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Goldman Sachs / SEC: political witch-hunting is no way to change a market

|Includes: Goldman Sachs Group Inc. (GS)

Reading the allegations against Goldman Sachs and Fabrice Tourre in the case of structured CDO scandal (aka Abacus), I am reminded of Spitzer and how a General Attorney used a witch-hunt as a political tool, only to be later exposed himself in the company of barely clad ladies.  I suppose the SEC is under intense pressure to deliver some scalps, and that going after the unapologetic and sometimes arrogant leader of the investment banking world delivered the biggest bang for the buck.  On the face of it, I have the distinct feeling that they are trying to play on the fear of financial innovation and need to find a culprit but actually do not have much of a leg to stand on.

In fact, they are in my mind polluting an important underlying debate about the sustainability of financial markets by trying to pin the blame on guys who benefited from the market exuberance.  A bit like blaming the CDS market for Greece's credit trouble, it's just misguided.  One should have a real societal debate about what constitutes sustainable growth, what leverage is acceptable for individuals and companies, understand that no amount of financial innovation can create profits out of thin air and just stop being so short-term focused.  In other words, we need to hack finance, not some random financiers who just happened to be the smartest guys in the room at the time.

There is a tendency to reduce the world to black and white complexity (such as the ridiculous "great vampire squid wrapped around the face of humanity" paranoia inducing article from Rolling Stone, now offline) which in my mind ends up diluting responsibility.  Everyone shares responsibility in the financial crisis, including those who thoughts they could live on debt forever.  It's a societal failure that started a long, long time ago with a culture of irresponsible spending and leverage that spread everywhere.  I can understand why people are feeling good that there's a bit of retribution (see DailyKos) but come on...  Pro-life / pro-choice type debates lead nowhere.  Complexity may not be satisfying, but it's how the world works (e.g. read this).

When you look at Goldman's role, it seems to have done what it usually does: matched opposite risk views and organised the transaction and its marketing.  You really need to dig into the details to get it but the vociferous press (including bizarrely a vociferous Felix Salmon at Reuters) seemed intent on spreading the news fast rather than do its journalistic job.

I like how Michael Hiltzik captures it, without throwing morality into it:

The real issue isn't what Goldman knew or didn't know about the larger economy. The issue is that Wall Street's business model has become corrupted into one dependent on creating transactions that spin financial wheels to virtually no economic end, merely to generate fees and profits.

Business Insider (and Henry Blodget would know) predicts that Fabrice Tourre will be thrown under the bus and that GS will settle.  He's probably right.  Maybe he can give Fabrice a job.  Don't think we will hear Lloyd Blankfein saying GS was doing God's Work anytime soon...

Anyway, for those so inclined, here is my detailed review of this case, original published on


First let's look at the transaction: a synthetic CDO was put together based on a selection of Mortgage-Backed Securities and invested in by ACA Capital Management and German bank IKB.  At the origin of the transaction was Paulson & Co using a vehicle designed by GS.  Paulson & Co. took exposure on the synthetic CDO as a way to short the market through Credit Default Swaps.  Paulson proposed a large set of underlying instruments which ACA whittled down a selection that they felt comfortable with.  ACA then invested and also marketed the transaction to some of its clients, including IKB, with the help of GS as arranger.

The SEC papers do not disclose exactly how Paulson played it but I assume they did the following:

  • took some or zero long exposure on the equity piece of the CDO transaction (this is the first loss tranche that takes immediate hits from credit defaults).  I suspect some of the equity was sold off, some retained by Goldman, some by Paulson probably.  This is an unanswered question right now.
  • took short exposure on the more senior tranches of the transaction through credit default swaps (also arranged by Goldman)
  • made money on the discrepancy between the premium it was getting paid for the equity tranche and how cheap it was to get insurance on the senior tranches (i.e. meltdown risk mispricing) whilst both were going to default, or used the discrepancy to create principal default exposure in their favor.
  • Optically it may have looked like they were going long but in fact they were taking a short overall position on the portfolio.
  • Nasty ?  Maybe.  Intent is clearly hidden here.  Illegal ? No.  Like high stakes poker, this is for real pros only.

The whole case rests on the fact that marketing materials prepared by GS did not disclose the role and intent of Paulson in the transaction but only relied on ACA's reputation as an experienced CDO agent.  Indeed, ACA previously had constructed and managed numerous CDOs for a fee. As of December 31, 2006, ACA had closed on 22 CDO transactions with underlying portfolios consisting of $15.7 billion of assets.

The SEC document can be found here whilst the Goldman Sachs placement document can be found here.

Have a look at the opening statements and how the SEC makes explicit reference to systemic risk:

The Commission brings this securities fraud action against Goldman, Sachs & Co. (“GS&Co”) and a GS&Co employee, Fabrice Tourre (“Tourre”), for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) GS&Co structured and marketed to investors. This synthetic CDO, ABACUS 2007AC1, was tied to the performance of subprime residential mortgage-backed securities (“RMBS”) and was structured and marketed by GS&Co in early 2007 when the United States housing market and related securities were beginning to show signs of distress. Synthetic CDOs like ABACUS 2007-AC1 contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.

ACA clearly played its role in selecting the assets

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.”

"GS&Co’s marketing materials for ABACUS 2007-AC1 were false and misleading because they represented that ACA selected the reference portfolio while omitting any mention that Paulson, a party with economic interests adverse to CDO investors, played a significant role in the selection of the reference portfolio."

