US: SEC charges Goldman Sachs with civil fraud in subprime deal
The Securities and Exchange Commission Friday charged Goldman Sachs
& Co. and one of its executives with fraud in a risky offshore deal
backed by subprime mortgages that cost investors more than $1 billion.
The SEC also contends that Goldman allowed a client, Wall
Street hedge fund Paulson & Co., to help select the securities.
Paulson in turn bought insurance against the deal and when the
securities tanked, losing almost all their value, Paulson made a $1
The civil fraud charges were the first to be filed against
Goldman, the prestigious Wall Street investment-banking titan that's at
the center of multiple inquiries into the causes of the global financial
Paulson has acknowledged that it reaped a $3.7
billion profit by betting against the housing market as it nose-dived in
2006 and 2007.
The securities cited by the SEC were part of a series of
offshore sales known as ABACUS.
The Goldman executive, vice president Fabrice Tourre,
31, was principally responsible for structuring the ABACUS deal known as
2007-AC1, a so-called synthetic package in which investors didn't buy
any actual securities. Instead, they bet on the performance of a
specified bundle of home loans to marginally qualified borrowers.
The complaint, filed in U.S. District Court for the
Southern District of New York, charges Tourre with making "materially
misleading statements and omissions" to investors.
Cornelius Hurley, a former counsel to the Federal
Reserve Board who now heads the Boston University law school's Morin
Center for Banking and Financial Law, called the complaint "stunning"
and said it raises at least two questions:
Was this an isolated incident at Goldman, or did the firm engage
in similar "egregious" practices in other deals?
- Did other Wall Street firms engage in similar
"It appears that the financial 'protection' provided by
Goldman and described in the SEC complaint may have been more akin to
the kind of protection provided by organized crime," Hurley said.
McClatchy Newspapers, in a series published in November
about Goldman's role in the subprime lending disaster, found that
Goldman sold more than $40 billion in mortgages in 2006 and 2007 while
secretly betting on a housing downturn that would sink their value. It's
unclear whether any of those transactions have drawn SEC or Justice
Department scrutiny, but a Senate investigations panel has been
McClatchy also reported in late December that Goldman
took initial positions in which it bet against the performance of at
least a dozen CDOs (collateralized debt obligations) that it assembled
and marketed through the Cayman Islands.
Robert Khuzami, the SEC's enforcement chief, was
asked on a conference call whether anyone higher up in Goldman might
"We charged those that we felt appropriate, based on
the evidence and the law," Khuzami replied.
Goldman said in a statement: "The SEC's charges are
completely unfounded in law and fact and we will vigorously contest them
and defend the firm and its reputation."
The complaint alleged that Paulson, one of the world's
largest hedge funds, paid Goldman to assemble a deal in which Paulson
would select certain mortgage-backed securities and then take short
positions, or bet against them.
The marketing materials for the investment, known as
a collateralized debt obligation, all represented that the
mortgage-backed securities were selected by ACA Management LLC, a third
"The product was new and complex, but the deception
and conflicts are old and simple," Khuzami said in a statement. "Goldman
wrongly permitted a client that was betting against the mortgage market
to heavily influence which mortgage securities to include in an
investment portfolio, while telling other investors that the securities
were selected by an independent, objective third party."
The deal, one of about two dozen similar bundles in
the ABACUS series, closed on April 26, 2007. Paulson paid Goldman about
$15 million for structuring and marketing the deal. Within six months,
83 percent of the mortgage-backed securities in the bundle had been
downgraded and 27 percent were placed on negative watch by Wall Street
ratings agencies, the complaint said.
By the following Jan. 29, it said, 99 percent of the
portfolio had been downgraded, costing investors more than $1 billion.
Khuzami said that the Paulson firm, which is not
affiliated with former Treasury Secretary Henry Paulson, was not charged
because it did not mislead investors.
However, the complaint said that Goldman and Tourre "knew that
it would be difficult, if not impossible," to find investors for a
synthetic CDO if they disclosed that a short player, such as Paulson,
played a significant role in selecting the securities. Thus, they sought
a third party to play that role and approached ACA, calling it
"important that we can use ACA's branding" in an internal email.
The complaint quoted Tourre as saying a Jan. 27, 2007
email to a friend, written in French and English: "More and more
leverage in the system, The whole building is about to collapse anytime
now ... Only potential survivor, the fabulous Fab[rice Tourre] ... standing
in the middle of all of these complex, highly leveraged, exotic trades
he created without necessarily understanding all of the implications of
A Feb. 11, 2007 email to Tourre from the head of
Goldman's structured product correlation trading desk said, "the cdo biz
is dead we don't have a lot of time left," the complaint said.
The SEC identified only one investor in the Abacus deal: IKB, a
commercial bank in Dusseldorf, Germany, lost nearly all of its $150
Friday's charges were the first to be filed by the SEC's
Structured and New Products Unit, formed to pursue abuses in highly
sophisticated deals, many of which were registered in the Cayman
Islands, where investors don't have to pay U.S. federal taxes.
Many of these deals are sliced according to risk, with
investors who take the greatest risk receiving the highest yield. In
deals that were partially or entirely synthetic, Goldman or some of its
clients would profit if the securities soured.
Goldman created a structured product correlation
trading desk around late 2004 or early 2005. A memo describing the
ABACUS 2007-AC1 transaction to the company's Mortgage Capital Committee
on March 12, 2007 stated that the "ability to structure and execute
complicated transactions to meet multiple clients' needs and objectives
is key for our franchise," the SEC complaint said.
Executing the deal "and others like it helps position
Goldman to compete more aggressively in the growing market for
synthetics written on structured products," it said.
At that point, Goldman was well on its way to ridding
itself of securities backed by risky home loans, a process that it's
acknowledged began in early December 2006.
Paulson & Co. was among a small number of U.S.
investors who foresaw the housing crash and bet heavily on it. According
to the complaint, Paulson came to believe that sub-investment grade,
and in some cases even higher-rated tranches of collateralized debt
obligations consisting of subprime mortgages, "would become worthless."
In late 2006 and early 2007, it said, Paulson
identified more than 100 mortgage bonds that it expected to collapse,
favoring those backed by loans to borrowers with low credit scores,
adjustable rate mortgages and located in the overheated real estate
markets such as Arizona, California, Florida and Nevada.
In early January, Tourre forwarded a list of 123
mortgage-backed bonds under the heading "Paulson Portfolio," leading to
negotiations between Paulson, Goldman and ACA over the final portfolio,
including a sizable number of those selected by Paulson.
- 208 Regulation