The SEC Takes Goldman Sachs to Court

The U.S. Securities and Exchange Commission (SEC) made headlines around the world on April 16, 2010, when it filed a civil lawsuit accusing Wall Street icon Goldman Sachs of fraud in the creation and marketing of a mortgage-backed security deal dating from 2007.
      Although no one can predict the outcome of this suit—and Goldman strongly denies the charges—this case raises a number of important issues involving government regulation, business ethics, marketing, the complexity of exotic financial investments, and a relationship between Wall Street and Washington that is perceived by some as too cozy for the good of other stakeholders in the economy.

Key Points in the SEC’s Complaint
The SEC charges that Goldman made “materially misleading statements and omissions” regarding an investment vehicle known as Abacus 2007-AC1. The Abacus deal was a synthetic collateralized debt obligation (CDO), a bundle of credit default swaps taken out against a package of residential mortgage-backed bonds.
      The SEC asserts that Goldman mislead investors by telling them the reference portfolio of bonds in the Abacus deal was selected by an independent, objective advisor (ACA Management), without disclosing that a third firm (Paulson & Co.) was also involved in structuring the CDO. Paulson’s alleged role is significant because it asked Goldman to create Abacus 2007-AC1 specifically as an opportunity to short sell the mortgage market—as in, bet that the market will fall rather than rise, which is what investors in Abacus 2007-AC1 anticipated. To make this bet, Paulson bought credit default insurance from Goldman that would pay handsomely if the Abacus investment lost all its value. In other words, critics charge, Paulson expected Abacus to fail.
      And fail it did. Within months of its creation, Abacus 2007-AC1 collapsed after the underlying subprime mortgages went into widespread default. The collapse cost investors over a billion dollars—while generating roughly a billion dollars for Paulson when it collected on its credit default insurance.
      As part of its lawsuit, the SEC claims that Goldman failed to inform investors of Paulson’s role or the fact that Paulson’s economic interests ran counter to theirs. Goldman did not bet against its own clients in this instance, as the firm has been accused in other instances recently, but it does appear to have made a sizable intermediary fee by helping one Goldman client (Paulson) bet against other Goldman clients.

More Questions Than Answers at This Point
While it is still digesting the news of the SEC’s lawsuit, the financial community has more questions than answers. Here are some of the points being made and questions being asked:

•  It’s been two years since the near-collapse of the financial system, and the best the SEC can do is file a single case involving just one CDO? The Wall Street Journal’s editorial page likens the SEC’s case to a “water pistol” instead of “the smoking gun of the financial crisis.”

•  This case might be relatively small in scope, but does it put Wall Street on notice? Is the SEC preparing other cases against Wall Street firms? Chairwoman Mary L. Schapiro has indicated that the SEC is returning to a vigorous enforcement posture following many years of a more hands-off approach.

•  Does this case signal the beginning of a change in the relationship between Wall Street and Washington? Will the so-called revolving door, in which people transition back and forth between industry and government, spin a little less freely in the years to come?

•  How much does political consideration have to do with the timing of this suit? The Wall Street Journal wasn’t the only news outlet noting that the SEC’s move comes on the eve of Senate debate over a financial reform bill.

•  Why didn’t the investors evaluate the deal more carefully to find out what they were really buying? These weren’t mom-and-pop investors buying into Abacus, but supposedly sophisticated institutional investors.

•  Investment banks such as Goldman often have information that other parties in a transaction don’t have access to, but in its defense, Goldman is up-front about this. The sales presentation for Abacus 2007-AC1 clearly states that Goldman may have access to information not available to investors, and that information could be material in evaluating the risk of the investment. But legal issues aside, did Goldman have an ethical obligation to tell investors about Paulson’s role in this specific deal?

•  Goldman changed its overall stance on the mortgage market from positive to negative in December 2006 (meaning it began to make investments on its own behalf based on the assumption that the market would fall, not continue to rise) and had been selectively betting against the market even earlier than that. However, it did not make this strategic change public, and it continued selling investments to various clients who expected the market to keep rising. The company says it was simply meeting clients’ demands for investment products. In the words of structured finance expert Sylvain R. Raynes, however, “the simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen.” If the practice is that distasteful, should it be illegal?