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The SEC’s recent charges against Goldman Sachs (NYSE:GS) involve something known as a collateralized debt obligation (heretofore referred to as “CDO”), which is a derivative instrument whose value is determined (or "derived") from the value of something else. Most CDOs are essentially investment funds, and their investments are generally chosen by their promotors and creators. In this particular case, the CDO was structured with residential mortgage bonds as the underlying "something else."

The case was disclosed last Friday, and it involved a “synthetic” CDO called "Abacus 2007-ACA." Synthetic means it did not hold underlying mortgages or collateralized bonds. Instead, it contained a type of derivative, known as “credit default swaps” (heretofore referred to as “CDS”) for which premiums are paid on a regular basis. So, this particular CDO was a derivative of derivatives.

CDS are "insurance" policies that pay off on bond defaults. The buyer of a CDS pays premiums to the seller, in exchange for this “insurance” protection. The sale of insurance has always been very profitable, but to make the premiums on this type of insurance even more attractive, derivatives dealers like Goldman Sachs managed to obtain special legislation exempting such policies from insurance regulations. Without the need to register as an insurer, or maintain statutory loss reserves, the stream of income is especially profitable, unless the bonds default. Investment banks used the attraction of potentially lucrative profits to draw in small, medium and large financial institutions all over the world.

The particular synthetic CDO in question was marketed as high quality debt instrument, providing a stream of income to supposedly sophisticated financial institutions. In truth, however, the Paulson Company, Inc. hedge fund paid $15 million to Goldman Sachs in exchange for finding a way for him to take large short positions on the housing market. This CDO was the firm’s method of providing the opportunity without exposing itself. Goldman's analysts, like Paulson, believed that the residential mortgage market would implode.

The deal closed in April 26, 2007, and by October 24, 2007, 83 percent of the residential mortgage backed securities (RMBS) that the ABACUS CDO was based upon, had been downgraded and 17 percent were on negative watch. By January 29, 2008, 99 percent of the portfolio had been downgraded. Eventually, the two institutional buyers of this particular CDO (who were de-facto“sellers” of the CDS insurance) lost $1 billion, and Paulson/Goldman Sachs gained $1 billion.

Assuming Goldman was the underwriter for the mortgage bonds upon which the CDO was based, it would have to have had detailed financial information about the borrowers that others did not have. It is hard to believe that this information was not used to evaluate whether and when the mortgages would implode. According to the complaint, Goldman Sachs was making its own bets against the housing market, and helping favored clients, like Paulson, do the same, while, at the very same time, misleading disfavored clients into buying the CDOs.

Each Wall Street[i] investment bank has a cabal of financially related satellite firms. According to the SEC complaint, Goldman Sachs led buyers to believe that Paulson Company, Inc. would be an "equity" holder in the deal. What they failed to disclose, however, is that he would be on the short side. Believing that Paulson's interests aligned with their own, the investors apparently allowed him to participate in choosing what bonds would be a part of the CDO. In fact, Goldman knew that Paulson would profit from the implosion of the deal, and that his interests were squarely arrayed against those of the CDO buyers.

Assuming that Paulson’s research and/or that of Goldman's own analysts relied, even in small part, upon the financial information concerning the borrowers that Goldman would have obtained in its capacity as underwriter of the bonds, both will have criminal as well as civil liability for illegal insider trading. That is because they would have used material non-public information to trade on a security.

Wall Street firms rarely engage in just one episode of a highly profitable trade. It is a small community. People attend the same seminars, invest in each other's firms, and, in with respect to the firms that are based in New York, they even alttend the same parties, and go to the same bars and nightclubs. They tend to copy each other.

The SEC complaint is likely to generate a lot of activity among aggrieved former Goldman clients as well as customers of other investment banks, who lost hundreds of billions of dollars in the housing market meltdown. No matter how you look it, it is hard to see how Goldman Sachs, Paulson, and, frankly, a lot of other investment banks, will avoid heavy penalties, including civil fines, tens of billions of dollars worth of economic and punitive damages in civil courts, and a race for the exit doors by clients.

Buying or retaining shares in investment banks, at this time, is VERY RISKY given the renewed potential for failure looming ahead. It is not unlikely that many current Goldman Sachs clients will leave the firm. If Goldman loses enough clients, fast enough, the company could go the way of Lehman Brothers. There is not enough political capital left in Washington D.C. to mount a multi-billion dollar bailout of a firm accused of fraud, even when the firm's executives are among the most politically savvy and connected in the world.

People are tired of seeing the value of Grandma's CDs and the legacy they want to leave for their children, stolen by the Federal Reserve and U.S. Treasury, for use in subsidizing firms like Goldman Sachs. Opposition is more organized now, and public revulsion more intense. The now discredited idea that seling out the future, to save today, by bailing out gamblers at big investment banks, won't convince anyone anymore. Not even Goldman's powerful friends at the Federal Reserve and Treasury will be able to bail it out of mutiple fraud convictions in civil courts, let alone the fleeing of a large number of clients who may now lack confidence in the truthfulness of advice given by the firm.

