Goldman Sachs making lemonade

April 27, 2010

Goldman Sachs has “a lot to answer for,” Sen. Carl Levin said ahead of a hearing that will focus on the role investment banks played in the financial crisis. Lawmakers have been pressing for more information ever since the SEC accused Goldman of fraud for its role in underwriting a controversial subprime security. Thomson Reuters’ WG&L Accounting & Compliance Alert looks at the issues.  Click here for more details.  
Some Goldman Sachs Group Inc. bankers decided that when the mortgage market gave them lemons, the only sensible thing to do was to make lemonade.
But Goldman’s drink soured on an epic scale, and now the bank’s controversial handling of a synthetic collateralized debt obligation has become Exhibit A in the case against Wall Street.
Lawmakers are questioning the bank’s ethics and its decision to switch strategies early in the financial crisis and go from being bullish on the mortgage market to making tens of billions of dollars in bearish bets. The bank has denied allegations that it traded against its clients.
According to a former Goldman partner and head of the firm’s mortgage trading department, Daniel Sparks, the investment bank “structured like mad,” and “worked their tails off to make some lemonade from some big old lemons.”
This and other insights from former and current Goldman employees can be found in pages of documentation the Senate Permanent Subcommittee on Investigations, chaired by Sen. Carl Levin (D-MI), obtained in its investigation into the causes and consequences of the financial crisis.
In a series of hearings the subcommittee has explored the roles mortgages, bank regulators, and credit rating agencies played in the financial meltdown. On April 27, 2010, the panel intends to explore the role of investment banks, using Goldman Sachs as a case study.
The hearing will come 11 days after the SEC alleged that Goldman Sachs used one of its synthetic CDOs to help a favored client make $1 billion from shorting the subprime market. Other Goldman clients lost $1 billion, because, the SEC alleged, they invested with the hope that the security would appreciate in value.
In the SEC’s view, Goldman’s failure to properly disclose the short position of its client, hedge fund Paulson & Co., was fraud.
Goldman has emphatically denied that it manipulated its clients or withheld material information.
According to the SEC’s complaint, the marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the residential mortgage backed security (RMBS) portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS.
The SEC alleged that the marketing materials didn’t disclose the role Paulson played in selecting the securities that it planned to short.
Robbins Geller Rudman & Dowd LLP announced April 26 that a class action has commenced in the U.S. District Court for the Southern District of New York on behalf of purchasers of the common stock of Goldman Sachs between October 15, 2009, and the time that the SEC’s complaint was filed.
In its investigation, Levin’s subcommittee found that Goldman made a practice of betting against the housing market.
“Goldman Sachs made billions of dollars from betting against the housing market, and it placed those bets in some cases at the same time it was selling mortgage related securities to its clients. They have a lot to answer for,” Levin told reporters during an April 26 press briefing.
Regarding the role of investment banks, the subcommittee found, among other things:
From 2004 to 2007, Goldman helped lenders securitize high risk, poor quality loans, obtain favorable ratings for the resulting RMBS, and sell the securities to investors;
The firm magnified the impact of toxic mortgages on financial markets by re-securitizing RMBS securities in CDOs, referencing them in synthetic CDOs, selling the CDOs to investors, and using credit default swaps (CDS) and index trading to profit from the failure of those same products;
Goldman took a net short position on the mortgage market and remained short through 2007; and
In 2007 the firm went beyond its role as market maker and traded billions of dollars in mortgage-related assets for its own account without disclosing its proprietary positions to clients and instructed its sales force to sell mortgage related assets it wanted to get off its books.
During Levin’s April 27 hearing, he and other subcommittee members will hear from Goldman chairman and CEO Lloyd Blankfein, executive vice president and CFO David Viniar, chief risk officer Craig Broderick, and current and former directors.

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