The SEC has charged Goldman Sachs
and one of its employees for making materially misleading statements and
omissions in connection with a synthetic collateralised debt obligation that
the investment bank structured and marketed to investors.
The performance of the ABACUS
2007AC1 CDO depended on the performance of a reference portfolio of subprime
residential mortgage-backed securities, at a time when the US real estate
market showed signs of weakening.
The SEC essentially accuses Goldman
of creating a mortgage investment that was secretly designed to fail.
According to the SEC complaint
Goldman Sachs did not disclose to investors that Paulson & Co. Inc., a
large hedge fund, played a significant role in the selection of the reference portfolio.
The hedge fund shorted the RMBS
portfolio it helped to create by entering into credit default swaps with
Goldman on specific layers of the CDO structure. This credit default swap
protection paid out if the underlying securities experienced certain credit
events or defaults.
As a result Paulson had the
economic incentive, the SEC claimed, to choose RMBS for the reference portfolio
that it expected would be likely to experience credit events in the future,
putting the hedge fund at odds with investors in the CDO, who would lose money
from such a default.
Goldman Sachs did not disclose
Paulson’s role or economic interests in the portfolio selection in documents
provided to investors, the SEC alleged.
Robert Khuzami, the SEC’s enforcement
chief, 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.”
Recognising that certain investors
require a collateral manager with experience in the US housing market to
analyse the default risk of securities that are to be included in the
portfolio, Goldman Sachs asked ACA to act as collateral manager.
According to the complaint, Fabrice
Tourre, a director with Goldman Sachs and a defendant named in the suit, misled
ACA by presenting Paulson as an investor intending to invest approximately
US$200 million into the equity of the ABACUS CDO, when in fact the hedge fund intended
to make large bets that parts of the CDO would be downgraded.
Only six months after the CDO was marketed
and sold to investors in April 2007 over 80 per cent of its underlying
securities had been downgraded. Three months later 99 per cent of the portfolio
had been downgraded, resulting in losses of over 1$ billion to the investors,
the suit said.
One of the investors, IKB Deutsche
Industriebank AG, became one of the high profile bank defaults in the subprime
crisis. Dutch bank ABN Amro is said to have lost over $800 million in transactions
involving the CDO.
The Paulson hedge fund in turn
pocketed profits of approximately 1$ billion from its credit default swap positions.
Paulson paid Goldman approximately
$15 million for structuring and marketing the synthetic CDO, the SEC said.
In a statement, Goldman called the
commission’s accusations “completely unfounded in law and fact” and said it
would “vigorously contest them and defend the firm and its reputation.”
Goldman Sachs said that
“[b]ased on all that we have learned, we believe that the firm’s actions
were entirely appropriate, and will take all steps necessary to defend the firm
and its reputation by making the true facts known.”
The investment bank further emphasised
that it had marketed the CDO to experienced investors.
The way Goldman and others profited
from the collapsing subprime mortgage market has been under government scrutiny
for some time, but the civil SEC law suit is the first of its kind.
The SEC claims that Mr. Tourre and
Goldman Sachs were fully aware of the impending collapse of the US housing and
CDO market, quoting an email in which Mr. Tourre said on 27 January 2007, “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 those monstrosities!!!”
Goldman Sachs however claimed on
Monday that it in fact lost $90 million in the ABACUS CDO transaction.
While CDOs enabled lenders to
bundle bonds backed-by home loans to enable them to transfer the associated
risks and make out more loans, the credit instruments have been widely blamed
for the extent of the subprime crisis.