We can expect the SEC to be very aggressive now, if only to deflect attention from its incompetent handling of the Bernie Madoff and Allan Stanford frauds. As it puts on its road show for the masses, one other big investment bank, Deutsche Bank, is also very likely to end up on the wrong side of an SEC enforcement action. According to a recent article published in Dow Jones’ Marketwatch:

From 2005 through late 2006, the U.S. securities arm of Deutsche Bank created several CDOs that sold credit protection on mortgage bonds that hedge-fund clients bet against, the Journal report said, citing people familiar with the matter.[ii]

This is as it should be, because once you add the illegal insider trading aspects of the CDO cases, the SEC has a solid case against many investment banks and hedge funds who took short positions while underwriting CDO deals . The fact that the underwriters of the bonds also issued the CDOs, and probably used privileged nonpublic information about the borrowers means that this is an issue that may end up costing the investment banks hundreds of billions of dollars. Some executives may also be criminally liable as well. In short, the Goldman Sachs case has the potential to expand into a second implosion of the finances of the Wall Street bankers, as companies are called upon to pay the piper for the misdeeds of the past.

Generally speaking, the SEC has proven itself, time and time again, to be an impotent regulator, incapable of taking on a politically savvy opponent. It is riddled by revolving door corruption. Staff are regularly moving from the agency into cushy jobs at the firms they are supposed to be regulating. Therefore, after the initial show for the masses, the SEC, as usual, will probably push for a few million dollars in settlement money paid, not by guilty executives, but by innocent shareholders.

However, for the investment bankers who were short on the mortgage market, and, particularly, for Goldman Sachs, it will not end there. The SEC has unwittingly let the genie out of the bottle. It will be next to impossible to put him back in. Foreign regulators are less deferential toward Goldman Sachs.

European regulators in the UK and in Germany are already looking into prosecuting. Although Goldman has influence all over the world, foreign loyalties are more with the European institutions who form the bulk of those who were defrauded. EU regulators may not aggressively go after Deutsche Bank (NYSE:DB) or Barclays (NYSE:BCS), but they won't think twice about pursuing a mostly American firm, Goldman Sachs.

The defrauded financial institutions, themselves, no longer have much incentive to keep their incompetence a secret. One of the biggest single victims appears to have been the American insurer, AIG (NYSE:AIG). It bought $6 billion worth of various Abacus CDOs from Goldman Sachs. Although it claims that there are no present plans to sue, AIG is reportedly considering potential claims against Goldman and other Wall Street banks over soured mortgage securities that led to heavy losses, according to a person familiar with the matter.[iii]

In fact, the executives and board of AIG have little choice but to pursue such actions. They have a fiduciary obligation to sue Paulson, Goldman Sachs and, perhaps, other investment banks and their favored hedge funds. At least two Congressmen are urging AIG to take action, given the huge losses taken by the US government, when it bailed out Goldman Sachs through AIG.

Paulson and his hedge fund are likely to be named defendants in most of civil lawsuits. Remember, these cases will be heard by juries of men and women who are also taxpayers. The AIG lawsuit alone, if not settled, could result in $6 billion in economic damages and tens of billions of dollars more in punitive damages for fraudulent conduct. Goldman Sachs could very easily be put out of business by the private litigation alone.

The most dangerous immediate concern is that many current and potential clients, unsure whether they are among Goldman Sachs' “favored” or “disfavored” clients, will simply stop doing business with the company. For example, just one trading day after the initial announcement, the general secretary of the Bavarian Christian Social Union (CSU), Alexander Dobrindt, told German business daily Handelsblatt that as long as investigations were ongoing, dealings with Goldman should be put on hold. This was followed, almost immediately, in the UK, by Liberal Democrat leader Nick Clegg, who said Goldman Sachs should be suspended as an adviser to the government. That is just the bare beginning of the clients who will be running for the exit doors over the coming weeks and months.

To make its legal troubles even worse, Goldman Sachs received a “Wells” notice in July, 2009, where the SEC warned it would be likely to bring this action. That was not disclosed until the day charges were brought, almost a year later. We do not know how many other investment banks have received similar notices. But, what we do know is material effect such allegations were sure to have on long term profit prospects, and share price.

The effect on the Goldman Sachs share price is obvious. It dropped by 12% on the day the fraud charges were announced. By failing to disclose the Wells notice, Goldman Sachs management defrauded their shareholders, and artificially pumped up the share price. However, it also insured that shareholder derivatives actions will be brought. It is more evidence of unethical conduct that will convince wavering clients to leave, and shareholders to dump the stock.

We are at the beginning of public awareness of this problem. It is a calm before the storm. The business media is very busy playing down the significance of the Goldman Sachs affair. Business writers from Marketwatch and CNBC have managed to induce a period of investor apathy and that means it is an ideal time for smart investors to take action, ahead of the herd, to protect their interests.

There are often onerous and lengthy notice requirements before an investor is allowed to withdraw from a hedge fund. Anyone invested in a hedge fund that may have been short on CDOs, who wants to withdraw assets, must give substntial notice. That should be done immediatelly in order to fulfill contractual obligations as soon as possible.

The ability to withdraw funds will depend upon the terms and conditions of asset management contracts and how many other people want to do it at the same time. Getting a jump on the others, with gains intact and future losses avoided, is a sensible move. There is, of course, no restriction on selling shares of stock that one may hold in the investment banks, including, but not limited to, Goldman Sachs.


[i] I use “Wall Street” as a general term to describe the large investment banking operations that play in the worldwide securities market, even though some, like Deutsche Bank, Barclays Bank, etc., are not headquartered anywhere in New York.

[iii] Id.

Disclosure: No positions

Source: Are SEC Charges Against Goldman More Serious Than Market Understands?