Goldman Sachs, one of the most powerful and influential investment banks on Wall Street and one of its employees by the name of Fabrice Tourre (read more about him here) were on April 16th, 2006 served with an investment fraud lawsuit by the U.S. Securities and Exchange Commission or SEC. This was the first time that Goldman’s reputation had been tarnished with a fraud case in its long history.
The SEC’s lawsuit alleges that Goldman and its employee defrauded investors by misstating and omitting vital information about a certain Collateralized Debt Obligation or CDO having been structured by a particular hedge fund. The CDO was known as the ABACUS 2007-AC1 CDO and was issued in April of 2007.
The hedge fund in question is Paulson and Co., a longtime Goldman client run by billionaire investor John Paulson (apparently no relation to former Goldman CEO Hank Paulson), which allegedly hand picked the soon-to-be-downgraded securities that would make up the CDOs offered by Goldman to its clients.
The hedge fund then subsequently purchased insurance on those securities from AIG International knowing that the underlying securities, which they had chosen, were of poor quality and would very probably be downgraded.
Collateralized Debt Obligations
A Collateralized Debt Obligation or CDO consists of a bundled up package of debt securities that are backed by collateral like sub-prime mortgage-backed securities which can then be traded as a single financial instrument.
They tend to have higher yields and can provide a helpful element of diversification in most cases in the risky market. Nevertheless, the CDO market had become quite selective by 2006, with only upper tiered securities considered for investment by most asset managers.
Goldman’s CDO Deal Followed a Similar Pattern to Merrill Lynch’s
In March of 2007, a similar deal to what Goldman is now accused of structuring to its clients’ detriment was structured by Merrill Lynch, now part of Bank of America, with the help of hedge fund Magnetar. This bundle of sub-prime mortgage-back securities was known as the Norma CDO Ltd. and showed a massive default rate of 96 percent by the following year, when 68 percent was the norm. A lawsuit alleging investment fraud is now pending by Dutch Bank Rabobank against Merrill regarding this deal.
Virtually the same strategy was then executed by Paulson and Co., another hedge fund, which paid Goldman Sachs about $15 million to set up and sell the ABACUS 2007-AC1 CDO in April, 2007. As of October of that year, more than 83 percent of all of the sub-prime Residential Mortgage Backed Securities or RMBSs that made up this doomed CDO had been downgraded, and the rest were on a negative credit watch for future downgrades.
As January of 2009 ended, almost all of the securities that were structured into the CDO were downgraded. This cost investors, a good number of which were pension funds, more than a billion dollars. Basically, the Paulson and Co. hedge fund played a substantial role in piecing together the contents of what may have been one of the more toxic RMBS CDOs ever and the security was dumped on unsuspecting clients of Goldman Sachs.
How Credit Default Swaps Were Involved
Apparently, Paulson and Co. then turned around and bought Credit Default Swaps at AIG International to insure against the risk of default. This wound up putting AIG in a huge hole only to be dug out by the U.S. Government in September of 2008 with a $180 billion taxpayer-funded bailout authorized by Treasury Secretary Timothy Geithner. Geithner, along with former Goldman Sachs CEO Hank Paulson, had also “rescued” Bear Stearns in 2008.
The Credit Default Swaps which were bought from AIG International, consisting of an insurance policy on the soon-to-be-toxic debt, and they eventually returned over $1 billion to Paulson and Co. Later, the funds paid out on this costly policy would be reimbursed to AIG by the U.S. taxpayers when the company pretty much went bankrupt over being obligated to pay out on exactly this type of CDS.
Goldman’s Response to the Fraud Charges
Goldman, perhaps understandably given the huge sum involved, currently denies any wrongdoing in its response to the SEC about the fraud charges. The investment bank even claims that it lost $90 million on the deal. Yet this seems to directly contradict another statement in which they claimed to have only been the “middleman” in the transaction.
Middlemen, like brokers, generally do not usually lose money, especially almost a hundred million dollars on any transaction they facilitate. Instead, they make money by collecting a commission, fee or margin from the transaction.
Kudos to the SEC – A Late, but Vital, Step in the Right Direction
The SEC finally taking fraud action against the brazen Goldman Sachs bankers may appear to be too little too late to many observers. Nevertheless, the move presents a step in the right direction. Better late than never, as the saying goes. Read more SEC filings on forex fraud here.
Basically, the SEC should be supported in its efforts to protect the American people and their pension funds against any bank who does not seem to mind defrauding them out of huge amounts of money to enrich another. This is even more vital when taxpayers’ funds also were required to bail out the insurance company that paid dearly for this transaction.
Nevertheless, perhaps the most surprising thing about this Goldman fraud case is that at least one billionaire’s hedge fund — Paulson and Co. — has so far been allowed to walk away with what seems to be most of the proceeds and without being formally accused of any wrongdoing or liability in the matter.