To quote the SEC's press release on April 16th:
"The product was new and complex but the deception and conflicts are old and simple," said Robert Khuzami, Director of the Division of Enforcement. "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.
Continuing:
According to the SEC's complaint, filed in U.S. District Court for the Southern District of New York, the marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. The SEC alleges that undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.
Wow, well when you put it like that, I can totally see what people like Anonymous are getting all up in a huff about! That sounds pretty damn shitty! But like all things, there are two sides to every coin - what possible defense could Goldman have against such charges? Well, so far they haven't said much (must be playing their cards close to their chest until a possible trial or settlement), but you can get an idea of what they'll likely say by looking at Goldman's Well's Notice response. Mark J. Astarita over at the SECLaw.com blog has a great summary of what that shit is if you're curious - as he says, its not their response to the complaint, but it does offer insight into their defense. To quote the submission:
There was nothing unusual or remarkable about the transaction or the portfolio of assets it referenced. Like countless similar transactions during that period, the synthetic portfolio consisted of dozens of Baa2-rated subprime residential mortgage-backed securities (“RMBS”) issued in 2006 and early 2007 that were identified in the offering materials (the “Reference Portfolio”). As in other synthetic CDO transactions, by definition someone had to assume the opposite side of the portfolio risk, and the offering documents made clear that Goldman Sachs, which took on that risk in the first instance, might transfer some or all of it through a hedging and trading strategies using derivatives. Like other transactions of this type, all participants were highly sophisticated institutions that were knowledgeable about subprime securitization products and had both the resources and the expertise to perform due diligence, demand any information that was important to them, analyze the portfolio, form their own market views and negotiate forcefully at arm's length.
Further:
All participants in the transaction understood that someone had to take the other side of the portfolio risk, and the offering documents clearly stated that Goldman Sachs might lay off some or all of the short exposure to the portfolio that it had taken on. A disclosure that the relatively unknown Paulson was the entity to which Goldman Sachs transferred that risk would have been immaterial to investors in April 2007.
Basically, Goldman is supporting what I've said all along - that the Abacus investors had a full idea about the underlying portfolio they were investing, and that they further understood that some other party was taking the opposite side of the portfolio; "betting against" them, so to speak. Moreover, Goldman alleges that all involved parties had access to all the relevant information - Goldman and Paulson did not in fact stack the deck without letting investors see what was inside as those like Anonymous have accused; instead, every party had access to the specific securities that made up the CDO. Moreover, IKB (one of European banks claiming fraud) actually claims in their investment prospectuses that the CDO pools they invest in are "are examined with a drill down to underlying assets and stress testing of the underlying asset pools" - see page 27 if you don't believe me! From the looks of it, if IKB and ABN Amro are claiming now that they weren't informed off all the risks, then they must have been lying back in 2007 when they spent 70 pages touting their expertise in CDOs - given how these investments tanked within a year after being sold, its highly likely that they were lying about their expertise. But if they were able to fool everyone including themselves about their expertise, how can we possibly hold Goldman accountable?
Of course, the issue is less about IKB and ABN Amro's technical abilities or investing knowledge, and more about whether or not Goldman misrepresented who was choosing the securities in the Abacus portfolio. The central aspect of the SEC's charges of fraud hinges around the accusation that Goldman Sachs misleadingly marketed the portfolio to investors as having been selected by ACA Management, a prestigious investment firm that was brought in for their name brand experience with this type of investment. Specifically, the investment materials Goldman released seemed to indicate that only ACA Management had picked the portfolio, with no mention of Paulson - this is supposedly a key difference, as ACA was entering into a long position on the deal (they'd lose money if it failed) whereas Paulson was shorting it and stood to make a fortune if it failed.
Now, the way that the European banks, the SEC, and the media tell it, Goldman let Paulson pick the entire portfolio and then pretended like ASA had picked the stocks - clearly this would be an egregious act of fraud if there ever were one. However, I simply refuse to believe that Goldman Sachs would do such a thing - its not that I believe them to all be good people who would never do such a thing; far from it, I actually believe they're a bunch of shitty, selfish bankers who act only in their self interest with flagrant disregard for anyone perceived as competition or "prey". However, its precisely this dismal view of Goldman that makes me question whether they would have committed such blatant fraud - after all, they're already an insanely profitable institution, and doing something so obviously illegal just to make a couple million dollars does not seem like the type of risk proposition Goldman would go for. So the question remains, how the hell did Goldman claim with a straight face that ACA picked the portfolio itself?
