Goldman’s CDO investors: fools or victims?
By Hugo Dixon and Richard Beales
Were the investors who lost $1 billion by buying a fearfully complex product sold by Goldman Sachs in the dying days of the credit boom fools or victims? That’s the key distinction on which the U.S. Securities and Exchange Commission’s fraud charges, which roiled the investment bank when they were unveiled on Friday, hinge.
Back in 2007, Goldman sold investors a $1 billion synthetic collateralised debt obligation (CDO). A CDO is a pool of securities, in this case 90 subprime residential mortgage backed securities. A synthetic CDO is based on a pool of derivatives that reference securities rather than the securities themselves.
The SEC’s key allegation is that Goldman marketed this synthetic CDO to investors without telling them that Paulson & Co, the hedge fund, had been involved in selecting the securities that were subject to the bet. What’s more, it didn’t tell investors — or ACA, an independent firm that officially selected the underlying securities — that Paulson was simultaneously placing bets with Goldman that these securities would fall in value.
Goldman’s defence has four elements. First, that it lost $90 million on the transaction. This shows, it says, that “we did not structure a portfolio that was designed to lose money”.
However, the firm has not said how it lost the $90 million. Did it intend to retain a long position or did it just get stuck with it? The answer to the question is crucial in judging the defense. The SEC has produced an email from Fabrice Tourre, the Goldman vice-president who handled the deal, in which the self-christened “fabulous Fab”, said: “The whole building is about to collapse anytime now”. This, at least, suggests that Goldman wasn’t gung-ho about the market. But on the other hand, the fact that the firm went long at all does undermine suggestions it knew the CDO would lose money.
Goldman’s second line of defence is that “extensive disclosure was provided”. It points out that these investors also understood that a “synthetic CDO transaction necessarily included both a long and short side”. The suggestion is that these were big boys who should have done their own homework.
But the SEC alleges a key fact – that Paulson was both betting against the CDO and heavily involved in selecting the underlying securities – was omitted.
This is where Goldman’s third defence kicks in. It admits that Paulson was involved in discussions about the selection but says this was “entirely typical of these types of transactions”. What’s more, ACA – as well as selecting the securities – was exposed to the transaction to the tune of $951 million. As such, according to Goldman, it had an “obligation and every incentive to select appropriate securities.” Paulson, which has not been charged, also says ACA had authority over the selection.
But again there are counterpoints. For a start, Paulson’s involvement, according the SEC, was pretty intimate. In one email, the Fabulous Fab said the portfolio had been “selected by ACA/Paulson”. In another, he says “I am at this ACA Paulson meeting, this is surreal” – a comment that raises the possibility that this type of meeting wasn’t typical.
The SEC also says Goldman knew that a key investor IKB, a bank which ultimately had to be rescued by the German state, would not invest in synthetic CDOs unless there was an independent agent selecting the underlying securities.
The regulator further alleges that ACA believed that Paulson was going to be a long investor in the synthetic CDO. As such, ACA arguably did not mind when Paulson helped it select the underlying securities.
This is where Goldman’s final line of defence — so far — comes in. It says it “never represented to ACA that Paulson was going to be a long investor”. The SEC, however, puts a different gloss on things. It has dug up an email from ACA to Goldman which makes clear that it believed Paulson was going long. The SEC says the Fabulous Fab knew or was reckless in not knowing that ACA had been misled about the matter.
Goldman’s defenders reckon the timing of the charges was motivated more by political considerations than the completeness of the SEC’s case. Be that as it may, the SEC and Goldman are now set to fight this out in court. But even if the charges don’t stick, they will be expensive in terms of time, money and reputation for the investment bank.