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.
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. Tags: Goldman Sachs, government, John Paulson, monoline bond insurers