Whoa. Quite serious. With the
Goldman Sachs (GS) shares are down 15% thanks to a civil fraud charge leveled by the SEC. It relates to a 2007 vintage collateralized debt obligation known as ABACUS 2007-AC1. It was a product tied to the performance of residential mortgages, and it quickly imploded and lost most of its value.
The civil charges relate to a lack of disclosure by Fabrice Tourre, the man who put this deal together...Namely that the mortgages involved in this transaction were selected by a third party who was betting against this security, with a financial incentive to see its value drop.
Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc. (“Paulson”), with economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO, played a significant role in the portfolio selection process. After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (“CDS”) with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure. Given its financial short interest, Paulson had an economic incentive to choose RMBS that it expected to experience credit events in the near future. GS&Co did not disclose Paulson’s adverse economic interests or its role in the portfolio selection process in the term sheet, flip book, offering memorandum or other marketing materials provided to investors.
The deal closed on April 26, 2007. Paulson paid GS&Co approximately $15million for structuring and marketing ABACUS 2007-AC1. By October 24, 2007, 83% of the RMBS in the ABACUS 2007-AC1 portfolio had been downgraded and 17% were on negative watch. By January 29, 2008, 99% of the portfolio had been downgraded. As a result, investors in the ABACUS 2007-AC1 CDO lost over $1 billion. Paulson’s opposite CDS positions yielded a profit of approximately $1 billion for Paulson.It's all in the disclosure, and it's very unclear exactly what must be disclosed. For example, I can call up an investment bank and ask them to create a new exchange traded fund called (for instance) the "Grocery Store ETF," comprised mainly of Safeway, Walmart, Kroger, Supervalu, etc. Then I could short that entire index if I thought the industry was facing tough times. The other side of that trade would be investors who wanted some cheap exposure to grocery stores and bought shares of the grocer index. One of us would make money and one of us wouldn't, but did Goldman need to disclose my involvement in creating this index?
The SEC cites a Paulson employee stating their interest in betting against the residential mortgage backed securities market:
“It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytical tools nor the institutional framework to take action before the losses that one could anticipate based [on] the ‘news’ available everywhere are actually realized.”I'm not sure what the level of necessary legal disclosure is in this case. Wall Street usually covers its a$$ VERY well. Beyond that, we're all adults, right? The people who bought this security probably could be sued by their OWN investors for lack of due diligence, yet they're suing Goldman Sachs.
The SEC of course, is the agency that was handed the Bernie Madoff case on a silver platter...No, scratch that, it was a manila envelope - but the work was done FOR them, yet they ignored that case and cost investors billions. I have no confidence that they are in the right in this case against Goldman Sachs. Shares will probably rebound promptly...
Copyright 2010 AlphaNinja