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Marc H. Gerstein ( or if already on Twitter, search for @MHGerstein) is an independent investment analyst/consultant specializing in rules-based equity and ETF investing strategies, with particular emphasis on small-cap equities and leveraged ETFs. Many of is views... More
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  • In Defense Of Goldman Sachs 7 comments
    Apr 30, 2010 3:47 PM | about stocks: GS

    I voted for Obama. I’m a Democrat. I believe we badly need financial regulatory overhaul. I think there has been much behavior among bankers and on Wall Street that was downright despicable. But the recent declaration of war against Goldman Sachs (NYSE:GS) looks wrong; very, very wrong.


    By now, we know the basics of the case being pursued by the SEC (and possibly by the US Attorney). Goldman marketed a derivative, ABACUS 2007-AC1, the performance of which would be based on the performance of a pool of mortgages. We also know from our 2010 vantage point that in terms of creditworthiness, these mortgages were dreadful. We also know that in 2007, when ABACUS 2007-AC1 was put together, a lot of people  believed sub-prime mortgages were great and that housing could continue to soar. One such team of professional investment geniuses bought ABACUS 2007-AC1 and wound up suffering a fate similar to that of former Dutch investors who ploughed into tulips at the wrong time; they got their heads handed to them.


    At first glance, one would think that for better or worse, Goldman, which brokered the ABACUS 2007-AC1 deal, would be no worse than the old tulip salesmen. But, according to the SEC, there’s a difference. Goldman didn’t disclose that Paulson & Co., a hedge fund that was smart enough to want to bet against subprime mortgages at the top of the market, grew or helped to grow these tulips . . . oops. . . select securities for ABACUS 2007-AC1.


    Let’s look more closely at the SEC’s allegations against Goldman and Fabrice Tourre, the Goldman employee who managed the ABACUS 2007-AC1 deal, as presented in Litigation release No. 21489, posted on the SEC web site:


    “[T]he 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.

    .  .  .  .


    “Tourre is alleged to have known of Paulson's undisclosed short interest and its role in the collateral selection process. He is also alleged to have misled ACA into believing that Paulson invested approximately $200 million in the equity of ABACUS 2007-AC1 (a long position) and, accordingly, that Paulson's interests in the collateral section process were aligned with ACA's when in reality Paulson's interests were sharply conflicting.”


    So who actually picked the securities, Paulson or ACA? Can we simply rely on Paulson as the architect? That’s hard. Here’s the announcement regarding Abacus 2007-AC1 as published on the ACA web site:


    “Since 2008, ACA Financial Guaranty Corporation has cooperated with a Securities and Exchange Commission (the “SEC”) inquiry focused on a specific collateralized debt obligation (“CDO”) transaction – Abacus 2007-AC1. ACA Management L.L.C., a subsidiary of ACA Financial Guaranty Corporation, acted as the portfolio selection agent in that transaction. On April 16, 2010, the SEC announced a civil action against Goldman Sachs & Co. and one of its employees in connection with this CDO. No ACA entity or individual is accused of any violation by the SEC in this action.” (Emphasis supplied.)


    Does that rule out the notion that Paulson actually picked some or all of the securities? Not necessarily. ACA’s language is vague, probably deliberately so and probably as a result of extensive word-crafting on the part of its legal representatives. But I think we have to at least assume that ACA had some sort of a role. If it didn’t, it would seem logical that the SEC would be charging it with fraud.


    Next, was ACA qualified to serve as “risk management agent”  (whatever the heck that is)? It’s hard for an outsider who just tuned into this as a result of the news to make a definitive conclusion. But it does seem clear ACA is trying to present itself as a qualified party. Here’s the biographic notation from the web site regarding its CEO Raymond J. Brooks (something I’m sure Goldman’s legal defense team already has in its files and is already researching further):


    “A former managing director with Alvarez & Marsal, Brooks has more than fifteen years of experience in risk management, capital markets and portfolio management. Over the course of his career, Brooks founded Pine Creek Healthcare Capital, which was a high yield and distressed healthcare debt manager. He also held positions at Price Waterhouse, Lehman Bros., and Aubrey G. Lanston / Industrial Bank of Japan. He is a former Member of the Chicago Mercantile Exchange and the International Monetary Market. Brooks received an MBA in finance from the University of Chicago’s Graduate School of Business and a B.S. from Saint John’s University.” (Emphasis supplied.)


