(updated Sunday, April 18 with details on synthetic CDO due to questions from a reader)
Last year, in a statement that made me momentarily question my understanding of the English language while simultaneously wonder whether I had inhaled too many potent diesel fumes over the years, Goldman Sachs' CEO Lloyd Blankfein declared, in a detailed interview, to a reporter from the The Times (London) that he and Goldman were not only part of a "virtuous cycle" that serves a "social purpose, " but, in fact, that together with his holy $1 Trillion firm, he was actually "doing God's work" (pg 4 of article). Yes, you read that correctly.
It was, apparently, through "doing God's work" virtuously and with social purpose that Mr Blankfein and Goldman felt absolutely justified in taking $12.9 Billion from the American taxpayers during the AIG counterparty pay-out festival; through "doing God's work" that the former investment bank was miraculously converted to a bank-holding company by the FR in late 2008 so it could take $10 Billion more in taxpayer dough through TARP; and through "doing God's work" that it issued $1.1 Billion of taxpayer-backed debt through the FDIC program. That's $24,000,000,000 from the taxpayers--wow, "doing God's work" sure does pay, but who'd ever think it had $$$ in front of it!
And, who'd ever think that for Goldman, "doing God's work" includes screwing its own clients to the tune of $1 Billion and committing FRAUD? Indeed, that the market-shakingly big news that hit the fan yesterday (Friday, April 16). The long-speculated but heretofore unconfirmed SEC investigation into Goldman Sachs' sales of toxic CDO's to clients in 2007 has finally culminated in not only confirmation, but action: The SEC has officially alleged Goldman Sachs engaged in FRAUD.
Repeat: the SEC has filed a civil lawsuit against Goldman Sachs on behalf of investors who were, according to the SEC, defrauded of over $1 Billion by Goldman through what was really a complex double-crossing fraud operation. We've known about this for some time, thanks in huge part to the awesome McClatchy News multi-piece expose published last November, "How Goldman Secretly Bet on the US Housing Crash." And, of course, those $1 Billion worth of investors--including pension funds, labor unions, insurance companies, etc--have long suspected that they were defrauded by these banksters. But that's not important--what's important is whether or not the SEC agrees, and on Friday they demonstrated that indeed they do.
Actually, its hard for the SEC not to agree: the evidence is overwhelming. Please read the McClatchy piece from last year and then these current Bloomberg articles (first, second, third) the raw details, because my quick explanation is actually only a matchbook-cover overview. The SEC complaint is 22 pages long (pdf), but I'll try to boil it down a bit.
Basically, it's like this:
1.) GOOD TIMES: It's sometime between 2002 and 2006, and the housing bubble is booming: Goldman and everyone else begins purchasing securitized mortgages bundles--mortgage backed securities, or MBS--from underwriters who can't sell them fast enough. Goldman keeps the "assets" on their balance sheet, because in the good ole' days here in 2002 through 2006, these securities are performing very well and increasing in value. Everything is great, dude. Goldman sells some of the MBS to others at a profit, and keeps some for itself. This is so super--everyone has a house, and house prices can't possibly fall. Uh, oh--what do you mean you can't make your house payment? What do you mean no one will buy that 600sq-ft shack for the $400,000 you paid for it? Oh, great, here we go. Enter the crisis.
2.) CRISIS: By mid-2006, some of the underlying mortgages of the various MBS begin to default, and by 2007, vastly overinflated home prices being to really reverse. A crisis is coming or here: suddenly, Goldman's dandy MBS are not only failing to pay the coupon, but are seriously losing value. Goldman tries Plan A: the firm decides to sell some while it can, but the over-saturated market is full of others doing the exact same thing. Plan A fails. Goldman moves to plan B. Enter ABACUS.
3.) ABACUS: Goldman starts issuing collateralized debt obligations (CDO's) by selecting bundles of MBS (collateral), securitizing them, and then selling them as securities (or debt) to clients (obligations). There are two types of CDO's that Goldman issues: "plain vanilla" CDO's and synthetic CDO's. Its an important distinction: plain vanilla CDO's are created when Goldman takes a portfolio of cash-flow producing assets (like MBS), bundles them up, and slices them into different risk-based tranches that each pay investors a different coupon. The higher the tranche, the lower the risk, and thus the lower the coupon payment. Conversely, the lower the tranche--that is, the more exposed to subprime loans--the riskier the bond, and thus the higher coupon. Goldman sells billions in plain vanilla CDO's, and seeing both the need to hedge itself further as well as the potential to profit from falls in the market as the bubble deflates faster, Goldman starts issuing synthetic CDO's by the name ABACUS. Unlike regular CDO's, synthetic CDO's do not require anyone to own a portfolio of asset-backed securities, but are instead "linked" to the performance of ABS through what is basically a contract bet (more details on this soon). On top of the billions of regular CDO's its already sold, Goldman issues at least $7.8 Billion of these synthetic-CDO's under the name "ABACUS," but according to Bloomberg, the dollar-risk shuffled over to investors is actually "multiples higher" than $7.8 Billion. Like regular CDO's, the synthetic-CDO "investments" entitle the purchaser clients to payments from Goldman, but Goldman itself is able to vastly reduced its own exposure by getting some of the debt off its its balance sheet. Goldman, however, is still in the position to lose money, and so the firm needs to hedge. Enter the other side of ABACUS--CDS.
