Friday, April 16, 2010

Man Bites Dog, or Goldman Sachs Charged by the SEC

The SEC shocked and amazed the civilized world today, filing civil charges against Goldman Sachs & Co. -- charging it with fraud in the sale of subprime securities. And what a fraud! Friends, these charges, if they stick, are going to sink Goldman. This is pure sliminess.

It all has to do with a collateralized debt obligation that Goldman sold a bunch of institutional investors (a/k/a "suckers"). This was not any old fraud, according to the SEC complaint:

According to the Commission's complaint, the marketing materials for ABACUS 2007-AC1 — including the term sheet, flip book and offering memorandum for the CDO — all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management LLC ("ACA"), a third party with expertise in analyzing credit risk in RMBS. Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc. ("Paulson"), with economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO played a significant role in the portfolio selection process. 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. Given its financial short interest, Paulson had an economic incentive to choose RMBS that it expected to experience credit events in the near future. GS&Co did not disclose Paulson's adverse economic interest or its role in the portfolio selection process in the term sheet, flip book, offering memorandum or other marketing materials.
Note what I've put in boldface. This is devastating. The Wall Street Journal says that "Goldman Sachs, which in a statement called the accusations 'completely unfounded in law and fact,' could face steep fines and be on the hook to repay nearly $1 billion of investor losses."

Now, I've long argued that short-sellers perform a valuable service to the markets, but this ain't an example of a short-seller performing a valuable service to the market. What it means is that Goldman entered into a slimy deal with a short to create a derivative that was ca-ca, and thus could create a profit opportunity for said short-seller, bigtime hedgie John Paulson.

It's a bit like designing a car in cahoots with an alternator manufacturer, for the purpose of being sure that it can break down so that it needs a new alternator. I can just see the anti-shorting nutcases going wild over this, and I can't really blame them. While nobody from the short side has been banged on this, yet, I expect that this is going to be like the Elgindy case: a big, fat black eye for short-sellers.

Paulson says it "is not the subject of this complaint, made no misrepresentations and is not the subject of any charges." JP is a quiet guy who doesn't care much for publicity, and is not happy with anything resembling negative press. Something tells me he's going to have to develop a thick skin, and fast, because a shit storm is coming. He didn't just sit back and smartly wager on a decline in the real estate market. This has him engaging in conduct that, morally speaking, is simply indefensible.

Interestingly, Paulson, as his statement acknowledges, wasn't charged. Whether he will be charged in the future is an open question. As I said a while back when I profiled him for Portfolio, this is one smart cookie. How he can escape from this with clean hands is beyond me. Fortune speculates on Paulson's possible exposure.

When I profiled Paulson for Portfolio, I said, " Left unexamined is the uncomfortable moral dimension of Paulson’s achievement. If he saw all of this coming, was it right for him to keep his own counsel, quietly trading while the financial system melted down?" According to the SEC complaint, he did considerably more than just see it all coming. Seems that he helped make it happen, by so generously helping Goldman design its toxic derivatives.

And now he's..... cooperating with the SEC, perhaps? Prepared to testify against Goldman, perhaps? If so, Goldman may be in major trouble.

Meanwhile, we have the amazing spectacle of a major bank actually being charged with wrongdoing in something related to the financial crisis. And Goldman Sachs, no less. Talk about man bites dog. Oh, and here's something else: the lead counsel for the SEC is Rick Simpson, who worked on the Crazy Eddie case years ago. Sam Antar tells me that Simpson is a dedicated, dogged guy. Diane Tucker has more on Simpson here. Goldman won't get off easy.

Still, you might argue that Goldman is already getting off easy in this sense: it has been accused of a criminal offense--fraud--in a civil action.

If I gave a bank a rubber check for twenty dollars I would wind up in the can. Can someone please explain to me why it is that a bank gets accused of defrauding people for a billion bucks and it gets a civil lawsuit?

Sure, it's a significant step. But what we're seeing, again, is the decriminalization of securities fraud.

UPDATE: Reports are filtering out of Goldman Sachs that a new theme song has been adopted by the company:

© 2010 Gary Weiss. All rights reserved.

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