From Financial Times FT.comGoldman versus the regulatorsBy Patrick Jenkins and Francesco Guerrera
Published: April 18 2010 20:15 | Last updated: April 18 2010 20:15
Wall Street
Back in early 2007, Fabrice Tourre was feeling pretty pleased with himself. Not only was the 28-year-old Frenchman working for Goldman Sachs in New York, he had become a high-flying specialist in the booming field of collateralised debt obligations, or CDOs – the complex business of chopping up multiple mortgage debts into investable securities.
Though Mr Tourre, a Goldman Sachs vice-president, had been concerned for some time about the failing health of the underlying market – the debt, or “leverage”, was overwhelming and poor people with big subprime mortgages were starting to default on their loans – his continued success in punting his CDOs to unconcerned investors was giving him a buzz.
On January 23 2007, he e-mailed a friend, flush with the success of his latest deal, the Abacus 2007-AC1. “More and more leverage in the system,” he wrote. “The whole building is about to collapse anytime now . . . Only potential survivor the fabulous Fab[rice] . . . standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities [sic]!!!”By last Friday, “the fabulous Fab” was looking rather less heroic. In a 22-page complaint, the Securities and Exchange Commission, the US financial regulator, charged Mr Tourre and Goldman with securities fraud, accusing them of misleading investors, omitting crucial information and misrepresenting the product. The lawsuit charged the Goldman team with encouraging unwitting investors to buy a product conceived, at least in part, by a client (hedge fund Paulson & Co) that was busy betting against the very same underlying mortgage investments via credit default swap (CDS) insurance contracts.
The result? “Investors in the Abacus 2007-AC1 CDO lost over $1bn,” says the SEC complaint. “Paulson’s opposite CDS positions yielded a profit of approximately $1bn for Paulson.” In the middle, Goldman made a decent fee, earning an expected $15-$20m for its structuring and marketing work.
The immediate financial implications of the SEC’s charge are tiny compared with the $13.4bn net profit Goldman made last year – the bank could be slapped with a fine, as well as having to return the money it made on the deal. But the broader damage the affair could wreak is vast. Goldman insiders say they were stunned by the SEC’s charges. In a company that built its ethos and pay structure on hiring the best and being the best, the surprise news that Goldman stood accused of securities fraud was a bombshell.
“I am not sure I can talk. I am still shell-shocked,” were the words of a normally loquacious Goldman banker shortly after the charges were announced. People who were in Goldman’s gleaming new building in downtown Manhattan when the news broke said the din of traders talking to clients and among themselves ceased almost immediately. The vast trading floors were enveloped in an eerie silence as staff and visitors stared at television screens.
Goldman’s executives could barely hide their anger at the way the regulators had handled the situation. They said the probe into the CDO the bank arranged for Paulson had begun nearly two years ago and the last time Goldman had heard from regulators was in July.
Goldman executives hint that the SEC’s apparent unwillingness to enter into settlement talks before making the charges public, which is customary especially in high-profile cases, and the timing of the announcement, had more to do with politics than regulation. With a closely fought battle over the post-crisis overhaul of financial regulation raging in Washington, the Goldman camp argues, Barack Obama’s administration needed a big scalp to throw at opponents of the new regulatory regime. Bankers will see similar thinking behind yesterday’s pledge by Gordon Brown, Britain’s prime minister – less than three weeks before a general election – that UK regulators also investigate.
SEC officials say it is normal practice to send companies a “Wells notice” – formal warning that they are under investigation – and then file charges afterwards without any further contact with the company. Goldman received such a notice around July last year but did not try to engage in settlement talks, according to people familiar with the regulator.
For all Goldman’s outrage at the way the charges were brought, Mr Tourre is not a “rogue trader” in the mould of the many misfits who have been behind financial scandals over the decades.