Finding out exactly how the CDO portfolio for the Abacus deals was constructed wasn't easy. However, this extremely well written essay about why the SEC has a strong case against Goldman does actually go into a bit of detail about what went down, summarizing and explaining what Gregory Palm, Goldman's chief counsel, said during their Q1 earnings conference call when asked about it. Apparently, the portfolio was selected in what appears to be a series of back and forth rounds between Paulson and ACA, where each round one party suggested a set of securities and the other would respond with the subset they found acceptable; this continued until all 90 securities comprising the deal in question were selected. Now, the SEC complaint includes the allegation that Paulson reserved the right to "delete safer securities" from the pool, though given the game-like nature of this exchange, I wouldn't be surprised if both parties actually had such veto power.
While its technically true in the English language that "Paulson picked the portfolio" in the sense that they selected or approved every security in it, it would thus also be true that ACA management picked the portfolio, too. And honestly, this makes sense; moreover, it puts Gregory Palm's cryptic comments about longs and shorts in much better perspective:
Keep in mind that this is a conference call transcript, hence the slightly confusing nature of this quote. But basically from what I can tell, Palm is referring to the standard industry practice of building a reference portfolio of securities (e.g. the Abacus deal) that is acceptable to both the longs and the shorts who will be entering into the deal. Because of this fact, I can hardly see how Paulson's involvement in the selection process would be considered fraudulent.
Ah, but its not about IKB or ABN Amro's technical (in)ability to assess credit risk (which, may I remind you, is a banks entire business). Nor is about Paulson being involved in the selection process! Nor is it the fact that ACA Management picked the portfolio - which they did. No, like all good legal battles, this one comes down to semantics: did Goldman Sachs mislead investors about who picked the portfolio? After all, this would be a bit like me baking a cake for you with my good friend, giving it to you, and then telling you that I had made you a cake - its certainly not a false statement, but it certainly is more likely to make you think that I baked the cake by myself. After all, if I tell you I made you a cake, you aren't going to immediately ask me who I baked it with.
But did Goldman bake a cake and then grossly misrepresent its authorship? After all, if I go to Build-A-Bear, pick a model and outfit and then let their employees actually stuff, dress, and box my bear, I still reserve the right to give it to you and say I made it; it would be silly to the point of obtrusiveness in to tell you that Build-A-Bear built you a bear according to my directions. To bring it back to cakes, I can say I baked you one without having to grow the strawberries and mill the flour myself . So where along this spectrum of implied linguistic intuitions about authorship does Goldman's case fall? Well, the distinction between what's disingenuous and what isn't seems to rely in all of these situations on the other person's reasonable expectations. After all, absolutely no one makes their own flour this day and age, so "baking a cake" won't imply having spent hard time at a stone mill, at least not to a reasonable person. Similarly, many people are more than capable of baking a cake by themselves, so without offering any extra information to resolve the ambiguity, "I baked you a cake" implies a solitary experience.
So the question seems to be, what were the reasonable expectations for the involved parties back in 2007 when the deals were made? This is a very vague question with even vaguer answers, and moreover considering that we're asking about a point in time over three years ago, its doubtful we'll be getting any black and white answers here. Still, I think its worthwhile to think about. Since our goal is determining whether Goldman's statement that "ACA picked the portfolio" was misleading, we should ask what the reasonable default assumptions for portfolio picking were?
On one hand as already described, for these types of deals to even go through, the portfolio had to be acceptable to both the longs and the shorts who were investing. Moreover, the existence of a short position is a necessary, so it would seem that reasonable assumptions for involved parties would include knowing that there was a person shorting the deal to whom the portfolio was acceptable. Basically, going into the deal, IKB and ABN Amro had to know that someone was betting against them. But when Goldman omitted to mention Paulson's involvement in the portfolio selection process, was this the type of thing that IKB and ABN Amro could have reasonably understood was going on? Goldman's argument that they could have asked unfortunately holds no water here? Remember, when I tell you I made you a cake you shouldn't have to ask me who helped - nor should you accuse me of fraud if I bought the flour instead of making it myself.
Now, the interesting fact of the matter is that when it came to building CDOs, Goldman wasn't alone in how they built them - lots of banks were structuring CDOs in the exact same way. Apparently letting the counter-signor help pick the portfolio was fairly common in the industry, an idea first pioneered back in 2005 by a hedge fund called Magnetar Capital. Apparently they were named after a type of neutron star that crushes anything nearby - how appropriate! Considering that such deal structuring had been happening for over two years by the time Abacus were sold, and moreover considering that IKB did things exactly the same way as Goldman for the CDOs they sold (and here's even more zany shit they did!), at this point I think its fairly safe to say that Goldman's statements were far from fraudulent - both IKB and ABN Amro clearly had a very good idea of exactly what type of deal they were getting into, along with exactly how such deals were conventionally done; if they didn't, they were the ones responsible for egregious professional misconduct. And finally, even if IKB didn't have access to every detail of how the portfolio was created (what time did you start it? what were drinking? was it sunny outside?), they did have raw access to the final portfolio itself, so if it had truly been created in a manner that stacked the decks so decisively against them, their stress tests, "security level drill downs" and other advertised investment acumen should have caught it, correct? Oh, but that would require assuming that IKB was competent - a fact that apparently Goldman should have known not to assume back in 2007.
