Goldman charge looks more like politics than fraud

[JohnSmith2007 353]

Goldman charge looks more like politics than fraud

Paul Krugman, Nobel economist, calls it "looting." The media, spoonfed a story line by the U.S. Securities and Exchange Commission, regurgitated the claim that Goldman Sachs had sold a $1-billion mortgage derivative product that was "designed to fail." The case against Goldman, said the Financial Times of London, "is damning."

It would indeed be damning if true - and if the SEC's story line on the evidence were to hold up before a jury, should it ever get to a jury, which is doubtful.

There's barely a thread holding it all together, and one of the thinnest bits is in an email from one Fabrice Tourre, a 31-year-old Goldman vice-president who put the alleged fraudulent deal together. On Jan. 23, 2007, Mr. Tourre wrote to a friend: "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 these complex, highly liveraged, exotic trades he created without necessarily understanding all of the implicaions of those monstrosities."

Very flip and savvy, in a juvenile way. But good enough for SEC investigators who spent 18 months on the Goldman file. They must have been desperate. Even in the SEC's version, the Goldman scandal looks far from being a fraud and a lot like a move on behalf of Democrats and the Obama administration to boost support for radical financial reform.

The commission's 22-page rap sheet, in a quick read, is like following the plot of a Quentin Tarantino film. It's complicated and scary, but what the hell's happening? Remove the blood and gore created by the SEC's screenwriters, and a different story emerges. The deal that is now rattling world financial markets turns out to have been a complicated piece of financial work to be sure, but it fails to live up to claims of massive deception and breach of U.S. securities law. It is telling that the charge is a civil fraud, not a criminal fraud, indicating a lack of hard evidence of deliberate malfeasance.

The SEC's version of the deal, stripped of incriminating assumptions, shows Goldman Sachs acting as middle-man in putting together a financial transaction in early 2007 between big-time mortgage-market players who had different views as to the future of the U.S. housing market.

Gambling that the market would stay strong were ACA Capital and ACA Management, subsidiaries of a U.S. bond insurer and experienced mortgage-backed risk analysts and players. Also taking the positive long position was IKB Deutsche Interbank, a commercial bank headquartered in Dusseldorf, Germany. In the years before 2007, IKB had become involved as an expert investor in derivative products based on U.S. mortgage securities. These were not small unsuspecting investors wandering in off the street.

Betting that the U.S. housing market was set to crash was Paulson & Co., the hedge fund which in the SEC's words "developed an investment strategy based upon the belief that, for a variety of reasons, certain mid-and-subprime [mortgage-backed securites] rated ‘Triple B' ... would experience credit events." A smart strategy, in retrospect.

According to the SEC, Paulson had compiled a list of Triple B-rated mortgage-backed securites and bonds that it expected to self-destruct. Paulson aimed to short (sell) a hypothetical portfolio of these mortgage-based products, thereby making money when and if the market crashed. In early 2007, Paulson approached Goldman Sachs asking it to find counterparties to its plan. It wanted someone to take up the other side of the bet.

Goldman Sachs, through Mr. Tourre, found two: IKB in Germany and ACA Management. IKB had already become nervous about the U.S. housing market, and it wanted future investments in the market to be vetted in advance by a more experienced player. ACA fit the description. The SEC says ACA had by 2006 come to specialize in mortgage-based investment deals and had "closed on 22 CDOs (collateralized debt obligations) worth $15.7-billion."

And so, for a relatively small fee of $15-million, Mr. Tourre and Goldman Sachs mediated a negotiation between the two bets on the future of the market. In early January, 2007, Paulson produced an initial list of 123 residential sub-prime mortage-backed securites that it wanted included in the portfolio. After about eight weeks of negotiations, various securities were added and others were removed. On February 26, Paulson and ACA "came to an agreement on a reference portfolio of 90" mortgage-backed securites.

Not that there were any securities to buy. The deal, ABACUS 2007-AC1, would contain a "reference portfolio" rather than an actual portfolio of mortgage-backed securites. It was to be a "synthethetic" collateralized debt obligation (CDO). In all, the deal contained more than $1-billion in make-believe securities. For its share, IKB in Dusseldorf put $150-million into ABACUS, a bet on the positive future for the mock portfolio. The investor on the other side of the transaction was Paulson & Co., betting on the negative.

Among the SEC's claims is that ACA somehow did not actually perform the official "selection" of the securities in the portfolio, even though its own summary makes it clear that ACA - a veteran in the business and a known expert in the field - signed off on the final selection. The SEC also claims that ACA was "misled" by Goldman into believing that Paulson would be investing on the same side of the bet that ACA was on.

Whether those allegations hold up remains to be seen. Goldman Sachs, in response, has issued its version of events and, among other things, categorically rejects the claim that it said Paulson was gambling on the same side as IKB and ACA. "Goldman Sachs never represented to ACA that Paulson was going to be a long investor," said Goldman in a note to clients last Sunday.

Goldman also has a more than plausible answer to the charge that documents did not disclose that Paulson was on the other side of the transaction. Goldman says it is being accused of fraud in part "because it did not disclose to one party of the transaction the identity of the party on the other side," something that market makers never do.

Goldman, moreover, says that - even though it knew who was on the other side - it invested a bit of money of its own directly in the ABACUS deal, and lost about $90-million. Did Goldman defraud itself?

ABACUS was also an easy investment call, at least on paper. The portfolio, full of Triple-B mortage junk, was rated AAA by Moody's and Standard and Poors. That reflects the theory at the time that while some mortgages may go bad, it was highly unlikely that all Triple-B mortgages would turn to junk simultaneously. Was Moody's defrauded too?

The SEC's portrayal of ACA as something of an innocent victim is hard to figure. After having worked on and approved the selection of securities, ACA took up more than $900-million of the deal when it closed on April 26. ACA would have been at risk on ABACUS for weeks until it eventially unloaded its position to ABN AMRO Bank, the Dutch bank, in late May of 2007. When the securities went bad, ABN - later controlled by Royal Bank of Scotland - paid out the $900-million loss, the money going to Paulson.

The SEC claims, without providing any hint of evidence, that ACA was snookered. "It is unlikely that ACA Capital would have written protection on the super senior tranche if it had known that Paulson, which played an influential role in selecting the reference portfolio, had taken a significant short position instead of a long equity stake in ABACUS 2007-AC1."

This is certainly a reach. Even if ACA were now to claim that it had been tricked, it was itself part of the trick. ACA agents approved the portfolio that ACA invested in. No blame can be passed on to Paulson or others.

These are the Goldman charges. If that's all there is to the case, they are unlikely to go far and were likely never intended to go very far beyond creating an environment that favours massive new regulatory reform for U.S. banks and investment houses. The vote at the SEC to press the charges split along party lines, with the Democrats on the panel approving the action.

In the ABACUS deal, Paulson & Co. made the right bet. Making the wrong bet were a top market insurance player (ACA), a sophisticated German bank (IKB), a world-class Dutch bank (ABN) and the world's leading investment bank (Goldman Sachs). Loot changed hands, to be sure, but there was no looting.

http://www.financialpost.com/news-sectors/financials/story.html?id=2926436