Seeking Alpha
What is your profession? ×
Long-term horizon
Profile| Send Message|
( followers)

According to the fraud complaint against Goldman Sachs (NYSE:GS), the SEC alleges that John Paulson, manager of a large hedge fund company, paid $15 million to get GS to structure a synthetic derivative which would allow him to short billions of dollars worth of residential mortgage backed securities (RMBS). He allegedly provided a list of securities that he wanted the CDO to include.

According to the SEC, these included bonds secured by mortgages that included borrowers with a

high percentage of adjustable rate mortgages, relatively low borrower FICO scores, and a high concentration of mortgages in states like Arizona, California, Florida and Nevada that had recently experienced high rates of home price appreciation.

Using credit information, in this manner, may have been illegal and subject to criminal penalties.

FICO is an acronym for Fair Isaac Credit Organization, which is the company that produces the software that credit reporting agencies, such as Equifax, Experian, and TransUnion, to analyze information they collect and produce the credit “score”.

The Fair Isaac Corporation, itself, also sells FICO scores it compiles from information obtained from those reporting agencies. The exact method by which the score is calculated is a secret, but, generally, it includes the timeliness of payments history, the percent of the person’s available credit lines that are being used, the length of the credit history, the types of credit that have been used, and the number and nature of the credit applications the person has filed.

People who have high FICO scores are usually offered better interest rates on mortgages. “Subprime” borrowers typically have the lowest FICO scores, and are charged high rates. The very lowest FICO scores will be found among the subprime borrowers who are most likely to default.

The Fair Credit Protection Act protects consumers, including subprime borrowers, from impermissible use of their credit information. The term “consumer report” means any written, oral, or other communication of any information by a consumer reporting agency bearing on a consumer’s credit worthiness, credit standing, credit capacity, character, general reputation, personal characteristics, or mode of living. [i] ‘‘Consumer information’’ means any record about an individual, whether in paper, electronic, or other form, that is a consumer report or is derived from a consumer report.[ii]

Such information may only be used with respect to specifically definedpermissible purposes.” Permissible purposes include those events that somehow involve or benefit the original borrower in some way. The borrower must either be applying for or receiving credit, or someone must be doing something, in the chain of contract, to facilitate the borrowers ability to receive credit, such as creating, buying or selling an existing loan.

The Act allows people to obtain credit information in order to purchase or sell mortgages. The Act facilitates necessary inquiries so that lenders who may need tocash inon mortgages that they own, can sell them to others. Investment banks who intendto use the information, as a potential investor or servicer, or current insurer, in connection with a valuation of, or an assessment of the credit or prepayment risks associated with, an existing credit obligationare allowed to use credit information and they do not need prior authorization by the borrower.[iii]

In other words, an investment bank can properly obtain and use credit information to underwrite real mortgage bonds, in order to facilitate making a market for real mortgages.

The wordexistingis critical. Personal credit information can be legally and properly used to help securitize real mortgages that already exist. That means that when an investment bank creates mortgage backed bonds, it is perfectly ok to use credit information. Using private personal credit report information, however, to create synthetic derivatives, is NOT permissible. Synthetic derivatives do not involve buying, selling or servicing existing loans in any way. Synthetic derivatives do not facilitate the salutary public purpose of financing homes for families.

Synthetic derivatives are created for the casino-like environment on Wall Street, and are generally designed to help third parties, like hedge funds, make bets. Such third parties usually have no involvement at all in the existing loans from which they are structured. The bets being made are not essentially different than betting on a poker game or at a craps table. The primary purpose is to enrich or impoverish parties to the transaction, and the derivatives dealer who creates the opportunity, not to assist mortgage borrowers.

The key to understanding this is to realize that a synthetic derivative is outside the chain of contract. It has no effect upon the existing credit obligation. The original borrower has no obligation at all on the derivative. It is solely a contract between two third parties. The only connection is that bets are being taken for or against the existing loans. Derivatives, in the abstract, are gambling contracts that were immune to state anti-gambling laws by virtue of various acts of Congress, obtained by bankers years ago.

