Lehman blew up on subprime CDO exposure
Bear Sterns blew up on subprime CDO exposure (and was given to JP Morgan with the Fed eating the loss on the worst CDO trash)
and that´s just the really big ones...

Wall Street should have understood these things if anyone did but Wall Street would have completely destroyed itself if the Feds hadn´t stepped in.

Only Goldman comes out looking rather clever and ironically they may just have been too clever by half. If this SEC lawsuit has legs it could sink Goldman and then all the great investment banks will have been killed off by CDO´s.

Sivaram Velauthapillai
April 23, 2010 at 11:02 AM

Sorry about the late response...

I was kind of joking when I said European bankers are worse. Both were incompetent and overpaid for what they did. There is also a lot of cross-ownership so it's hard to ascribe blame to one or the other (European banks were hurt by American subsidiaries and vice versa.) It also depends on who you blame when employees may be in one region but senior management, who are the ultimate risk officers, are from another region.

Lehman and Bear Stearns blew up but that is to be expected given how they were bond shops (anyone dealing in mortgage bonds was toasts.) I'm not excusing their behaviour but it isn't a surprise to me. They made a fortune on selling toxic assets and, well, they were poisoned by the toxicity after dealing in them too much.

It's still not clear to me that Merrill Lynch, Goldman Sachs, and Morgan Stanley were as dumb as they seem. Some of these companies have posted huge losses but they earned a fortune selling this stuff in the last decade. It wouldn't surprise me if the losses aren't that bad when you offset it with the profits earned over the last decade. If you look at stock prices of some of these banks, they are not as bad the situation indicates.

I agree with you that Citigroup was run by incompetents or the greedy (in it for themselves and not their employer.)

I don't really know if AIGFG was mostly Americans. I could be wrong but my impression was that it was Europeans.

As for European bankers, we have two giants that nearly collapsed: UBS and ING. There was also RBS, HBOS, and a few others.

Overall, American institutions will probably end up with bigger aggregate losses. But I suspect their situation may not be as bad if you count the profits they made selling this stuff. The problem for the Europeans is that they were mostly the buyers. For me, the biggest surprise is not the collapse of, say, Citigroup; but rather, the collapse of a conservative institution like UBS.

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