Goldman’s Settlement with the SEC
by Linda Beale
crossposted with Ataxingmatter
Goldman’s Settlement with the SEC
On July 15, it was announced that Goldman had reached a settlement of the SEC’s charges regarding material misrepresentations in an Abacus CDO deal, acknowledging that its materials were “incomplete”. See Chan & Story, Goldman Pays $550 Million to Settle Fraud Case, NY Times (July 15, 2010).
Goldman sold the deal to buyers without informing them of the involvement of the counterparty to the deal. The counterparty was Paulson, a hedge fund manager, who had personally selected “most likely to fail” mortgages on offer and gotten Goldman to create a CDO package with those deals in it so that he could bet against the deal. The bet against the deal was a naked credit default swap. The person who bought the other side of Paulson was essentially buying a deck intentionally stacked against him, rather than a more diversified cross-section of subprime mortgages. Not surprisingly, that particular Abacus deal was particularly bad and went south within months of its creation and sale.
Now, in my view naked credit default swaps should be illegal. They are nothing but an insurance contract when the protected insurance buyer has no insurable interest in the reference property. As many have observed, such a situation presents a dangerous moral hazard– it is like letting an arson take out an insurance contract on the most expensive house in the neighborhood and then reap the benefit of the payout after he burns the house down. Nonetheless, the financial lobby is extraordinarily powerful, and Congress did not yet bite the bullet to ban naked credit default swaps in the financial reform package. (I say “yet” because I am convinced that we must dampen the use of such derivatives or stand by to witness destruction of both financial system and economy through continuing crises fueled by rampant speculation.)
But even if naked credit default swaps aren’t illegal (which is the current situation), that doesn’t mean that a bank should be able to cater to one client to create a financial product stacked with the worst of the worst subprime mortgages and neglect to tell another client about that critical fact. The SEC might have had difficult proving fraud: Goldman is no dumbie, and it is adept at selecting facts to cast itself in the best life and working to obscure facts that do not. Anyone hearing Paulson’s side of the story (read Michael Lewis, The Big Short) would want to know about his involvement in a deal, especially when those products were nonetheless rated AAA. (Yeah, rating agencies were in on the game too, but the banks were tailoring their synthetic CDOs to match the known rating agency procedures, sort of like stacking up a room full of people paid the average income and needing to boost it to make it look like incomes are higher, so adding a multimillionaire with just the right income to the mix to bring the average up to the desired goalpost and no more. Crapola.) And I for one suspect that the SEC could have rather easily proven material misrepresentation.
Goldman took a battering from having the suit out there and clearly wanted to settle. But Big Banks want to settle on terms that don’t produce real pain. So Goldman got a deal with essentially a $550 million price tag, which, as the weekend Wall St. Journal editorial notes, is “a mere two weeks worth of recent trading profits.” Goldman’s Bailout Fee, Wall St. Journal, July 17-18, 2010, at A12. Too little, methinks, even with the concession not to seek a tax deduction for any part of the fine which might otherwise have been deductible. See Donmoyer, Goldman Sachs Waives Tax Deduction on SEC Settlement, Bloomberg.com (July 16, 2010). In my view, anything under 10% of Goldman’s profits last year, plus no tax deduction, is de minimis. Anything smaller than that will be viewed by the financial industry as no more than a slap on the wrist. To be instructive and to spur more prudential banking from Big Banks, the penalty needs to be severe enough to be taken very seriously.
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Update: Michael Perelman at Econospeak has Seven Questions for the SEC regarding Goldman
“The counterparty was [represented by ACA], [an expert in selecting mortgages for CDO construction], who had personally selected “most likely to [succeed]” mortgages on offer and gotten Goldman to create a CDO package with those deals in it so that [the counterparties] could bet [with] the deal.”
In each of these deals there has to be a long-buyer and a short-buyer. The sentence you wrote is biased against the short position, which I reframed to be biased against the long position. There’s no reason to be biased against either position, which is why ACA and Paulson negotiated which mortgages were included and which were tossed out.
Naked swaps should be regulated by the gaming commission since they are gambling. I suspect that you could find a bookie somewhere in the world willing to take a bet on the situation. In fact perhaps we should divide financial products into gaming products and useful products (A fairly narrow list of basically old instruments such as stocks bonds options and futures). The rest are called gambling, and in gambling one recognized that the position to be in is the house as they always win. So lets call a spade a spade and make it pure gambling.
The fact that a third party, Paulson, had a significant role in putting together the contents of the Abacus derivatives is certainly material. The fact that that third party made the selection of the content mortgages based upon a likely to fail measurement is certainly material. The fact that that third party then purchased CDOs insuring itself against failure of the derivative bonds is reasonable material evidence that a scam was in the works. That the purchasers of the purloined derivative bonds were themselves sophisticated participants is not a point that out weighs the material facts that indicate an effort to conceal the true nature of those derivative bonds. GS holds itself out as a trusted investment banker with products that can be relied upon to be what they are represented to be. In this case supposedly AAA mortgages in a package designed to earn the investors a certain return on their investment. That’s what investment banking is about, trust, honesty and expertise in finding and offering one’s clients worthwhile investment opportunities.
