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Goldman’s Stacked Bet
By TOBIN HARSHAW

The ThreadThe Thread is an in-depth look at how major news and controversies are being debated across the online spectrum.
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goldman sachs, mortgages, s.e.c., Wall Street

From Government Sachs to guest of the government?
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* Room for Debate: What Goldman’s Conduct Reveals April 16, 2010

“Goldman Sachs, which emerged relatively unscathed from the financial crisis, was accused of securities fraud in a civil suit filed Friday by the Securities and Exchange Commission, which claims the bank created and sold a mortgage investment that was secretly devised to fail,” report The Times’s Louise Story and Gretchen Morgenson. Release the schadenfreude!

“Oooh, things are starting to get interesting,” writes Yves Smith at Naked Capitalism. She explains what the bank may have done that crossed the fuzzy, fuzzy line between right and wrong on Wall Street:

A number of journalists and commentators (yours truly included) have taken issue with the fact that some dealers (most notably Goldman and DeutscheBank) had programs of heavily subprime synthetic collateralized debt obligations which they used to take short positions. Needless to say, the firms have been presumed to have designed these CDOs so that their short would pay off, meaning that they designed the CDOs to fail. The reason this is problematic is that most investors would assume that a dealer selling a product it had underwritten was acting as a middleman, intermediating between the views of short and long investors. Having the firm act to design the deal to serve its own interests doesn’t pass the smell test (one benchmark: Bear Stearns refused to sell synthetic CDOs on behalf of John Paulson, who similarly wanted to use them to establish a short position. How often does trading oriented firm turn down a potentially profitable trade because they don’t like the ethics?)

But she’s not sure how the federal action will play out: “Strange as it may seem, structured credit-related litigation is a new area of law, with few precedents. Until the credit crisis, unhappy investors seldom sued dealers and other key transaction participants.”

The S.E.C. says the bank defrauded clients on bundled mortgages. Will it lose its privileged position on Wall Street and in Washington?

For the handful of Americans who haven’t read this, here’s a good bare-bones explanation of what the firm allegedly did from Annie Lowrey of The Washington Independent: “The hedge fund Paulson & Co … handpicked mortgage-backed securities that were doomed to stop performing, being backed with subprime mortgages, and Goldman packaged them into a kind of bond. Paulson bet against the bond, with Goldman acting as the broker; at the same time, Goldman sold the bond to other clients without disclosing that Paulson had engineered the bond to fail. The S.E.C. filing notes that those other clients lost $1 billion. Goldman had no direct stake in the success or failure of the CDO. It made money either way.”

“Finally!!!!” adds Dakinikat at the Confluence. “The details of a S.E.C. lawsuit against Goldman Sachs basically confirms everything we’ve been saying for some time out here in the financial/economic blogosphere. GS basically let some of its hedge fund managers design CDO’s that were bound to fail, sold them as safe, and then placed sidebets knowing full well they would fail. My biggest hope is that this translates into tougher regulation and more transparency in the derivatives market. We’ve been seeing just the opposite as reform moves through committees. If more of this comes, it will be hard for Dodd to pass watered-down regulations while the focus on such antics is sharp.”

“This isn’t just about the fact that Goldman sold its clients some bonds and then later bet against them,” writes Stephen Spruiell at The Corner. “In my view, that wouldn’t be so bad.” So what’s the problem?

Goldman structured and sold a particular bond, a structured product known as a Collateralized Debt Obligation (CDO). … The outside consultant Goldman hired to select which mortgages would go into the CDO, a hedge-fund manager named John Paulson, is now known as one of the most famous housing shorts ever — he made an estimated $3.7 billion betting that these kinds of mortgage-backed bonds would go bad. So it is pretty disturbing that Goldman would bring him in as an “independent manager” to help it construct a CDO and not disclose this fact to the CDO’s buyers.

It would be like holding a basketball game, letting a Vegas sharp secretly select the players on one of the teams, and then presenting it to the public as a fair game. The sharp would have an incentive to select the worst players for his team and then bet against it. According to the SEC, that is exactly what Paulson and Goldman did.

“Knowing nothing other than what I am reading here, that sounds like a winnable suit for the S.E.C.,” adds Tom Maguire at JustOneMinute. “So why hasn’t Goldman settled? My current wild guess — a spate of private lawsuits will come in the wake of this action if it succeeds.”

He’s not the only raising questions about why the firm didn’t cut a deal with the feds. “Shares of Goldman Sachs fell as much as 15 percent on Friday, pulling down other financial stocks, after the Securities and Exchange Commission filed civil fraud charges against the firm, accusing it of creating subprime mortgage securities that were designed to fail,” writes Cyrus Sanati at The Times’s DealBook blog. “But while the charges are serious, there may be signs that the market is overreacting somewhat. The sell-off sliced about $13 billion off Goldman’s market value when it faces fines and penalties that are expected to be in the millions of dollars — most likely considerably less than $100 million. Indeed, by mid-afternoon, Goldman’s shares cut their losses somewhat.”

Not long after the charges became public, Clusterstock’s Henry Blodget, no stranger to fraud investigations himself, wondered about the lack of a settlement and Goldman’s failure to provide a quick response.

