Aiki14 Market Sense

On April 16th, the Securities and Exchange Commission charged Goldman Sachs with fraud in structuring and marketing of CDO tied to subprime mortgages. The Complaint can be found HERE.

The Commission brings this securities fraud action against Goldman, Sachs & Co. and a GS&C employee, Fabrice Tourre, for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation GS&Co structured and marketed to investors.

The case as I see it is both unwarranted by the evidence currently released and based on a questionable point of law. Testimony by parties involved and statements made both under oath and to the media indicate the allegations are at best tenuous in my opinion.

The SEC had 6 lawyers working on the case for 6 months and the best they could do was a civil complaint alleging fraud by Fabrice Tourre, a 28 yr old junior executive against ACA Management LLC. ACA was acting as Collateral manager for its parent company ACA Capital Holdings which provided financial guaranty through its wholly owned subsidiary, ACA Financial Guaranty Corp. and IKB. On or about May 31, 2007, ACA Capital sold protection or “wrapped” the $909 million super senior tranche of ABACUS 2007-ACl, meaning that it assumed the credit risk associated with that portion of the capital structure via a Credit Default Swap. The super senior transaction with ACA Capital was intermediated by ABN AMRO Bank N.V., which was one of the largest banks in Europe during the relevant period. This meant that, through a series of CDS between ABN and Goldman and between ABN and ACA that netted ABN premium payments of approximately 17 basis points per year, ABN assumed the credit risk associated with the super senior portion of ABACUS 2007ACI ‘s capital structure in the event ACA Capital was unable to pay.

The complaint alleges that hedge fund Paulson and Co. chose the securities underlying the CDO and this was not disclosed to ACAor IKB.

The Offering memorandum included a description of ACA as “Portfolio Selection Agent” and made no mention of Paulson, its economic interest in the transaction or its role in selecting the portfolio.

While Paulson did choose the initial 123 securities inside the CDO, ACA had full access to all of them and removed all but 55 from the portfolio adding 31 of its own. ACA sent Mr. Tourre this list of sub prime mortgages “we would recommend taking exposure to synthetically”. The name of the portfolio and the subject line of the E-mail was “Paulson Portfolio 1-22-10.xls.”

It is nearly impossible to believe that ACA and its Client IKB to whom it had a fiduciary responsibility were unaware of Paulson’s participation in the selection of at least some of the underlying securities.

The total value of this portfolio, Abacus 2007-AC1 was approximately $1billion. ACA acted as Collateral manager of over $60 billion in CDO during the period Abacus 2007-AC1.

It is also in my opinion and is Goldman’s position that Paulson’s participation and Economic interest is not material, as in a CDO there are always long and short parties in the transaction.

It is my belief that the SEC rushed this complaint to take pressure off itself that it incurred the day before from its Inspector General alleging 10 years of incompetence and poor performance, charges of highly paid employees spending time watching porn at work and other embarrassing charges. It also furthers the desire of the current administration to pass the financial regulation bill currently up for cloture in the Senate. While I am not implying any involvement of the Obama administration, the SEC answers to it and may have concluded that any action furthering its goals would deflect the attention of the administration from the Inspector General’s scathing report.

Nothing the SEC has done for the last ten years, including under the tenure of the current Chairperson Ms. Shapiro inspires any confidence that these charges are well thought out or constructed. Goldman Sachs is an easy target and seen as having greatly benefitted from the economic collapse of the last 2 years. The SEC would know the public, unfamiliar with the workings of the firm and the products involved, would rally to its side as would the politicians eager to deflect responsibility off themselves in this era of anti incumbent sentiment.

The inclusion of the following sentence on page 1 of the complaint (a document very few people will drill down into) is simply inflammatory and offers nothing to the case:

Synthetic CDOs like ABACUS 2007-ACI contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.

They could have just as easily included a statement saying the ratings agencies who placed high ratings on the underlying securities contributed to the downturn or that government deregulation did. That would not have furthered their cause but would be equally valid statements as well as equally immaterial to the case.

I assert that the current sentiment of the public and many in our government towards the financial industry is warranted, but it should be noted that Goldman Sachs was not bailed out and took TARP money essentially by force so that the vulnerable firms would not be singled out by accepting it and have their reputations sullied. They also paid back that money with interest of over 23% annualized. By that measure giving Goldman Sachs loans would be a lot better than borrowing from China. The current attitude of the public punishes the firms who managed their risk better than the ones who were bailed out.

The media and the politicians have demonized Goldman Sachs in some cases through the lack of an understanding the roll the firm plays in the commerce of this country and in most cases to further some agenda of their own.

I believe the case against Goldman Sachs will be thrown out of court or quietly dropped. If the SEC continues to prosecute the case, I believe Goldman will defend itself even if it has to go to trial. I didn’t think this to be the case last thursday when I debated Josh Brown, the author of the fine blog The Reformed Broker, on the subject but based on new information I believe it now. I realize this is an unpopular position, but now I am joined by the likes of Dick Bove and Bill Ackman.

Goldman Sachs probably should never have gone public and in my opinion would be best served by taking itself private. My belief is they will start that process in the next 12 months.