The SEC’s attack on Goldman strikes at the heart of the business model that has turned the company into the world’s most powerful investment bank.Under the leadership of Lloyd Blankfein, the Bronx-born son of a postal worker who rose to the top via Goldman’s cut-throat trading floors, the bank turned its knowledge of the market and network of corporate clients into a formidable money-making machine. “Being in the flow” – collecting intelligence gleaned from myriad market and corporate sources to inform both its own trading and that of its clients – has been the mantra that enabled Goldman to pull away from rivals such as Morgan Stanley, which still relied on the more traditional advisory and underwriting businesses.
Goldman’s status as the best-connected trader is self-perpetuating, as clients find themselves having to share information with the bank in order to get valuable ideas on what everyone else is doing. “People trade with Goldman not because they want to but because they have to,” a fund manager said recently.
In this respect, Goldman is less a “giant vampire squid” – Rolling Stone magazine’s famous characterisation of the bank – and more like a financial amoeba, constantly absorbing information that it uses to its own and its clients’ advantage.
That is why Goldman executives talk of the Paulson trade as normal business: helping a client achieve his aims, in this case profiting from his very negative views of the US housing market. It is also why, in 2006, when John Paulson – yet to become the multibillionaire fund manager feted for predicting the bursting of the housing bubble – came to Goldman in 2006 with a request for a tailor-made CDO, the bank went to work.
The resulting product was the Abacus security, which was approved by Goldman’s mortgage credit committee, a group of its most senior executives in the mortgage unit – another sign that Goldman saw nothing wrong with the trade.
The tale of Abacus 2007-AC1 began on January 8 2007, when Paulson presented Goldman Sachs with a list of 123 underlying residential mortgage backed-securities (RMBS), many related to home loans in California, Arizona, Nevada and Florida, where house prices had recently rocketed. These were the investments Paulson wanted included in a new CDO.
Yet the hedge fund was convinced that house prices were overheated and that mortgage defaults were going to rise – a powerful incentive to bet on the value of the mortgage securities falling, or sell them short, in Wall Street parlance. According to the SEC complaint: “Paulson intended to effectively short the RMBS portfolio it helped select by entering into CDS [insurance deals] with Goldman to buy protection on specific layers of the CDO’s capital structure.”
In other words, the SEC complaint alleges, the creation of the CDO was a cover for Paulson’s real belief that the investments were poor ones and were set to fall in value. The trouble was that Paulson needed buyers of the CDO, in order that it could be a seller. Although Goldman could structure the CDO as required, it knew it would find no buyers if Paulson was associated with it as a clear short-seller.
“Goldman and Tourre knew that it would be difficult, if not impossible, to place the liabilities of [the] CDO if they disclosed to investors that a short investor, such as Paulson, played a significant role in the collateral selection process,” the complaint says. “By contrast, they knew that the identification of an experienced and independent third-party collateral manager as having selected the portfolio would facilitate the placement of the CDO liabilities in a market that was beginning to show signs of distress.”
ACA was a well-known independent manager and fitted the bill perfectly. Having ACA’s name on the deal as “portfolio selection agent”, Mr Tourre said in an internal e-mail, “will be important . . . we can use ACA’s branding to help distribute the bonds”. ACA spent the next six weeks in to-and-fro discussions with Paulson, brokered by Goldman, finalising a list of 90 underlying investments for the CDO. Though ACA had some input, the majority of them came from Paulson and, says the SEC, the hedge fund vetoed some of the potentially higher-quality loans.
The regulator’s conclusions are damning:
“Goldman’s marketing materials for Abacus 2007-AC1 were false and misleading because they represented that ACA selected the reference portfolio while omitting any mention that Paulson, a party with economic interests adverse to CDO investors, played a significant role in the selection of the reference portfolio.”
In fact, says the SEC complaint, Goldman made investors think the reverse – that Paulson, widely respected for its shrewd investment views, was buying into the equity of the CDO to the tune of $200m.