    OK. So we have to assume that ACA, a firm that publicly conveys the impression it is experienced and proficient in the analysis of risky distressed securities was somehow involved in putting together the Abacus 2007-AC1 portfolio.


    How would you expect such a firm to go about doing its job?


    Might they assess the likelihood of default of each mortgage in the pool? One would expect that.


    Might they assess the likelihood of default by many mortgages in the pool at the same time? One would expect that.


    Might they assess the extent of losses likely to be incurred in the event of default? One would expect that.


    Might they base their analysis on whether someone on the selling side of the Abacus 2007-AC1 transaction is bullish or bearish? You’ve got to be kidding!


    Is the SEC really going to argue that a firm spearheaded by someone who brags about “more than fifteen years of experience in risk management” needed to know if Paulson was bullish, bearish or apathetic in order to make a professionally competent judgment as

    to the quality of the securities in the Abacus 2007-AC1 pool? Is that how ACA has been analyzing distress credits . . . by asking sellers if they’re bullish or bearish?


    Give me a break!


    One of the elements of securities fraud is that the representation or omission be “material” to the victim’s decision  to trade the security. Where is the materiality here? Who cares if Paulson is betting against the derivative? Who cares if Goldman agrees with Paulson and helps him implement his strategy? Neither Paulson nor Goldman were assuming the role of objective analyst. That role was assumed by ACA.


    Now, it is possible that ACA and/or the buyer really did suffer a massive brain-cramp and rely on something absurd like what Paulson thought or did. We all have bad days, sometimes even very bad days.


    But that would not be sufficient to make a case of fraud.


    The victim’s reliance needs to have been “reasonable.” If you buy a 1955 un-remodeled Chevy because the seller tells you it gets 250 miles for each gallon of gasoline, you can’t sue for fraud even though the seller was an impressive liar. Your reliance on such nonsense would not have been reasonable. The institutional-professional buyer of Abacus 2007-AC1 was no better, and if ACA needed to know what Paulson thought, they’d have been even dumber because they were supposed to be the distressed security experts.


    Frankly, I’m baffled as to why the SEC isn’t chasing ACA (I haven’t even considered the ratings agencies, and I won’t because if I did, I may trigger too many browser obscenity filters).


    In any case, much needs to be done in the area of financial reform and there will undoubtedly be vigorous debates along the way. Sadly, as this case moves through the courts and as evidence and legal principles come to be considered by judges and possibly jurors rather than by politicians and journalists, I fear it may cloud, rather than focus, the case for financial reform.

    Disclosure: No position in GS
    Stocks: GS
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Comments (7)
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  • Tom Au, CFA
    , contributor
    Comments (6774) | Send Message
    Goldman may be "guilty."


    But probably "not as charged."
    30 Apr 2010, 05:15 PM Reply Like
  • Rich in Quebec
    , contributor
    Comments (4542) | Send Message
    If I were offered a fund of companies chosen by Marc Gerstein, I would be greatly interested. I think he has demonstrated great stock picking ability. I don't expect perfection. The market may go against me, and Mr. Gerstein may have a bad run even within a good market. There is only one instance where I would have a case against any advisor that I had freely chosen. If that advisor had included what he thought were the worst choices, and he sold them to me as his best choices, I believe I would have a case against him (provided they went down). That he would take a position against me would clinch the case. Not only would he have failed his fiduciary responsibility towards me, he would have profited in direct relationship to my loss. Even if GS manages to weasel out of their present predicament, will their clientele ever be sure again that GS is working for, and not against, them?
    30 Apr 2010, 10:02 PM Reply Like
  • Marc Gerstein
    , contributor
    Comments (1081) | Send Message
    Author’s reply » There's the point. Goldman was not the buyer's adviser. ACA, with an assist from the rating agencies, is the one that had those fiduciary duties.


    This is not at all like Henry Blodgett, Mary Meeker, et. al. from a decade ago. Goldman rendered no advice. The relationship between Goldman and the buyer was a hard-core adversarial arm's length relationship. The buyer, an institution in its own right, understood this.