I think this argument is weak at best -- you choose a respected manager in a segment to help you market assets, there is per se nothing wrong with not disclosing Paulson's role.

Was a disclosure of Paulson ultimate intentions required ?

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.

I believe it is probably that Paulson in fact did take the first loss risk (someone had to take it) but then hedged the exposure with credit default swaps on more senior tranches which were priced too aggressively (cheaply) and did not capture the default risk appropriately.  Hence the arb.  But that's what hedge funds do (the name may hold a clue :-)).

The SEC is making assertions that appear speculative at best, and has no smoking gun

"Tourre also 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."

The crux of the argument is based on the following information which you should read attentively:

"On January 12, 2007, Tourre spoke by telephone with ACA about the proposed transaction. Following that conversation, on January 14, 2007, ACA sent an email to the GS&Co sales representative raising questions about the proposed transaction and referring to Paulson’s equity interest. The email, which had the subject line “Call with Fabrice [Tourre] on Friday,” read in pertinent part:  “I certainly hope I didn’t come across too antagonistic on the call with Fabrice [Tourre] last week but the structure looks difficult from a debt investor perspective. I can understand Paulson’s equity perspective but for us to put our name on something, we have to be sure it enhances our reputation.”

And then:

"On January 16, 2007, the GS&Co sales representative forwarded that email to Tourre. As of that date, Tourre knew, or was reckless in not knowing, that ACA had been misled into believing Paulson intended to invest in the equity of ABACUS 2007-AC1."

Pardon me ?  An experienced CDO investor needs to be held accountable for its own investment decisions.  Paulson did probably take the first loss piece, what their overall view of the market is and what they did in related transactions is no-one's business except Paulson's. 


On the one hand is a counterparty (Paulson) who wants to short the market.  Said counterparty needs to find people in the market who have the opposite view and uses a bank (Goldman) to intermediate and find a sponsor (ACA) who is willing to put its name on it and market it to its investor base.  Paulson does not disclose its ultimate intentions, and neither does Goldman.  Because Paulson is apparently taking the equity portion, ACA seems to believe the Paulson is going long in the transaction, and the GS banker does nothing to disprove that assumption. 

Was he fraudulent in doing so, or doing his job and protecting the confidentiality of his client ?  Unless more details at to emerge from meetings and notes to point in that direction, I believe from what I read that Fabrice Tourre did nothing wrong.  At no point was Fabrice Tourre asked by his client ACA to confirm what Paulson's  market view was to ensure their interests were aligned; they seem to have assumed that was the case. 

There is nothing in the documents to suggest Tourre made fasle representations, only that he did not disclose to them the overall intent of Paulson.  Yet that is precisely the role of the bank: to intermediate between counterparties who have opposing views and interests. 

I don't think you can sue people for being smart; here is what a Paulson employee wrote:

“It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytical tools nor the institutional framework to take action before the losses that one could anticipate based [on] the ‘news’ available everywhere are actually realized.”

The financial world is not pretty, because it's all driven by short-term incentives and personal optimisation.   It's the naked face of profit making and I can see why it would make people angry.  I left investment banking in 1999 when I realised that what is was doing was taking money off folks that were less sophisticated than myself.  But before taking the moral high ground, you need to think carefully through all this.  After all, the first derivatives were futures used to help farmers protect against changes in the prices of crops.  

For reference, here is the Goldman Sachs line of defense:

  • Goldman Sachs Lost Money On The Transaction.  Goldman Sachs, itself, lost more than $90 million.  Our fee was $15 million.  We were subject to losses and we did not structure a portfolio that was designed to lose money.
  • Extensive Disclosure Was Provided.  IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities.  The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side.
  • ACA, The Largest Investor, Selected The Portfolio.  The portfolio of mortgage backed securities in this investment was selected by an independent and experienced portfolio selection agent after a series of discussions, including with Paulson & Co., which were entirely typical of these types of transactions.  ACA had the largest exposure to the transaction, investing $951 million.  It had an obligation and every incentive to select appropriate securities.
  • Goldman Sachs Never Represented To ACA That Paulson Was Going To Be A Long Investor.  The SEC's complaint accuses the firm of fraud because it didn't disclose to one party of the transaction who was on the other side of that transaction.  As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor.

In 2006, Paulson & Co. indicated its interest in positioning itself for a decline in housing prices.  The firm structured a synthetic CDO through which Paulson benefitted from a decline in the value of the underlying securities.  Those on the other side of the transaction, IKB and ACA Capital Management, the portfolio selection agent, would benefit from an increase in the value of the securities.  ACA had a long established track record as a CDO manager, having 26 separate transactions before the transaction.  Goldman Sachs retained a significant residual long risk position in the transaction.
IKB, ACA and Paulson all provided their input regarding the composition of the underlying securities.  ACA ultimately and independently approved the selection of 90 Residential Mortgage Backed Securities, which it stood behind as the portfolio selection agent and the largest investor in the transaction.
The offering documents for the transaction included every underlying mortgage security.  The offering documents for each of these RMBS in turn disclosed the various categories of information required by the SEC, including detailed information concerning the mortgages held by the trust that issued the RMBS.
Any investor losses result from the overall negative performance of the entire sector, not because of which particular securities ended in the reference portfolio or how they were selected.

The transaction was not created as a way for Goldman Sachs to short the subprime market.  To the contrary, Goldman Sachs' substantial long position in the transaction lost money for the firm. 

Disclosure: No positions