4.) CDS: Synthetic CDO's aren't based on the cash-flow from some underlying mortgages bundled into a security and divided into tranches like a regular CDO is--instead, they basically consist (and pay-out) of one each side betting against the other on the performance of an "associated" group of debt. Both the cash flow and the betting on the synthetic CDO is accomplished through credit default swaps, or CDS. In a synthetic CDO contract, the seller (Goldman) is effectively shorting the associated assets by purchasing a credit default swap from the buyer (investors, clients), meaning that Goldman has to make regular payments to the buyer of the CDO (who is now the seller of a CDS). This creates the cash flow that makes a synthetic CDO look like a regular CDO, as the investors are recieving payments for the CDS "policy" that are much like the coupon payments they'd be recieving in a regular CDO. However, in the synthetic CDO, if the associated/linked assets go bad, the buyer of the CDO (investors) who is also the seller of the CDS now has to pay the buyer of the CDS (Goldman) who is also the seller of the CDO--and they have to pay the entire face value of the debt, even if Goldman doesn't own it, which in all cases of ABACUS, they didn't. The CDS coverage on the synthetic CDO's therefore make it more profitable for Goldman that the synthetic CDO's its selling to its clients fail than it does for them to succeed. If they fail, the clients are on the hook for debt to pay Goldman. While this is bad, and probably unethical, and insanity that anyone would make this agreement with Goldman, its not actually fraud yet. At least at this point, Goldman itself was selecting the underlying assets from its own portfolio, and so was at least partially co-investing, even though it was still covering itself with the CDS "insurance" and pushing the risk to investors in a fashion "multiples higher" than to itself. Where it starts to move towards fraud is when, for the last ABACUS synthetic CDO set, Goldman turns to some third parties to pick the collateral and create the portfolios, which it then will sells with not only zero liability of its own, but that it takes a bet out on to fail. The fraud part has to do with the third parties and the Goldman executives who know it. Enter Fabrice Tourre.
4.) FABRICE TOURRE: While Goldman had already sold billions in CDO's and ABACUS synthetic CDO's that consisted of portfolios it had itself chosen, in 2007, the firm decides to issue synthetic CDO's selected by a third-party group, ACA Management. The debt, sold as "ABACUS-2007 AC1," is under the principle supervision of Goldman executive Fabrice Tourre. Tourre delivers a portfolio of picks made by the $30-million-dollar hedge fund, Paulson & Co, to ACA to consider for selection, and tells ACA that Paulson & Co plan to invest $200 million in the portfolio. ACA itself will eventually take the majority position on the CDO--fronting some $951 million--and so the group obviously has an interest to select collateral that will not fall in value. Goldman, meanwhile, is marketing the debt to clients, stating ACA's dual role as both majority holder and collateral selector as proof that the CDO will have a rock-solid base, and "leverag(ing) ACA's credibility and franchise" to sell the contracts (SEC complaint, pg 8). When ACA receives the Paulson picks from Goldman exec Tourre along with his assurance that the hedge fund will invest $200 Million, ACA is assuming that Paulson's interest must be in-line with their own, and so ACA accepts the Paulson picks. They assemble the ABACUS-2007 AC1 synthetic CDO, and Goldman starts selling with no exposure. By this time, Goldman is outright shorting the MBS market, and so the firm itself takes out more CDS on the ABACUS-2007 AC1 synthetic CDO's, even though they have no exposure: they aren't hedging by this time, they are betting. ACA, meanwhile, is still believing Tourre's statement to them that Paulson & Co plans to invest that $200 Million. The money never comes.