I just want to point out that in every story I read about Goldman supposedly defrauding an investor, the common theme I see is that in every case, some European bank bought an obviously horrible financial product without even pretending to research its viability. They had likely been doing such things for awhile, and only had it catch up with them when the market finally crashed. Said bank loses billions and then claims they've been the victims of fraud - after all, admitting that you're simply unable to properly assess a basic credit deal would be tantamount to corporate suicide for these banks, and although they apparently aren't able to do basic bank work, they're too big to fail so no one will let them admit it. Instead, the Eurozone melts down and Goldman - being one of the only banks that actually still has money left - becomes the only viable target for litigation. Meanwhile, I can't help but wonder - why is an American firm left with the blame for what appears to be an obvious European failure? I find it no coincidence after all that Europe was apparently filled to the brim with banks that eagerly jumped on deals their peers across the pond had determined were complete shit more than 2 years prior. Even if Goldman Sachs was potentially misleading, the biggest cause of IKB, ABN Amro and every other bank that is bitching's massive losses wasn't fraud, but rather their own simple stupidity.
Of course, the issue is less about IKB and ABN Amro's technical abilities or investing knowledge, and more about whether or not Goldman misrepresented who was choosing the securities in the Abacus portfolio. The central aspect of the SEC's charges of fraud hinges around the accusation that Goldman Sachs misleadingly marketed the portfolio to investors as having been selected by ACA Management, a prestigious investment firm that was brought in for their name brand experience with this type of investment. Specifically, the investment materials Goldman released seemed to indicate that only ACA Management had picked the portfolio, with no mention of Paulson - this is supposedly a key difference, as ACA was entering into a long position on the deal (they'd lose money if it failed) whereas Paulson was shorting it and stood to make a fortune if it failed.
Now, the way that the European banks, the SEC, and the media tell it, Goldman let Paulson pick the entire portfolio and then pretended like ASA had picked the stocks - clearly this would be an egregious act of fraud if there ever were one. However, I simply refuse to believe that Goldman Sachs would do such a thing - its not that I believe them to all be good people who would never do such a thing; far from it, I actually believe they're a bunch of shitty, selfish bankers who act only in their self interest with flagrant disregard for anyone perceived as competition or "prey". However, its precisely this dismal view of Goldman that makes me question whether they would have committed such blatant fraud - after all, they're already an insanely profitable institution, and doing something so obviously illegal just to make a couple million dollars does not seem like the type of risk proposition Goldman would go for. So the question remains, how the hell did Goldman claim with a straight face that ACA picked the portfolio itself?
Finding out exactly how the CDO portfolio for the Abacus deals was constructed wasn't easy. However, this extremely well written essay about why the SEC has a strong case against Goldman does actually go into a bit of detail about what went down, summarizing and explaining what Gregory Palm, Goldman's chief counsel, said during their Q1 earnings conference call when asked about it. Apparently, the portfolio was selected in what appears to be a series of back and forth rounds between Paulson and ACA, where each round one party suggested a set of securities and the other would respond with the subset they found acceptable; this continued until all 90 securities comprising the deal in question were selected. Now, the SEC complaint includes the allegation that Paulson reserved the right to "delete safer securities" from the pool, though given the game-like nature of this exchange, I wouldn't be surprised if both parties actually had such veto power.
While its technically true in the English language that "Paulson picked the portfolio" in the sense that they selected or approved every security in it, it would thus also be true that ACA management picked the portfolio, too. And honestly, this makes sense; moreover, it puts Gregory Palm's cryptic comments about longs and shorts in much better perspective:
In this market there has to be a long and a short. That is perfectly clear. Other point I would really emphasize is in order to have a transaction in this market you have to have some reference portfolio of securities which is satisfactory to both the longs who are looking at the portfolio; they are not really looking at really anything else and the short who are looking at the same portfolio and deciding that. As you know, whether the shorts are us or anyone else.
Keep in mind that this is a conference call transcript, hence the slightly confusing nature of this quote. But basically from what I can tell, Palm is referring to the standard industry practice of building a reference portfolio of securities (e.g. the Abacus deal) that is acceptable to both the longs and the shorts who will be entering into the deal. Because of this fact, I can hardly see how Paulson's involvement in the selection process would be considered fraudulent.