It appears that m. jed is trying to take corev’s place, or worse yet add his deceptive point of view, to the comments on each of the AB threads lately. The free market ideology does not include freedom from accurate representation of the facts about products for sale or for investment. The injured parties were not speculating on pink sheet stocks nor betting against what they might perceive as poor investments. They were investing through a trusted bank with what had been a reputation for professional advisement to their clients. Is that what Paulson was doing in his role in constructing the Abacus bonds?
Jack, it would be useful if you read the SEC complaint: http://www.sec.gov/litigation/complaints/2010/comp-pr2010-59.pdf
“On January 9, 2007, GS&Co sent an email to ACA with the subject line, “Paulson Portfolio.” Attached to the email was a list of 123 2006 RMBS rated Baa2. On January 9, 2007, ACA performed an “overlap analysis” and determined that it previously had purchased 62 of the 123 RMBS on Paulson’s list at the same or lower ratings.”
So absent Paulson’s involvement, ACA had already determined that half of the RMBS’ he selected “to blow-up” were those they wanted to own.
“On January 22, 2007, ACA sent an email to Tourre and others at GS&Co with the subject line, “Paulson Portfolio 1-22-10.xls.” The text of the email began, “Attached please find a worksheet with 86 sub-prime mortgage positions that we would recommend taking exposure to synthetically. Of the 123 names that were originally submitted to us for review, we have included only 55.””
ACA used its distreciton as Portfolio Selection Agent to throw out mortgage securities recommended by Paulson.
“Later the same day, ACA emailed Paulson, Tourre, and others at GS&Co a list of 82 RMBS on which Paulson and ACA concurred, plus a list of 21 “replacement” RMBS. ACA sought Paulson’s approval of the revised list, asking, “Let me know if these work for you
at the Baa2 level. . .On February 5, 2007, Paulson sent an email to ACA, with a copy to Tourre, deleting eight RMBS recommended by ACA, leaving the rest, and stating that Tourre agreed that 92 bonds were a sufficient portfolio.”
That sounds like a negotiation to me.
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That a third party had a role in putting together the contents of the Abacus deal with an economic interest in seeing the value decline is material, only to the point that when I sell a stock through Schwab – either from an exisiting position, or short, I have a behavioral interest in seeing it not appreciate as much as what I’m putting the proceeds into. For each buyer there’s a seller. To the extent that the buyers were “sophisticated” it’s that they should have at a minimum understood this.
When you bet Ohio St.-Michigan at Caesar’s, the casino has no responsibility to tell you who’s on the other side of the bet, and in fact, if I were a client of Goldman, would take issue with them divulging my identity without my permission.
The injured parties were seeking higher returns than the risk associated with AAA-securities normally warrant. Goldman was not an investment advisor to the parties that bought the securities. It would also be useful if you could parse the different roles that a global investment bank has because you seem to be amalgamating them into one and demonstrating a lack of understanding.
yes, there is always a buyer and seller, and since credit default swaps are bets, there is always a winner and a loser in these deals.
In either case, allowing one of the parties to select the referenced items without the other party being aware of that involvement is a material misrepresentation–anybody buying the side not involved would want to know that the items were not selected by someone independent of both buyer and seller but rather by the counterparty to the deal. Generally, the counterparty can be expected to have their own interest in mind…..
As reported in the WSJ On-Line edition:
“As part of the settlement, which has to be approved by a New York federal court, Goldman was required to issue a statement saying it made “a mistake” by not disclosing the role of hedge fund Paulson & Co. to investors for helping to arrange the mortgage deal. Goldman pledged to toughen oversight of mortgage securities, certain marketing materials and employees who create or pitch such securities. It neither admitted nor denied the charges. A spokesman for Paulson & Co. declined to comment.”
As reported in Bloomberg Businessweek:
“Goldman Sachs didn’t admit or deny wrongdoing in the SEC accord, disclosed on July 15. The firm acknowledged it made a “mistake” and that marketing materials tied to the offering had “incomplete information” because they stated that the portfolio was “selected by” ACA Management LLC without disclosing Paulson’s role. The company agreed to pay $150 million to IKB and to pay $100 million to Royal Bank of Scotland Plc, the British government-owned bank that ultimately owned the risk assumed by ACA Management.”
It would appear that it was the other investors that were led to believe that ACA had a central role in putting together the CDOs and that Paulson’s participation and short position was hidden and material. You see m. jed half the story is insufficient to understanding the fraudulent character of the deal. But that seems to be an earmark of your point of view, that half a story is better than none.
I’d like to say, “only you”, Jack, but we know that’s not true. Nevertheless, it takes a special level of chutzpah to claim I’m only presenting half of a story when I reproduce facts alleged in the SEC’s complaint.
As for your hyperbole, with respect to understanding the fraudulent character of the deal, fraud has a legal definition, and since you’re citing the settlement statements, you’ll also note that fraud charges were dropped, so while Goldman admitted to making a “mistake”, the SEC admitted, by dropping the charges, that there was no fraud.
“… when I reproduce facts alleged in the SEC’s complaint.”
And again produce only a portion of the facts as represented by the complaint and by the reality of the actions of GS. Pointing to half the glass of water and describing it as a glass of water is a fact, but it still leaves out the half empty nature of the story.