Posted on Fri, Apr. 16, 2010
last updated: October 28, 2011 03:13:10 PM
WASHINGTON — Goldman Sachs, whose tactics exiting the collapsing subprime mortgage market have been under government scrutiny for months, now faces federal fraud charges that it duped investors into losing $1 billion on a rigged offshore deal pegged to dicey home loans.
The suit, brought Friday by the Securities and Exchange Commission, accuses Goldman and one of its vice presidents, 31-year-old Fabrice Tourre, of allowing a Wall Street hedge fund to secretly select many of the securities in the deal.
The hedge fund, Paulson & Co., then bet that those subprime mortgage securities would fail. When they did, Paulson made a $1 billion profit and investors lost more than $1 billion, nearly all their money, the complaint charges.
In an e-mail to a friend in January 2007, the complaint says, Tourre remarked that, "The whole building is about to collapse anytime now" — an apparent allusion to a plunge in the housing market that would depress the value of the mortgage securities.
The case suggests that a reinvigorated SEC, after a long lull, is pressing to hold Wall Street accountable for its role in the worst financial crisis since the Great Depression. People familiar with the SEC investigation of Goldman said it could expand, and a special Senate investigations panel is preparing to hold a hearing that will put Goldman under yet another magnifying glass.
Elizabeth Nowicki, a former SEC attorney who's a visiting law professor at Boston University, called the SEC's fraud suit "a political case as much as it is a case that they needed to bring to stop this sort of favoritism."
"The SEC wanted to convey the message that no, they're not sitting back on their heels," she said. "This is going after Goldman Sachs. You can't really go after anybody bigger than that . . . . The SEC has the stomach to follow this out, absolutely, and they've got a bigger incentive now that they are clearly perceived as shamed and disempowered."
It's still unclear whether Goldman also could face legal exposure for failing to disclose to investors in 2006 and 2007 that it had secretly bet that the housing market would collapse when it sold off more than $40 billion in securities backed by subprime mortgages. McClatchy Newspapers described those dealings in a series of articles in November and December 2009, including Goldman's role in betting on a housing downtown in at least a dozen offshore deals that it marketed.
The company, in a terse statement, denounced the charges as "completely unfounded in law and fact," and vowed to "vigorously contest them and defend the firm and its reputation."
Underscoring Goldman's stature as the world's most prestigious investment bank, the enforcement action triggered a 126-point drop in the Dow Jones index on Wall Street. Shares of Goldman led the way, plummeting nearly 13 percent.
After the market closed, Goldman issued a second statement, saying that it lost $90 million on the transaction and that all of the involved parties were "sophisticated" investors that were well aware of the risks.
Goldman said the largest investor, ACA Capital Management, selected the securities "after a series discussions, including with Paulson & Co." Goldman called the exchange "entirely typical."
Sylvain Raynes, a New York expert in structured securities of the type described in the SEC charges, said the stakes are huge for Goldman.
"To lose its reputation," he said, "Goldman does not need to be found guilty many times. They only need one instance."
Besides naming the company as a defendant, the civil complaint accuses Tourre of concealing Paulson's role from investors in a synthetic securities deal known as ABACUS, 2007-AC1 — one in which investors didn't actually buy any securities.
Instead, they effectively bet that a specified bundle of home loans to marginally qualified borrowers would perform well, while Paulson took "short" positions, meaning it bet that those bonds would founder.
Paulson profited grandly from the nation's economic collapse, taking in a total of $3.7 billion from its bets. The SEC complaint says the firm paid Goldman $15 million to assemble the deal, which Tourre was principally responsible for structuring.
The marketing materials for the investment, known as a collateralized debt obligation, told investors that ACA Management LLC, an independent third party, selected the mortgage-backed securities. The Paulson firm wasn't mentioned.
"The product was new and complex, but the deception and conflicts are old and simple," SEC enforcement chief Robert 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. 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 says.
By the following Jan. 29, it says, 99 percent of the portfolio had been downgraded, costing investors more than $1 billion.
Khuzami said that the Paulson firm, which isn't affiliated with former Treasury Secretary Henry Paulson, wasn't charged because it didn't mislead investors.
However, the complaint charges 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, had a significant role in selecting the securities. Thus, they sought a third party for that role and approached ACA, calling it "important that we can use ACA's branding" in an internal e-mail.
The complaint quoted Tourre, then 28, as saying in a Jan. 27, 2007 e-mail to a friend that was 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 (sic)!!!"
A Feb. 11, 2007 e-mail to Tourre from the unidentified head of Goldman's structured product correlation trading desk said, "the cdo biz is dead we don't have a lot of time left," according to the complaint.
Paulson said in a statement that, while it bought credit protection from Goldman via the ABACUS deals, "We were not involved in the marketing of any ABACUS products."
It said that ACA "had sole authority over the selection" of all securities in the deal, noting that two Wall Street ratings agencies — Moody's Investors Service and Standard & Poor's — gave them Triple A grades, the highest investment rating.
Both Moody's and S&P have suffered tremendous damage to their reputations as a result of issuing favorable ratings to pools of U.S. mortgages that turned out to be junk.
The SEC said the only other investor in the ABACUS deal, IKB, a commercial bank in Dusseldorf, Germany, lost nearly all of the $150 million it invested. Goldman said the largest investor, ACA Capital Management, put up $951 million. ACA lost nearly all the money.
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 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.
Gary Kopff, an expert in mortgage securities who's studied Goldman's role in betting against investors in deals it marketed though the Cayman Islands, said that, "They manifest, in my opinion, the same misconduct that the SEC asserts occurred in the ABACUS deal."
Goldman created a structured product correlation trading desk in late 2004 or early 2005. A memo describing the ABACUS 2007-AC1 transaction to the company's Mortgage Capital Committee on March 12, 2007, said that the "ability to structure and execute complicated transactions to meet multiple clients' needs and objectives is key for our franchise," the SEC complaint says.
Executing the deal "and others like it helps position Goldman to compete more aggressively in the growing market for synthetics written on structured products," the e-mail said.
According to the complaint, Paulson came to believe that the underlying securities in the ABACUS 2007-AC1 deal "would become worthless."
In late 2006 and early 2007, it charges, 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 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 among Paulson, Goldman and ACA over the final portfolio, which included a sizable number of those selected by Paulson.
Kevin G. Hall and Marisa Taylor contributed.
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