SEC Accuses Goldman Sachs of Civil Fraud (Updated)
[Guest post by DRJ]
… for helping a client sell mortgage derivatives while betting against them:
“Goldman told investors that a third party, ACA Management LLC, had selected the pools of subprime mortgages it used to create what are known as synthetic collateralized debt obligations. But, the SEC alleges, Goldman misled investors by failing to disclose that Paulson & Co. also played a role in selecting the mortgage pools and stood to profit from their decline in value.
“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,” Khuzami said in a statement.”
Goldman Sachs denies the charges:
“Our short positions were not a ‘bet against our clients,'” Goldman said in the letter. “Rather, they served to offset our long positions. Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits.”
This MIT professor had the best and perhaps most accurate quote:
“It undermines their brand,” said Simon Johnson, a professor at the Massachusetts Institute of Technology and a Goldman critic. “It undermines their political clout. I don’t think anybody really values being connected to Goldman at this point.”
He continued: “There are many people who — until this morning — thought Goldman Sachs was well-run.”
According to Open Secrets, Goldman Sachs gives primarily to Democrats. Could that be why this is a civil case and not criminal fraud? Either way, Politico says the Goldman Sachs’ charges are good news for the Obama Administration’s hopes for more financial regulation of the derivatives market.
— DRJ
UPDATE 4/20/2010 — The GOP questions the timing:
“Rep. Darrell Issa, the top Republican on the House Oversight committee, is demanding a slew of documents from the Securities and Exchange Commission, asserting that the timing of civil charges against Goldman Sachs raises “serious questions about the commission’s independence and impartiality.”
Issa’s letter, addressed to SEC Chairwoman Mary Schapiro and signed by eight other House Republicans, asks whether the commission had any contact about the case, prior to its public release, with White House aides, Democratic Party committee officials, or members of Congress or their staff.
“[W]e are concerned that politics have unduly influenced the decision and timing of the commission’s controversial enforcement action against Goldman,” Issa writes.”
Uh, Yeah, DRJ. It could be. 😉
Government Sachs is not the only Wall Street firm to work with John Paulson. A good read that details Paulson’s (and others’) tactics is The Greatest Trade Ever.
Stu707 (0981d5) — 4/16/2010 @ 1:26 pmCan’t the SEC only file civil charges? Don’t criminal charges have to originate from the dept. of justice, which this has already been referred to for potential criminal charges?
Chris Hooten (bc3301) — 4/16/2010 @ 2:12 pmBye bye Goldman.
HeavenSent (a9126d) — 4/16/2010 @ 2:16 pm… and fact is, yes they were betting V their customers.
The whole reason AIG paid them 10Billion was for insurance against the LONG positions. So why now claim they used Paulson for much the same insurance???
Essentially they are claiming they got INSURANCE TWICE for the same positions.
Once via Paulson and then via AIG. Possible but odd with bilateral trades. More to come.
HeavenSent (a9126d) — 4/16/2010 @ 2:20 pmI think that’s correct, Chris Hooten, but the reports I’ve read don’t say whether the DOJ is considering criminal charges. It will be interesting to see if criminal charges are forthcoming.
DRJ (09fa6c) — 4/16/2010 @ 2:20 pmGoing from memory, underwriters can short a security to maintain an orderly market during an offering. That is usually disclosed in the underwriting or plan of distribution section of a prospectus. The SEC knows that. Goldman seems to be hanging its hat on that type of a rule, while the SEC is focused on a lack of disclosure. In the 1980s we used to hedge corporate bond exposures in the government market.
Lack of disclosure is a big no no.
daleyrocks (1feed5) — 4/16/2010 @ 2:22 pmI think the problem is Paulson (Short) asked Goldman (The Cook) to create a poisonous steak (Specific CDO w/ Specific Securities) to sell to its Institutional Customers (Longs) for purpose of then buying Life Insurance on the CDO.
Kind of like the waiter agreeing to poison your dinner b/c your wife paid him to do so and she then went out and got life insurance.
HeavenSent (a9126d) — 4/16/2010 @ 2:37 pmi question the timing of the announcement.
redc1c4 (fb8750) — 4/16/2010 @ 3:19 pmPaulson’s many contributions to GOP Org’s and candidates is being floated to take some of the sting out of this.
All major indices were down on Wall Street today between 1 & 1.5%, including overseas.
Could this be today’s equivalent of Justice’s filing against MS in the Spring of ’00, that led to the NASDAQ sell-off, and the end of the .com boom?
