The Securities Exchange and Commission, charged Goldman Sachs Group Inc. with deceiving clients by selling them mortgage securities secretly designed by a hedge-fund firm, Paulson & Co, run by John Paulson. The SEC accused Goldman and one of its vice presidents, Fabrice Tourre, of failing to alert investors in the collateralized debt obligation (CDO), ABACUS 2007-AC1.
More specifically, regulators say Goldman allowed Paulson’s $32 billion hedge fund to help design a financial investment known as CDO built out of a specific set of risky mortgage assets—essentially setting up the CDO for failure. Paulson played a significant role in picking the residential mortgage-backed securities included in the CDO. Paulson then bet against it, while investors in the CDO weren’t told of Paulson’s role or intentions. “The product was new and complex, but the deception and conflicts are old and simple,” said Robert Khuzami, the SEC’s enforcement chief.
On Friday, Goldman Sachs denied charges. In a press release, Goldman called the SEC charges “completely unfounded in law and fact” and promised to “vigorously contest them and defend the firm and its reputation.” Goldman argued that “the portfolio of mortgage-backed securities in this investment was selected by an independent and experienced portfolio selection agent,” ACA Management, “after a series of discussions, including with Paulson & Co., which were entirely typical of these types of transactions,” the firm said. “ACA had the largest exposure to the transaction, investing $951 million. It had an obligation and every incentive to select appropriate securities.”
Also, in its press release Goldman said that it never told or implied to ACA that Paulson would not be betting against the CDO. However, it did make clear that Goldman was not shorting the vehicle. “The transaction was not created as a way for Goldman Sachs to short the subprime market,” it said. “To the contrary, Goldman Sachs’s substantial long position lost money for the firm.” Goldman said it lost more than $90 million; Paulson paid it $15 million to structure the transaction.
Paulson and his firm aren’t named as defendants. The hedge-fund firm said in a statement that it wasn’t involved in marketing the bonds to third parties. “Goldman made the representations, Paulson did not,” Khuzami said. Paulson took home $4 billion in 2007 for correctly betting on a housing collapse.
The SEC suit charges only Goldman and a vice president who handled the Abacus transaction, Fabrice Tourre. But, according to The New York Times, the executive involvement in Goldman’s housing bets went much further up the corporate ladder, though the SEC didn’t specify how high up it believes the knowledge extended. The firm’s top executives, including CEO Lloyd Blankfein, CFO David Viniar and President Gary Cohn, were active in overseeing Goldman’s mortgage unit, the Times reports. And it was those executives who eventually agreed with Tourre that housing prices were likely to fall. Goldman said that none of its senior leadership was involved in the Abacus deals.
Despite its robust defense of itself, Goldman may soon find itself in hot water in multiple jurisdictions. Both British and German regulators are looking into the case and may bring charges of their own. British Prime Minister Gordon Brown, with an election just weeks away, told the BBC that he wants the U.K. Financial Services Authority to look into the CDO transaction. “There is a moral bankruptcy reflected in what I am reading about and hearing about,” he said. Meanwhile, across the North Sea, Germany’s BaFin has sought details about the SEC’s lawsuit from the regulator itself, Bloomberg News reports.
The SEC lawsuit likely strengthens the position of President Barack Obama as he tries to push financial-overhaul legislation through Congress. He vowed Friday to veto any version of the bill that doesn’t bring the derivatives market “under control.”
Goldman’s shares fell 13%, one of the steepest slides since the firm went public in 1999, erasing some $12 billion of market capitalization.