Normally, the SEC is in close communication with the targets of an investigation as the investigation progresses. This is why you often see SEC complaints filed at the same time that a settlement is announced. (Recall the Bank of America settlement last year, in which the charges and the settlement agreement were made public at the same time). In this case, however, Goldman appears to have been caught flat-footed. Not only was a settlement not announced, Goldman has not even issued a statement yet.

This suggests that the SEC wanted to maximize the headline value of this charge: For the past hour, the SEC and its allegations have consumed the financial press with no response from Goldman. It also suggests that the SEC may be trying to avoid the intense criticism it got when it filed the Bank of America charges last year.

A rebuttal from Lucas van Praag, Goldman’s supercilious spokesman, wasn’t long in coming — “The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation” but its brevity does lend credence to the idea that the firm was blindsided. (The firm, which has had a bad week, issued a longer explanation of its role in the mortgage markets earlier this month.)

James Kwak at Baseline Scenario has good explanation of the culpability question:

The problem is that the marketing documents claimed that the securities were selected by ACA Management, a third-party CDO manager, when in fact the selection decisions were influenced by Paulson’s fund. Goldman had a duty to disclose that influence, especially since Paulson was simultaneously shorting the CDO. (According to paragraph 2 of the complain, he bought the credit default swaps from Goldman itself. I used to wonder about this; if he bought the CDS from another bank, then Goldman could claim it didn’t know he was shorting the CDO, implausible as that claim might be. But in this case Goldman must have known.)

It seems like the key will be proving that Paulson influenced the selection of securities enough that it should have been in the marketing documents. Paragraphs 25-35 include quotations from emails showing that Paulson was effectively negotiating with ACA over the composition of the CDO, so it’s pretty clear he had influence. The defense will presumably be that ACA had final signoff on the securities, and Paulson was just providing advice, so Paulson’s role did not need to be disclosed. (I don’t know what kind of standard will be applied here.)

Clusterstock’s Joe Weisenthal listened in on an S.E.C. conference call on Friday, in which the agency said that not only did Goldman fail to reveal Paulson’s role in putting the package together, but that “Paulson was presented [to Goldman clients] as having gone long the CDO, when in fact he was short.” Weisenthal took a few other notes:

* The unit is still investigating. It’s possible other banks will be charged
* John Paulson is not included in the charge because he was not misrepresenting anything to anyone.
* If the SEC finds similar structures at other banks, there could be charges against them. But again, nothing official.
* Why aren’t there charges against the CEO? The SEC only goes as high as necessary.

Bloggers are also having fun depicting with a couple of e-mails sent by a Goldman executive with the priceless name Fabrice Tourre, who was at the center of the firm’s shenanigans. According to the S.E.C. complaint:

Portions of an email in French and English sent by 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!!!”

Similarly, an email on February 11, 2007 to Tourre from the head of the GS&Co structured product correlation trading desk stated in part, “the cdo biz is dead we don’t have a lot of time left.”

Not so fab, Fab, writes Elie Mystal at Above the Law: “Giving voice to thought is never good when you are fleecing the masses ….”

To insiders, Goldman’s actions were apparently an open secret. Bloomberg’s Christine Harper reported a few days ago that disgraced former Washington Mutual C.E.O. Kerry Killinger smelled a rat long ago: “ “I don’t trust Goldy on this,’ Killinger wrote in an Oct. 12, 2007, e-mail reply to Todd Baker, Washington Mutual’s executive vice president for corporate strategy and development. ‘They are smart, but this is swimming with the sharks. They were shorting mortgages big time while they were giving CfC advice,’ he said, referring to Countrywide Financial Corp., the home lender that ran short of cash the same year.”

Newsweek’s Michael Hirsh is waiting for the other shoe to drop — or, more likely, an Imelda Marcos-style closetful. “Securities-fraud charges related to the subprime debacle have been few and far between until now (plenty of mortgage originators have been indicted, but Wall Street has remained mostly unscathed),” he points out. “By naming the most prestigious firm on Wall Street and a world-famous hedge fund — Paulson & Co.— known for making some of the biggest profits by shorting subprimes, the S.E.C. has signaled that there may be a lot more indictments to come. And there ought to be. All indications are that, in the late stages of the subprime-mortgage bubble, the kind of alleged fraud identified in the complaint was far more common than is typically acknowledged.”

So, where will things end up? The aforementioned Henry Blodget consulted his crystal ball:

Goldman Sachs will have to write a big check, and then it will be fine: 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…

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 … 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).

Looking beyond this specific suit, one wonders how this will affect Goldman’s close ties to the government. Interestingly, Timothy P. Carney of The Washington Examiner posted an article this morning on the firm’s efforts to become the good guy on Wall Street.

In his self-styled war against Wall Street, President Obama appears to have a powerful ally: Goldman Sachs…. The nation’s largest investment bank, famously cozy with top government officials in both parties, has tipped its hand to its shareholders, indicating that major financial “reform” proposals will help Goldman’s bottom line.

Goldman’s executives are calling for two regulations here. First, they want the federal government to restrict free-wheeling, heavily leveraged, high-stakes financial risk taking. Second, they want government to set more rules of the road for trading derivatives — financial products that are often complex.These are the very “fat cats” to whom Obama directed his trash talk in January: “If they want a fight, that’s a fight I’m willing to have.” Well, it looks like they don’t really want a fight. It looks like they want more regulation. The question is: What’s in it for Goldman?

Well, as the S.E.C. would like to make clear, that’s always the question, at least for Goldman Sachs.

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