5.) PAULSON & CO: Not only is Mr Tourre's statement to ACA that Paulson & Co plans to invest $200 million in the portfolio totally untrue, it is actually the outright opposite of what the investment outlook of Paulson actually is. In truth, Paulson & Co has long since identified the housing market as an incredible bubble, and is shorting everywhere it can. Paulson & Co sees the new ABACUS synthetic CDO's, and, knowing it is very likely to fail--at least in part due to the fact that Paulson picked the underlying securities to which it was associated with the intent of those securities failing--the hedge fund piles up on CDS against the ABACUS 2007-AC1. What ACA, and all of the investors to whom Goldman was pitching and selling the ABACUS 2007-AC1, do not know is that Paulson & Co actually paid Goldman $15 Million to get ACA to somehow include the hedge fund's toxic picks into the ABACUS portfolio, and Mr Tourre with his made up stories, got the job done. Now, that, ladies and gentlemen, is fraud.
The rest--the implosion of the CDO and the pay-out of the CDS to Goldman and Paulson are now history, and the story is best summarized in the SEC complaint by this statement (pdf pg 3):
"The deal closed on April 26, 2007. Paulson paid GS&Co approximately $15 million 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."
"Our clients always come first."
And so, that is were we stand this weekend. The flesh of the SEC suit is that Goldman not only allowed Paulson & Co to hand-pick mortgages to create the most toxic CDO's possible for Goldman to sell, but that Paulson & Co paid Goldman $15 million for the privilege to do this--and Goldman didn't bother to disclose these facts to the clients, nor did it bother to mention it was itself betting against the very CDO's Paulson's picks yielded. Additionally, the investors who bought the synthetic CDO's have claimed to the SEC that Goldman also did not disclose that the values of the underlying mortgages themselves were based "on inflated appraisals and were bought from firms with poor lending practices, " despite the fact that Goldman knew this, as well.
On Goldman Sachs' site is a list of "Business Principles." The top one, in bold, states "Our clients' interests always come first." Obviously, Paulson & Co is very happy--a billion bucks worth of happy--that this core Goldman Sachs "business principle" is, apparently, only half-true.
Perhaps the words of one my favorite analysts, the hard-core researcher Christopher Whalen of Institutional Risk Analytics, summarize it best. Whalen stated yesterday that “this litigation exposes the cynical, savage culture of Wall Street that allows a dealer to commit fraud on one customer to benefit another.” Yep, that's why we call 'em banksters, Mr Whalen. You can't trust them as far as you throw them soaking wet--and honestly, I don't have much sympathy for those that do. In my opinion, when you're dealing with a group of folks whose entire livelihood rests on the "legalized" counterfeiting of the American currency, you ought to expect fraud. And the beneficiary of the fraud in this case was both Goldman and its privileged client, Paulson & Co.
The idea that Goldman would accept a list of picks for an MBS-associated synthetic CDO from a hedge fund that was actively and passionately shorting the entire subprime MBS market is bad enough, but to get paid $15 Million by that same hedge fund to "oh, please, please please" use their toxic picks--bloody hell, man, that is just so bad. Top it off with Goldman's own bets against the "investments" that it was selling, and you've got a real whopper there. In his Rolling Stone piece, "The Great American Bubble Machine," Matt Taibbi colorfully declared Goldman Sachs "a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money." With my very visual mind, I laugh every time I read that great description, but like the "Business Principles," its only half true--and you'd know it if your "humanity" was with Paulson & Co. In that case you'd be thinking, "Oh, vampire squid are so cute!"
Paulson & Co.
Please note, the SEC has not charged Paulson & Co with any crimes, and likely will not, because as a private investment group, the hedge fund is under no legal obligation whatsoever to disclose anything, nonetheless to investors purchasing debt from another company. In response to the SEC complaint, Paulson & Co said the following in a released statement:
". . . we were not involved in the marketing of any ABACUS products to any third parties.
"ACA as collateral manager had sole authority over the selection of all collateral in the CDO, securities of which were subsequently rated AAA by both S&P and Moody's."
"Paulson did not sponsor or initiate Goldman's ABACUS program. . ."
Compare that to the following, from the SEC complaint itself (pg 2):
"GS&Co marketing materials for ABACUS 2007-AC1 -- including the term sheet, flip book and offering memorandum for the CDO - all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management LLC ("ACA"), a third-party with experience analyzing credit risk in RMBS. 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."
"In sum, GS&Co arranged a transaction at Paulson's request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson's role in the portfolio selection process or its adverse economic interests."
Those are strong statements from the SEC that Paulson did "play a significate role in the portfolio selection process" for its own "economic interests," and Goldman, of course, didn't bother to mention that. ACA Management, meanwhile, has long since drowned in the wake of the crisis, and is now under the ownership of its former counterparties. As for Goldman Sachs: the firm will likely declare a $4,000,000,000 first quarter profit when it reports next week.
Hey--its all about "doing God's work," son.
More posts on this to come!