AD - RtR/OS! (f9a039) — 4/16/2010 @ 4:11 pmMonday will be a very nervous opening on Wall Street;
pay attention to the overseas markets starting with the Nikkei Sunday Night.
This seems part of the same story that is in the new book The Big Short. One part of that is about Dr. Michael Burry, and how he went looking for a way to short the mortgage market when there was no obvious mechanism to do so. The book says he was the first hedge fund operator who saw credit default swaps as a mechanism to take a position betting that securitized mortgages would default. In that sense, he seems to have been no different that Paulson. He asked the help of Goldman and some other big financial services companies in finding counter-parties on the other side of his positions, but he was allowed to pick “tranches” from within individual bonds — slices of mortgages that were of a similar type, say sub-prime or Alt-A — and bet that those tranches would suffer defaults that would cause them to decline in value.
The key to his position was that the middlemen — the Goldman’s — set the price for the parties. In effect, they would bring the other side to the table and tell Burry what it was he would have to pay in the form of a premium for the other side to write the “insurance” policy in the form of a CDS.
What Burry figured out is that the middlemen — like Goldman — established the “premium” based on the credit rating assigned by Standard or Moody’s to the entire bond, while allowing him to “short” — or bet on the decline — of just a portion of the bond. A particular bond might carry an overall rating of AA, but a “tranch” within that bond might have had a group of mortgages that were so risky that they would have been rated much lower. Goldman priced the credit default swap based on the overall rating, while allowing Burry to “short” on the worst part of the bond.
When it began to dawn on the financial services companies that the mortgage industry was headed for some difficult times, they started buying some of Burry’s positions for their own account. Burry sold some of his positions — at significant profits — to Goldman, BofA, Duestch Bank, etc. — all of whom had arranged deals for him as the middleman, earning a fee.
Shipwreckedcrew (fe3b5b) — 4/16/2010 @ 6:15 pmBurry’s story is also told in the book I referenced above. He resented that Paulson received more recognition than he did though was the first to discover CDS as a way to profit from the fall of securtitized mortgages. I think that this was because Paulson made nearly $4 Billion f for himself and $15 Billion for his firm. He was located on Walls Street while Burry was in the Bay area.
Both Paulson and Burry were hedge fund operators. An LA real estate owner named Jeffrey Greene was the probably the only individual investor who was able to profit from CDS. He persuaded Merrill, Lynch to sell them to him. Merrill bought them back when real estate market began to crash.
As Shipwrecked mentioned CDS were a type of insurance policy. Buyers had to pay an annual premium. Typically, it was 1% of the face value of the asset being covered. They were only available in very large denominations, e.g. $1M annual premium for coverage of $100 M mortgage securities. Needless to say, investors in the hedge funds began to get nervous as time went by before the crash.
Stu707 (0981d5) — 4/16/2010 @ 8:22 pmThe linked article in the Wall Street Journal discusses this case. One of the reporters is the author of The Greatest Trade Ever. Near the bottom left of the article is a graphic that will step you through the making of a collateralized debt obligation.
Stu707 (0981d5) — 4/16/2010 @ 9:52 pm#5
The decision to bring charges on a case like this lies with the SEC commissioners.
DOJ makes its decision independently.
As a very general rule, failure to disclose tend to be civil only. It usually takes affirmative misrepresentations to get the DOJ interested because of the much higher standard of proof in a criminal case. (There are many, many exceptions, of course, where the size of the fraud or the materiality of the omissions was obvious enough to earn a criminal indictment.)
I can very much see why DOJ is leery of a criminal case. Here the alleged fraud was not in the disclosure concerning the assets, but rather who picked them. This is a pretty unusual theory for a very unusual case. Since it is a five year statute of limitations, DOJ can wait unti 2012 to see what happens in the civil case. Not bringing an indictment now also makes taking the Fifth harder.
The upshot–given the novelty of the case, going civil first makes a lot of sense.
Cyrus Sanai (311cd8) — 4/18/2010 @ 4:33 pmCyrus,
I agree that announcing civil charges, particularly last Friday, makes sense but not for the reason you suggest.
DRJ (09fa6c) — 4/18/2010 @ 5:16 pmComment by DRJ — 4/18/2010 @ 5:16 pm
Right!
AD - RtR/OS! (4249dd) — 4/18/2010 @ 5:33 pmThere are far too many big-$ Dem donars involved to be throwing around criminal indictments.