    I've been in that situation in the past when I managed a junk bond mutual fund. I always understood that the brokerage firms that pitched bonds to me, whether IPO or in the secondary market, were out to feather their own nests and that they'd skin me alive without even bothering to blink. I always understood it was my responsibility to do my own analysis and protect myself, which I did and, hence, earned the nickname "Dr. No" from the former E.F. Hutton firm because of all the IPOs I refused to participate in. (I even refused to allow the brokers to tell me what ratings S&P and Moody's had assigned because even back in the '80s, I knew the agency ratings were often idiotic -- not based on any factual evidence of improper practices but simply because the ratings didn't mesh with my own analysis.) Even so, as diligent as I tried to be, nobody's perfect and every now and then, I screwed up and bought a lemon. But I always understood that these mistakes were mine and mine alone, and I took the heat.
    1 May 2010, 01:03 AM Reply Like
  • lower98th
    , contributor
    Comments (1420) | Send Message
    I think the point, outside of Wall Street, is the tainted milk analogy. No matter who the broker was, or what he knew or should have known, the victims are the end consumers - in this case pension plans. If anything is fair play, subject to due diligence, then watch out. You better get out your test kit before taking medications or drinking the melamine-milk. That FDA approval is for sale. The products do not have to be as represented, and the producers and brokers are all insured....and will benefit from your loss. Be careful advocating that there is no such thing as fraud. It is not only the financial products that can play that game.
    1 May 2010, 07:01 AM Reply Like
  • Rich in Quebec
    , contributor
    Comments (4542) | Send Message
    In an anti-intellectual country as is the U.S., the defense of caveat emptor is not likely to assuage the revulsion of the great majority of otherwise anti-government investors. Survival of the fittest goes over particularly badly when you realize that you are part of the fleeced, and that you supported policies that led to that fleecing.
    1 May 2010, 09:44 AM Reply Like
  • Marc Gerstein
    , contributor
    Comments (1081) | Send Message
    Author’s reply » But nobody here was fleeced. Let's not forget that the institutional-professi... buyer made a judgment that sub-prime mortgages were good, a judgment that was shared by many back in 2007. That was wrong on the part of the buyer. It was stupid. But the buyer knew what it wanted and it got exactly what it chose to buy.


    Bear in mind that one of the elements of the SEC's case that I didn't cover in the instablog is that the Goldman's omission must be proven to have caused the buyer to do what it did. I have no doubt Goldman's lawyers will examine the buyer's trades and portfolio back in 2007. If the buyer had other investments in sub-prime or in anything that could more or less correlate with sub-prime, Goldman's counsel will argue that even if the buyer was told in detail of Paulson's role it would most likely have considered Paulson a fool and would still have bought Abacus. If the buyer did have other similar investments, this would be another ground requiring dismissal of the SEC's case.


    All we're dealing with here is a buyer who had one opinion of the sub-prime market and a seller who had an opposite opinion of the sub-prime market. This has nothing to do with caveat emptor, fraud, or anything else. It's a plain vanilla free market and if the government tries to impinge on that, we'll see screaming and ranting the likes of which we can't imagine even after the healthcare battles.


    I agree that fraud is a bad thing. But the facts here are just plain bogus. The SEC picked the wrong case. The only wrongdoing I can see is negligence or recklessness against ACA and the rating agencies and I think it's reprehensible that nobody is proceeding against them. Perhaps the headline value of such a case is just not that appealing to the SEC. Or, perhaps it did proceed against ACA and perhaps ACA is trying to save its own skin by trumping up something against a higher-profile fish. Go back and re-read the statement ACA posted. It is somewhat bizarre and it does seem like ACA is heavily lawyered up, so I do feel justified letting my imagination roam a bit here.
    1 May 2010, 09:23 PM Reply Like
  • Rich in Quebec
    , contributor
    Comments (4542) | Send Message
    Marc, you may be right that none of those involved , as lower98th's analogy would put it, will have sufficiently tainted the milk as to be legally liable. Even if the the concept of justice is put aside, greater regulation becomes necessary for the sake of the entire economic system. If nothing else, the right to `" provide a market" when it means shorting a security that you have devised and marketed should be curtailed. As for the political repercussions, a rereading of the history of the gilded age and its robber barons , followed by the legislation of the progressive era, might have one coming to a different conclusion than yours. As an honest and talented practitioner in the art and science of stock picking, and as a Democrat, you should be delighted.
    3 May 2010, 09:19 AM Reply Like
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