WASHINGTON — The Securities and Exchange Commission Friday charged Goldman Sachs & Co. and one of its executives with fraud in a risky offshore deal backed by subprime mortgages that cost investors more than $1 billion.
The SEC also contends that Goldman allowed a client, Wall Street hedge fund Paulson & Co., to help select the securities. Paulson in turn bought insurance against the deal and when the securities tanked, losing almost all their value, Paulson made a $1 billion profit.
The civil fraud charges were the first to be filed against Goldman, the prestigious Wall Street investment-banking titan that's at the center of multiple inquiries into the causes of the global financial meltdown.
Paulson has acknowledged that it reaped a $3.7 billion profit by betting against the housing market as it nose-dived in 2006 and 2007.
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The securities cited by the SEC were part of a series of offshore sales known as ABACUS.
The Goldman executive, vice president Fabrice Tourre, 31, was principally responsible for structuring the ABACUS deal known as 2007-AC1, a so-called synthetic package in which investors didn't buy any actual securities. Instead, they bet on the performance of a specified bundle of home loans to marginally qualified borrowers.
The complaint, filed in U.S. District Court for the Southern District of New York, charges Tourre with making “materially misleading statements and omissions” to investors.
Cornelius Hurley, a former counsel to the Federal Reserve Board who now heads the Boston University law school’s Morin Center for Banking and Financial Law, called the complaint “stunning” and said it raises at least two questions:
- Was this an isolated incident at Goldman, or did the firm engage in similar “egregious” practices in other deals?
“It appears that the financial ‘protection’ provided by Goldman and described in the SEC complaint may have been more akin to the kind of protection provided by organized crime,” Hurley said.
McClatchy Newspapers, in a series published in November about Goldman’s role in the subprime lending disaster, found that Goldman sold more than $40 billion in mortgages in 2006 and 2007 while secretly betting on a housing downturn that would sink their value. It’s unclear whether any of those transactions have drawn SEC or Justice Department scrutiny, but a Senate investigations panel has been examining them.
McClatchy also reported in late December that Goldman took initial positions in which it bet against the performance of at least a dozen CDOs (collateralized debt obligations) that it assembled and marketed through the Cayman Islands.
Robert Khuzami, the SEC’s enforcement chief, was asked on a conference call whether anyone higher up in Goldman might face charges.
“We charged those that we felt appropriate, based on the evidence and the law,” Khuzami replied.
Goldman said in a statement: “The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation.”
The complaint alleged that Paulson, one of the world’s largest hedge funds, paid Goldman to assemble a deal in which Paulson would select certain mortgage-backed securities and then take short positions, or bet against them.
The marketing materials for the investment, known as a collateralized debt obligation, all represented that the mortgage-backed securities were selected by ACA Management LLC, a third party.
“The product was new and complex, but the deception and conflicts are old and simple,” Khuzami 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.”
The deal, one of about two dozen similar bundles in the ABACUS series, closed on April 26, 2007. Paulson paid Goldman about $15 million for structuring and marketing the deal. Within six months, 83 percent of the mortgage-backed securities in the bundle had been downgraded and 27 percent were placed on negative watch by Wall Street ratings agencies, the complaint said.
By the following Jan. 29, it said, 99 percent of the portfolio had been downgraded, costing investors more than $1 billion.
Khuzami said that the Paulson firm, which is not affiliated with former Treasury Secretary Henry Paulson, was not charged because it did not mislead investors.
However, the complaint said that Goldman and Tourre “knew that it would be difficult, if not impossible,” to find investors for a synthetic CDO if they disclosed that a short player, such as Paulson, played a significant role in selecting the securities. Thus, they sought a third party to play that role and approached ACA, calling it “important that we can use ACA’s branding” in an internal email.
The complaint quoted Tourre as saying a Jan. 27, 2007 email to a friend, written in French and English: “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 monstruosities!!!”
A Feb. 11, 2007 email to Tourre from the head of Goldman’s structured product correlation trading desk said, “the cdo biz is dead we don’t have a lot of time left,” the complaint said.
The SEC identified only one investor in the Abacus deal: IKB, a commercial bank in Dusseldorf, Germany, lost nearly all of its $150 million.
Friday’s charges were the first to be filed by the SEC’s Structured and New Products Unit, formed to pursue abuses in highly sophisticated deals, many of which were registered in the Cayman Islands, where investors don't have to pay U.S. federal taxes.
Many of these deals are sliced according to risk, with investors who take the greatest risk receiving the highest yield. In deals that were partially or entirely synthetic, Goldman or some of its clients would profit if the securities soured.
Goldman created a structured product correlation trading desk around late 2004 or early 2005. A memo describing the ABACUS 2007-AC1 transaction to the company’s Mortgage Capital Committee on March 12, 2007 stated that the “ability to structure and execute complicated transactions to meet multiple clients’ needs and objectives is key for our franchise,” the SEC complaint said.
Executing the deal “and others like it helps position Goldman to compete more aggressively in the growing market for synthetics written on structured products,” it said.
At that point, Goldman was well on its way to ridding itself of securities backed by risky home loans, a process that it's acknowledged began in early December 2006.
Paulson & Co. was among a small number of U.S. investors who foresaw the housing crash and bet heavily on it. According to the complaint, Paulson came to believe that sub-investment grade, and in some cases even higher-rated tranches of collateralized debt obligations consisting of subprime mortgages, “would become worthless.”
In late 2006 and early 2007, it said, Paulson identified more than 100 mortgage bonds that it expected to collapse, favoring those backed by loans to borrowers with low credit scores, adjustable rate mortgages and located in the overheated real estate markets such as Arizona, California, Florida and Nevada.
In early January, Tourre forwarded a list of 123 mortgage-backed bonds under the heading “Paulson Portfolio,” leading to negotiations between Paulson, Goldman and ACA over the final portfolio, including a sizable number of those selected by Paulson.
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