SEC Takes on the Vampire Squid

The Securities and Exchange Commission (SEC) stepped up its game in a big way this morning, filing civil charges alleging that Goldman Sachs was fraudulent in its marketing of a financial product tied to subprime mortgages. This is the first time the SEC has brought charges against a major Wall Street bank for misrepresenting such securities, which played a central role in the financial crisis.

The SEC alleges that Goldman and one of its vice presidents, Fabrice Tourre, failed to disclose key information regarding a financial instrument known as a collateralized debt obligation (CDO), a complex type of security backed by a pool of assets that can include bonds, loans, mortgage-backed securities, and other CDOs.

According to the complaint, Paulson & Co., a major hedge fund, paid Goldman $15 million to structure and market a CDO known as ABACUS 2007-AC1. The SEC alleges that Goldman and Tourre failed to inform investors about the key role Paulson played in selecting certain residential mortgage-backed securities (RMBS) to be included in ABACUS, or the fact that Paulson was well-positioned to profit if these securities went south.

From the SEC’s press release:

The SEC’s complaint alleges that after participating in the portfolio selection, Paulson & Co. effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure. Given that financial short interest, Paulson & Co. had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson & Co.’s short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors....

According to the SEC’s complaint, the deal closed on April 26, 2007, and Paulson & Co. paid Goldman Sachs approximately $15 million for structuring and marketing ABACUS. By Oct. 24, 2007, 83 percent of the RMBS in the ABACUS portfolio had been downgraded and 17 percent were on negative watch. By Jan. 29, 2008, 99 percent of the portfolio had been downgraded.

Investors in the liabilities of ABACUS are alleged to have lost more than $1 billion.

Goldman has issued a response, stating that “the SEC’s charges are completely unfounded and we will vigorously contest them and defend the firm and its reputation.” No charges were filed against Paulson or any of its employees.

Much has been written about Goldman and other investment banks betting against the same debt products they structured and marketed to investors, a strategy that generated significant profits as the subprime mortgage crisis unfolded, and played a key role in the demise of firms such as AIG. The SEC’s lawsuit against Goldman could potentially have far-reaching consequences for other firms that engaged in similar practices contributing to the financial crisis. It will also be interesting to see what role if any the credit rating agencies played in evaluating ABACUS.

Last week, ProPublica published an exhaustive investigative report describing how a different hedge fund, Magnetar, repeatedly pressured investment banks and third-party CDO managers to create CDOs filled with securities that Magentar had bet against, a fact that was typically withheld from investors. ProPublica’s article and the accompanying story on This American Life are a must-read and -listen for anyone who wants to learn more about the types of deals described in the SEC’s complaint.

The charges also represent a significant development for the SEC, which has come under intense criticism for failing to adequately monitor many of the firms at the heart of the financial crisis. We’ve also been highly critical of the SEC in recent months, but we applaud the Commission for bringing such a high-profile case against one of the biggest players on Wall Street.

The SEC’s complaint can be viewed here.

-- Michael Smallberg

Comments

[Industrial Coating Services]

Hopefully the SEC can control this issue. These bank executives think that they are invincible.

[Jeff Hamilton]

Michael, you missed a golden opportunity to post a picture of a vampire squid. Also, I trust that you saw MoJo's Nick Bauman reference to Reuters stylebook regarding this issue.