Ah, but its not about IKB or ABN Amro's technical (in)ability to assess credit risk (which, may I remind you, is a banks entire business). Nor is about Paulson being involved in the selection process! Nor is it the fact that ACA Management picked the portfolio - which they did. No, like all good legal battles, this one comes down to semantics: did Goldman Sachs mislead investors about who picked the portfolio? After all, this would be a bit like me baking a cake for you with my good friend, giving it to you, and then telling you that I had made you a cake - its certainly not a false statement, but it certainly is more likely to make you think that I baked the cake by myself. After all, if I tell you I made you a cake, you aren't going to immediately ask me who I baked it with.
But did Goldman bake a cake and then grossly misrepresent its authorship? After all, if I go to Build-A-Bear, pick a model and outfit and then let their employees actually stuff, dress, and box my bear, I still reserve the right to give it to you and say I made it; it would be silly to the point of obtrusiveness in to tell you that Build-A-Bear built you a bear according to my directions. To bring it back to cakes, I can say I baked you one without having to grow the strawberries and mill the flour myself . So where along this spectrum of implied linguistic intuitions about authorship does Goldman's case fall? Well, the distinction between what's disingenuous and what isn't seems to rely in all of these situations on the other person's reasonable expectations. After all, absolutely no one makes their own flour this day and age, so "baking a cake" won't imply having spent hard time at a stone mill, at least not to a reasonable person. Similarly, many people are more than capable of baking a cake by themselves, so without offering any extra information to resolve the ambiguity, "I baked you a cake" implies a solitary experience.
So the question seems to be, what were the reasonable expectations for the involved parties back in 2007 when the deals were made? This is a very vague question with even vaguer answers, and moreover considering that we're asking about a point in time over three years ago, its doubtful we'll be getting any black and white answers here. Still, I think its worthwhile to think about. Since our goal is determining whether Goldman's statement that "ACA picked the portfolio" was misleading, we should ask what the reasonable default assumptions for portfolio picking were?
On one hand as already described, for these types of deals to even go through, the portfolio had to be acceptable to both the longs and the shorts who were investing. Moreover, the existence of a short position is a necessary, so it would seem that reasonable assumptions for involved parties would include knowing that there was a person shorting the deal to whom the portfolio was acceptable. Basically, going into the deal, IKB and ABN Amro had to know that someone was betting against them. But when Goldman omitted to mention Paulson's involvement in the portfolio selection process, was this the type of thing that IKB and ABN Amro could have reasonably understood was going on? Goldman's argument that they could have asked unfortunately holds no water here? Remember, when I tell you I made you a cake you shouldn't have to ask me who helped - nor should you accuse me of fraud if I bought the flour instead of making it myself.
Now, the interesting fact of the matter is that when it came to building CDOs, Goldman wasn't alone in how they built them - lots of banks were structuring CDOs in the exact same way. Apparently letting the counter-signor help pick the portfolio was fairly common in the industry, an idea first pioneered back in 2005 by a hedge fund called Magnetar Capital. Apparently they were named after a type of neutron star that crushes anything nearby - how appropriate! Considering that such deal structuring had been happening for over two years by the time Abacus were sold, and moreover considering that IKB did things exactly the same way as Goldman for the CDOs they sold (and here's even more zany shit they did!), at this point I think its fairly safe to say that Goldman's statements were far from fraudulent - both IKB and ABN Amro clearly had a very good idea of exactly what type of deal they were getting into, along with exactly how such deals were conventionally done; if they didn't, they were the ones responsible for egregious professional misconduct. And finally, even if IKB didn't have access to every detail of how the portfolio was created (what time did you start it? what were drinking? was it sunny outside?), they did have raw access to the final portfolio itself, so if it had truly been created in a manner that stacked the decks so decisively against them, their stress tests, "security level drill downs" and other advertised investment acumen should have caught it, correct? Oh, but that would require assuming that IKB was competent - a fact that apparently Goldman should have known not to assume back in 2007.
I just want to point out that in every story I read about Goldman supposedly defrauding an investor, the common theme I see is that in every case, some European bank bought an obviously horrible financial product without even pretending to research its viability. They had likely been doing such things for awhile, and only had it catch up with them when the market finally crashed. Said bank loses billions and then claims they've been the victims of fraud - after all, admitting that you're simply unable to properly assess a basic credit deal would be tantamount to corporate suicide for these banks, and although they apparently aren't able to do basic bank work, they're too big to fail so no one will let them admit it. Instead, the Eurozone melts down and Goldman - being one of the only banks that actually still has money left - becomes the only viable target for litigation. Meanwhile, I can't help but wonder - why is an American firm left with the blame for what appears to be an obvious European failure? I find it no coincidence after all that Europe was apparently filled to the brim with banks that eagerly jumped on deals their peers across the pond had determined were complete shit more than 2 years prior. Even if Goldman Sachs was potentially misleading, the biggest cause of IKB, ABN Amro and every other bank that is bitching's massive losses wasn't fraud, but rather their own simple stupidity.
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