Goldman Sachs Charged with Billion Dollar Subprime Fraud - Paulson Sub Prime Hedge Fund Scandal

Today saw the headline many anti Goldman Sachs crusaders had been waiting for, Goldman Sachs Charged with Billion Dollar Subprime Fraud. The Securities and Exchange Commission charged Goldman Sachs Group Inc with fraud, stating Goldman enabled and was complicit with John Paulson’s hedge fund in shorting and selling a CDO with some of the riskiest subprime mortgages and then selling the CDO’s to its customers without disclosing this information to buyers of the product.

Goldman made huge fees on the transactions and it is estimated to have cost a billion dollars to the buyers with Paulson gaining $1 billion. Paulson & Co.'s chief, John Paulson famously made $15 billion in 2007 on the housing market collapsing and risky mortgages would be scorched. His huge bet has been labeled by some as the ‘Greatest Trade”.

It is not clear how complicit Paulson was in this and was merely taking advantage of Goldman to put on a ‘great trade’. Paulson has not been charged in the matter. Goldman Sachs was charged along with a Goldman Vice President, Fabrice Tourre. These are civil charges, not criminal. Criminal charges may be filed at a later date by the Department of Justice (DOJ). The last major criminal charges against a major corporation in similar circumstances were against Arthur Anderson over the Enron scandal. Arthur Anderson went bankrupt and 10,000 people lost their jobs so the DOJ will be mindful of this.

SECURITIES AND EXCHANGE COMMISSION

Litigation Release No. 21489 / April 16, 2010

Securities and Exchange Commission v. Goldman, Sachs & Co. and Fabrice Tourre, 10 Civ. 3229 (BJ) (S.D.N.Y. filed April 16, 2010)

There are many theories flying on why Goldman was charged, if it a sham or is the Sec really toughening up. It is notable that the charges were laid as the White House was trying to push financial reform legislation through congress and the senate. Either way the SEC's civil lawsuit is one of the biggest retaliatory moves against players in the subprime crisis that set off the global financial crisis.

The markets responded by punishing Goldman Sachs stock to down 12.8 percent on Friday, closing down $23.57 at $160.70 on the New York Stock Exchange. This wiped out more than $12 billion of market value from Goldman stock with trading volume of over 100 million shares. U.S. equity indexes fell more than 1 percent on the news.

Goldman has responded with the compulsory stiff upper lip; "The SEC's charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation."

The CDO in question is ABACUS 2007-AC1 which we will no doubt hear and more about. ABACUS 2007-AC1 was directly linked by how subprime residential mortgage-backed securities ("RMBS") performed. What is it issue is when it was formed and what Goldman Sachs knew in that formation. The United States housing market and securities structured from it were beginning to show signs of distress in early 2007 when ABACUS 2007-AC1 was structured and marketed.

The SEC alleges that the marketing materials for ABACUS 2007-AC1 all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management LLC ("ACA"). ACA is a third party with expertise in analyzing credit risk in RMBS. These materials included the term sheet, flip book and offering memorandum. What was undisclosed in this marketing materials and kept secret from any of the investors was Paulson & Co. Inc ("Paulson") played a significant role in the portfolio selection Paulson had economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO.

Paulson was using the CDO as a vehicle to short the Subprime real estate market. Paulson was able to achieve this short position by entering into credit default swaps ("CDS") with Goldman Sachs on specific layers of the ABACUS 2007-AC1 capital structure. This is where it is manipulative at best, to make this a better short the CDO had to have the riskiest mortgages on board, that is those most likely to default. Goldman Sachs did not disclose this adverse economic interest of Paulson or the role played in the portfolio selection process in the term sheet, flip book, offering memorandum or other marketing materials.

 
Fabrice Tourre ("Tourre") was also had securities fraud charges filed against him by the Securities and Exchange Commission today  along with those filed against Goldman, Sachs & Co. for making material misstatements and omissions in connection with a synthetic collateralized debt obligation ("CDO") Goldman Sachs structured and marketed to investors. Mr. Tourre, 31 years old, currently works in London as an executive director of Goldman Sachs International. A lawyer for Mr. Tourre couldn't immediately be reached. 

The SEC alleges Tourre was principally responsible for ABACUS 2007-AC1. They allege Tourre devised the transaction, prepared the marketing materials and communicated directly with investors. It is also alleged Tourre knew of Paulson's undisclosed short interest and its role in the collateral selection process.

What is striking given Paulson’s bearish tone and desire to short RMBS it is also alleged Tourre misled ACA into believing that Paulson invested approximately $200 million in the equity of ABACUS 2007-AC1. That is that Paulson took a long position and thus Paulson's interests in the collateral section process were aligned with ACA's when in reality Paulson's interests were the other side of the trade.

The Commission's complaint, which was filed in the United States District Court for the Southern District of New York, charges Goldman Sachs and Tourre with the following violations.

• Section 17(a) of the Securities Act of 1933,
• 15 U.S.C. §77q (a),
• Section 10(b) of the Securities Exchange Act of 1934,
• 15 U.S.C. §78j (b)
• Exchange Act Rule 10b-5, 17 C.F.R. §240.10b-5.

The Commission seeks injunctive relief, disgorgement of profits, prejudgment interest and civil penalties from both defendants.

ABACUS 2007-AC1 had a short but destructive career which went as follows.

1. The deal closed on April 26, 2007.
2. Paulson paid Goldman Sachs approximately $15 million for structuring and marketing ABACUS 2007-AC1.
3. By October 24, 2007, 83% of the RMBS in the ABACUS 2007-AC1 portfolio had been downgraded and 17% was on negative watch.
4. By January 29, 2008, 99% of the portfolio had allegedly been downgraded. Investors in the liabilities of ABACUS 2007-AC1 are alleged to have lost over $1 billion.
5. On April 14 at a hearing before the Senate Judiciary Committee, Sen. John Cornyn (R., Texas) asked Attorney General Eric Holder whether there were any "show trials" coming up. "We simply haven't had the people who were guilty of criminal conduct brought to justice," Mr. Cornyn said. Mr. Holder replied that the cases are hard to put together but he said he expected more cases.
6. Paulson's opposite CDS positions yielded a profit of approximately $1 billion.
7. On April 16, 2010 the SEC filed fraud charges against Goldman Sachs and Fabrice Tourre. Goldman Sachs Charged with Billion Dollar Subprime Fraud
   

The SEC also reiterated it has an ongoing investigation into the practices of those involved in, purchased and securitized pools of subprime mortgages and the resecuritized CDO market The period of interest is late 2006 and early 2007 as the U.S. housing market was beginning to show signs of distress.