However, the bankers made a mistake because they probably never forsaw the creation of synthetic debt related derivatives. They failed to obtain an exemption for violation of the Fair Credit Reporting Act. Therefore, the use of credit reports to structure or create synthetic derivatives is blatantly illegal.

In spite of this illegality, however, persons such as Paulson & Co, Inc. obtained and used FICO scores, which are personal credit information covered by the Act, to help choose mortgages they wanted to include in a synthetic derivative. This was done to permit a bet against the financial future of thousands of subprime borrowers, who never consented to release their financial information. How was this credit information obtained?

The information may have been attached to the bonds, themselves, for use in informing potential purchasers about the risk of the bond. Or, more likely, it was credit report information gathered by mortgage originators, and sent on to Goldman Sachs, for use in its capacity as the issuer of securitized mortgage bonds. Without more information, we dont know how the information got to Goldman Sachs and Paulson & Co. executives. However, once the information was used to create synthetic derivatives, it become aculpable act”, potentially subjecting the wrongdoers to civil and criminal liability.

Creators, buyers or sellers of real collateralized bonds are held responsible to either destroy personal financial information used during the transaction, or to keep it secure.[iv] Persons who maintain or otherwise possess consumer information for a business purpose must properly dispose of such information by taking reasonable measures to protect against unauthorized access to, or use of the information.[v] Clearly, either Paulson, GS, or both, did not secure the information they discovered, and, instead, used the information to enrich themselves. Thus, the information was obtained under false pretenses.

Whoever facilitates the use of consumer credit information in the creation of synthetic derivatives breaks the law. Persons who violate the Federal Credit Reporting Act have civil liability in a minimum of $1,000 per person, plus attorneys fees and costs.[vi] The synthetic derivatives created by Goldman Sachs for John Paulsons hedge fund (at least those referenced in the SEC complaint) probably involved less than, lets say, 15,000 borrowers. If 15,000 borrowers had their personal financial information comprised and a class action is brought on their behalf, the total compensatory damage claim would be about $15 million.

A total of $15 million in damages for a situation where the wrongdoers made a gain of $1 billion by violating the law is a drop in the bucket. However, Congress also provided for an award of punitive damages. The U.S. Supreme Court has indicated, in past cases, that punitive damage awards should normally not exceed a single digit multiple of the compensatory damages. In the Paulson/GS case, given a $1 billion profit, a combination of regulatory fines and punitive damages in excess of $1 billion would be needed to deter the wrongful conduct.

Accordingly, there is every likelihood that the Supreme Court would uphold such a verdict in spite of past precedents. Similar punitive verdicts would probably be upheld in cases involving other investment banks engaged in similar activities.

Persons who knowingly and willfully obtain information on a consumer from a consumer reporting agency under false pretenses may also be fined under title 18, United States Code, and imprisoned for not more than 2 years, or both.[vii] Ignorance of the law is no excuse. Beyond that, Wall Street bankers and hedge funds have certainly have plenty of law firms, and legal departments to advise them.

In short, if the FTC or the U.S. Justice Department is in the mood to strictly enforce the law, the proverbialbookcould be thrown at some of the derivatives players, including Goldman Sachs. So far, only the SEC has acted. However, other government agencies like the FTC have fewer conflicts of interest with the financial industry, and may well be more effective regulators of this type of activity. Beyond that, there is no doubt in my mind that private class actions will be coming soon to a courtroom near you.

There is potential jail time and plenty of civil liability ahead for Goldman Sachs executives, John Paulson and, perhaps, many others. The Federal Credit Reporting Act is merely one more platform on which prosecutors, both public and private, might base their case. The fallout from the Credit Crisis may just be starting.

[i] 15 U.S.C. § 1681a

[ii] 16 C.F.R. PART 682

[iii] 15 U.S.C. § 1681b

[iv] 16 C.F.R. PART 682

[v] Id.

[vi] 15 U.S.C. § 1681n

[vii] 15 U.S.C. § 1681q

Disclosure: No positions