By February 15, although the final portfolio selection for Abacus 2007-AC1 was still 10 days away from being finalised, the Goldman marketing machine was ready to swing into action. Within a matter of days, investors around the world had been sent terms sheets, flip charts and offering memorandums. Among them was one perfect example of the return-hungry but naive investor that helped fuel both the global boom in structured products such as CDOs and the rapid blow-up of the global financial markets that followed.
IKB, a small but ambitious business lender based in Düsseldorf, collapsed in a heap of worthless investments in the summer of 2007. But in February of that year it was still riding high. Senior management had turned a little cautious about the US property market late in 2006, and were insisting that Goldman’s new CDO had an independent portfolio selection agent. But with ACA’s name on the marketing material, IKB was reassured and pumped $150m into Abacus 2007-AC1. “IKB lost almost all of its $150m investment,” says the SEC complaint. “Most of this money was ultimately paid to Paulson in a series of transactions between Goldman and Paulson.”
Goldman strenuously denies the SEC’s charges, arguing that it lost $75m on the CDO, net of its $15m fee – a point that could make it difficult for the SEC to argue the bank had a powerful motive to stuff the CDO with loans that turned out to be junk.
“We were subject to losses and we did not structure a portfolio that was designed to lose money,” Goldman says. Insiders at the bank argue that both IKB – the principal investor in the CDO – and ACA, the independent firm whose job was to select the securities to be included in the CDO, had plenty of information on the underlying loans and knew the risks associated with them.
They also knew that there would be investors going short on the CDO. “In trades of this kind, there is always an investor going short. It is just common practice,” Goldman says.
A presentation to investors for the Abacus deal, seen by the FT, does contain a complex graphic explaining that, as part of the structure of the CDO, some investors will short the security. However, it depicts the shorting investor as Goldman itself and not Paulson, which by Goldman’s admission had participated in discussions over the CDO’s composition. Goldman contends that is normal market practice for market makers not to “disclose the identities of a buyer to a seller and vice-versa”.
Perhaps more controversially, Goldman flatly denies the SEC’s allegations – evidenced by e-mail communication between ACA and Goldman describing Paulson as the “equity investor” – that it told ACA that Paulson would take a long position in the CDO. “Goldman Sachs never represented to ACA that Paulson was going to be a long investor,” the bank said in a statement on Friday.
The SEC has been enigmatic about whether other banks are being probed for having used similar practices, or whether it will raise the pressure on Mr Blankfein by unveiling complaints about further Goldman activity.
Goldman insiders are adamant that the positions of Mr Blankfein and his inner circle are safe. They argue that none of them is named in the complaint and point out that the bank’s robust defence means no heads will roll.
People close to the board, which meets this week to discuss Goldman’s first-quarter results, say there is little immediate pressure on Mr Blankfein but admit some members are getting worried about Goldman’s repeated mishaps. Goldman insiders believe Mr Blankfein’s near-term future will hinge on the share price, which lost more than 12 per cent on Friday. But in the long run, the chief executive’s hold on the job will depend on whether Goldman’s two factions – the investment banking dealmakers as well as the traders that he grew up with – can still unite behind him.
Mr Blankfein is buttressed by Gary Cohn, the bank’s number two executive and a fellow trader. But since the abrupt departure last year of Jon Winkelried, the former head of the investment banking division who shared the title of president with Mr Cohn, the grumblings of Goldman’s bankers have grown louder.
In the past week alone, the bank has been wounded by allegations that a Goldman director helped hedge fund Galleon trade on insider information, an attack by the former head of Washington Mutual testifying before Congress and revelations that one of its Whitehall property funds had paper losses of 98 cents on the dollar last year. “At what point do clients start to say maybe I don’t have to deal with this firm any more?” asks the head of one major competitor.
“Lloyd has done a good job of keeping the board on his side,” says a former Goldman executive. “But the patience may run out soon, especially if new revelations turn up.”
Additional reporting by Henny Sender
Copyright The Financial Times Limited 2010.
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