Wednesday, April 21, 2010

The Case Against Goldman Sachs

I’d like to weigh in on this whole SEC securities-fraud action against Goldman Sachs. The feds have, of course, alleged that Goldman made materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (CDO) that was structured by Goldman and marketed to investors.

This is all very complicated. And I know some very smart people lining up on one side saying the SEC’s fraud action is weak. And I know some equally smart people on the other side saying this is an extremely serious matter that will be followed by numerous other SEC fraud charges against other Wall Street underwriters.

Look, I’m not a lawyer. I don’t know how this lawsuit will eventually play out. But let me make a couple of simple, straightforward, points that may help inform regarding the question of hedge fund manager John Paulson’s involvement in the securities selection for the Abacus CDO, and whether this is a material fact that Goldman should have disclosed to investors.

Here’s a very important timeline of the securities-selection process that was made by ACA management, the portfolio selector. This is from the actual SEC complaint:


January 9, 2007
Goldman sends email to ACA, titled "Paulson Portfolio," containing list of 123 RMBS selected by Paulson for the Abacus 2007-AC1 reference portfolio

January 22, 2007
ACA sends email to Fabrice Tourre & others at Goldman containing list of 86 RMBS, including 55 of the 123 selected by Paulson; 68 were rejected. This is very important. Goldman maintains that ACA was in fact the portfolio selector. ACA rejected 68 of Paulson’s recommendations. They accepted 55.

February 2, 2007
After meetings with Paulson & Tourre, ACA emails Paulson, Tourre & others at Goldman a list of 82 RMBS on which Paulson & ACA concurred, plus 21 others. So at this point, they are in agreement on 82, but they insert 21 others.

February 5, 2007
Paulson sends email to ACA & Tourre deleting 8 of the RMBS recommended by ACA and leaves the rest alone.

February 26, 2007
After further discussion, Paulson & ACA agree on a reference portfolio of 90 RMBS for Abacus 2007-AC1.

Now, what I gather from all of this is that ACA management was most definitely the portfolio selector. There’s no question about it. This is Goldman’s single biggest defense in not mentioning hedge fund manager John Paulson’s name.

However, I’m looking at this and I’m thinking, with all these negotiations, all of this back-and-forth, that it’s quite clear that John Paulson played a pivotal role in the portfolio-selection process. That seems undeniable. So that raises the key question of whether Goldman Sachs’ decision not to disclose Paulson’s involvement was a correct judgment, or whether it was a material omission. It just seems to me that Goldman Sachs should have named Paulson in the offering circular for the CDO. They didn’t. Is it because they didn’t want investors to understand that this was a bear-market, short-the-bond CDO?

Second point: Some highly placed, senior Wall Street sources who have been deeply engaged in structured mortgage-based CDOs tell me that this CDO in question was weak and appeared designed to unravel quickly. They go on to say, in general terms, that this CDO constructed by Goldman Sachs lacked sufficient cash; its covenants were weak; and it afforded less investor protection than usual in order to provide higher yields. This troubles me enormously.

Creating something that’s designed to fail? Well, you know what? If it’s not illegal, it certainly appears unethical. So I must blame Goldman for this. Why sell it to customers if it’s going to fail? Why go there in the first place? What kind of brokerage service is this?

Now, there’s nothing wrong with creating a neutral security that will attract buyers and sellers. That’s called free-market capitalism. And the buyers and sellers do not have to know who the buyers and sellers are. But if, in fact, these Goldman CDOs were designed to fail, then there’s something seriously wrong with this system and it must be changed.

Whether Goldman lied about Paulson’s $200 million equity stake is another difficult issue. If they lied, then it’s a material misrepresentation and the SEC is dead right. But there are different opinions about this.

One final thought: Wouldn’t it be wonderful if Washington could somehow solve these issues without totally demonizing, demoralizing, and even destroying America’s great global banks? We need these banks for full-fledged economic recovery. We also need them for America’s full-fledged leadership in the global financial system and world economy. In other words, can we please figure out a way not to throw out the baby with the bathwater?

This is way too important a time for our recovering economy and financial system. Our future is at stake.