Tuesday, April 20, 2010

Is the SEC Reaching?

Goldman Sachs offers a pretty thorough defense of its business practices:

We want to emphasize the following four critical points which were missing from the SEC's complaint.

-- Goldman Sachs Lost Money On The Transaction. Goldman Sachs, itself, lost more than $90 million. Our fee was $15 million. We were subject to losses and we did not structure a portfolio that was designed to lose money.

-- Extensive Disclosure Was Provided. IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities. The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side.

-- ACA, the Largest Investor, Selected The Portfolio. The portfolio of mortgage backed securities in this investment was selected by an independent and experienced portfolio selection agent after a series of discussions, including with Paulson & Co., which were entirely typical of these types of transactions. ACA had the largest exposure to the transaction, investing $951 million. It had an obligation and every incentive to select appropriate securities.

-- Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor. The SEC's complaint accuses the firm of fraud because it didn't disclose to one party of the transaction who was on the other side of that transaction. As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor.
Obviously, this is all pretty self-serving. Ezra describes the charges against Goldman this way:

Another way of think about it comes from the Washington Independent's Annie Lowrey, who analogizes it to a housing sale. Imagine a broker shows you a home. It looks good to you. Looks like the other homes, in fact. But when you buy it, it turns out that the foundation is cracked and the roof leaks and the neighborhood is full of crackhouses.

How can this be? You got the home appraised! And your broker knows all about homes!

Well, it turns out that your broker was working for the seller, who did the appraisal himself. And the seller had bet a bookie that whoever he sold the home to would move out within a year, which and your broker knew that but never told you. In this analogy, as you've already guessed, the broker is Goldman, the seller is Paulson, and the buyer is the counterparties.

But that's not a very fair presentation of the facts either. Since Goldman Sachs was also taking a long position on the CDO in question, the "broker" in this analogy would have had a much greater incentive to see the house appraised well. Goldman was gambling way more of its own money on the assumption that this CDO would pay off. The fees it was receiving from Paulson & Co. were paltry in comparison.

To me, this seems like a rather salient point. If the SEC is trying to prove that Goldman was engaging in some kind of nefarious deception, why did it work out so badly for them?

Update: Here is Felix Salmon's take on the whole thing, and here is the SEC's formal complaint.

The big question seems to be whether Fabrice Tourre -- the Goldman employee who helped structure the deal and market it to investors -- mislead ACA into believing that Paulson was taking a long equity position on the ABACUS 2007-AC1 CDO, when in fact Goldman knew all along that Paulson had intended to short it.

Here is the SEC's primary evidence:

On January 10, 2007, Tourre emailed ACA a “Transaction Summary” that included a description of Paulson as the “Transaction Sponsor” and referenced a “Contemplated Capital Structure” with a “[0]% - [9]%: pre-committed first loss” as part of the Paulson deal structure. The description of this [0]% - [9]% tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche. In fact, GS&Co never intended to market to anyone a “[0]% - [9]%” first loss equity tranche in this transaction.
As the key evidence against Tourre, this seems pretty weak. The SEC is essentially quoting one phrase from an email out of context. I suspect that the upshot of this case will depend largely on whether Tourre ever explicitly stated that Paulson would be investing in the CDO alongside ACA. The actual wording of this email matters immensely.

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