Friday, April 16, 2010

SEC Has Weak Case Against Goldman

Today, the SEC filed civil charges against Goldman, a short summary from the NY Times reads,

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.

After reading more details of this transaction, I'm not sure if the SEC has a case or not. ACA knew that Paulson was involved with picking the securities, they exchanged e-mails with him and both negotiated over which securities would be included in the CDO.

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.”

It seems the whole SEC case hinges on the fact that Goldman did not disclose Paulson had purchased Credit Default Swaps (CDS) on some of the underlying securities from Goldman, and was involved with ACA in the initial selection process. However someone else on Felix Salmon's blog raised a really good issue,

“After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (“CDS”) with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure.”

In other words Paulson bought insurance for the underlying portfolio from Goldman.

If the underlying portfolio fails–or if it were to fail–Goldman will have to post collateral.

If Goldman knew that these are bad securities (implying that at some point it has to post collateral to Paulson & Co.) then why would GS structure them in a way that Paulson wants?

Even if for some strange reason GS did structure it the way Paulson wanted and got a fee in return, how can GS be held culpable, given the fact it is long on the underlying insurance?"

This will be a very hard case and is not a clear case of wrongdoing. Goldman was not an underwriter, they were just the broker in the deal. There's no guarantee that anything a broker sells has to be a "good" security in the eyes of the broker or the seller. It's like a yard sale, the buyer knows that the stuff there is junk in the eyes of the seller, but one man's junk is another's treasure. In the financial world, no one is omniscient, Paulson turned out to be right, but ACA had the opportunity to review the proposed list of securities, made revisions, and agreed to the final list. They could have rejected any of the securities on the list, and in fact did reject 21 out of the initial list as well as pick the replacement securities. It was a negotiation and ACA is a big boy who should have done better analysis (actually it's really the willingness of subsequent investors to accept risk for such a low yield). The fact that these were to be based on subprime mortgages at the Baa2 credit level underscores that this wasn't going to be as safe as a government bond.

This occurred on February 2, 2007: “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.”

The only fault I can see is that Goldman didn't correct ACA's false assumptions that Paulson was long in the fund.

On January 10, 2007, Tourre emailed ACA a “Transaction Summary” that included a description of Paulson as the “Transaction Sponsor” and referenced a “Contemplated Capital Structure” with a “[0]% – [9]%: pre-committed first loss” as part of the Paulson deal structure. The description of this [0]% – [9]% tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche. In fact, GS&Co never intended to market to anyone a “[0]% – [9]%” first loss equity tranche in this transaction…

On February 12, 2007, ACA’s Commitments Committee approved the firm’s participation in ABACUS as portfolio selection agent. The written approval memorandum described Paulson’s role as follows: “the hedge fund equity investor wanted to invest in the 0- 9% tranche of a static mezzanine ABS CDO backed 100% by subprime residential mortgage securities.”

All the instant analysis on the mainstream news sites don't do justice to the complexity of the issue. It's a good thing there are blogs out there that will provide real analysis from people who understand the business, but that's bad for the SEC as the deeper you look into the case, the worse it appears for the SEC.

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