The Securities and Exchange Commission vs. Goldman Sachs
Apr 18, 2010
Posted by Jody Eisenman | Filed under Uncategorized
When I was thinking of this blog post on Friday, I was planning on writing about Goldman, but for a different reason. It seems that GS has an international real estate fund (called Whitehall Street International) which raised $1.8 billion in 2005. As of the end of 2009, the fund was down to a paltry $30 million, which means that it managed to lose 98% of their equity in about 4 years. However, the real news on GS came Friday, with the lawsuit of the SEC against the form and Fabrice Tourre. The charges are a bit complex, so I will try to break it down such that the average person can understand what all this is about. This is what the government is alleging that GS did:
1. In early 2007, GS was approached by Paulson and company, which is a large hedge fund run by John Paulson. Paulson has become famous for identifying the housing crash and making substantial bets against it. Paulson eventually made up making about $20 billion for his investors, while most Americans were losing their shirts. How did Paulson do it? In this case, he made about a billion by buying CDS (credit default swaps) on CDOs (collateralized debt obligations). Ok, lets define this! A CDO is mortgage backed security with a unique structure. Basically, the investment bank takes a large pool of mortgages and sells them to investors. However, the pools are then broken into tranche. To illustrate this, imagine the pool. consisted of just one mortgage. Lets say the mortgage was a total of $900,000 on a home worth $1 million. Now here comes the fun part. The investment bank takes the $900,000 mortgage and divides into three pieces, called tranches. Should the homeowner default, The first or top tranche would be paid off first. Only if there were sufficient funds, would the second tranche be paid, and so on with the third tranche. Clearly, the last tranche would be the riskiest, and would therefore carry the highest interest rates. Paulson allegedly helped GS select the portfolio of lower rated mortgages. He actually paid GS $15MM for this privilege. He specifically looked for mortgages that had homeowners with low credit scores. The person who put the portfolio together for GS was Fabrice Tourre. Paulson’s goal was to then buy credit default swaps on the portfolio, essentially betting that it would lose value.
2. GS designed this portfolio, and somehow managed to get a AAA rating from both Moodys and S and P. Why did the ratings agency do this? It’s hard to say in this case, but previous cases show that the ratings agency were both negligent and incredibly optimistic. In many cases, they never really analyzed the value of these securities in great detail. There were many cases of the agencies giving ratings on several million dollars of CDOs after analyzing these securities for less than a day! In addition, the agencies agreed to a conceptual argument by the investment bankers that went like this: “Yeah, it’s true that each individual mortgage in this portfolio is BBB rated, but its unlikely they will all go bad at once. After all, don’t real estate prices increase every year? So, in aggregate, they should get a really high rating, right?” Incredibly, the agencies bought this ridiculous argument. In any case, they did rate this CDO a AAA, the highest possible rating. The portfolio was called ABACUS 2007.
3. GS knew that it would be difficult to sell this CDO to any sophisticated investor if they disclosed that Paulson had helped design it only to bet against it. Therefore, they hired a firm called ACA financial to serve as portfolio selection agent. ACA had previously placed billions of dollars of these CDOs in the past. One of the investors in this was a German bank called IKB. IKB was nervous about investing in these products without having an independent third party (ACA) involved. Based to a certain extent on ACA. IKB invested $150MM in April of 2007. The total value of ABACUS was $909MM.
4. One month later, Paulson purchased a CDS on ABACUS for about 50 basis points, or half a percent. When ABACUS lost all its’ value a few months later (which would lead many to believe it was never worth what GS said it was at the time of sale), Paulson reaped a profit of about $840MM. By my estimates, he made about 200 times his money in a relatively short period. IKB, as well as the other investors in ABACUS who did not purchase CDS, were wiped out.
5. The SEC believes that not only did GS not disclose Paulsons’ role (which would have made selling this instrument next to impossible) but actually led investors to believe that Paulson was actually BUYING the a part of the CDO. If this is true, then GS committed fraud. Even worse, it would seem that GS’ pledge to put clients first would be severely questioned.
Based on this news, GS, the banks and the market got hit hard on Friday. GS stock was down over 23 points on Friday, while the Dow fell 125. All the banks dropped in sympathy, with the financial sector ETF (symbol:XLF) losing 3.65%, its’ biggest drop in a very long time. Whether or not this leads to the long overdue correction should be played out shortly.
April 26th, 2010 at 5:25 pm
[...] well as the high rating issued by Moody’s or Standard and Poors. As I discussed last week (http://www.jodyeisenman.com/2010/04/the-securities-and-exchange-commission-vs-goldman-sachs/), these ratings were, by 2007, were simply wrong. A more jaundiced view might view them as [...]