What’s next for Goldman Sachs?

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The fraud charges filled by the SEC against Goldman Sachs could be a pivotal moment in financial industry as the United States continues its painful recovery from the financial crisis.     According to some experts this case signals that the regulators could eventually target other banks over how much they told investors about at least $40billion of collateralized debt obligations (CDO) that share similar profiles.   

The allegations of the case can be summarized as follows:  In early 2007, Paulson & Co. hedge fund manager John Paulson believed the U.S. housing market was in a bubble, and wanted to short the entire sector.   Lacking any easy way to do this, he worked with Fabrice Tourre, a London based senior vice president at Goldman Sachs, to draw up a list of mortgage-backed securities that were certain to default. 

Tourre then shared that list of securities with a mortgage analysis company named ACA Management, and persuaded ACA into using that list to draw up collateralized debt obligations Goldman Sachs could sell to investors, CDOs whose value would depend on homeowners continuing to make their mortgage payments.

Tourre neglected to tell ACA or investors that Paulson had pre-selected those securities on the assumption that the homeowners funding them would not continue to make their payments. Paulson, meanwhile, also purchased credit default swaps on those CDOs, betting that they would default. When they did, the investors lost $1 billion. Paulson profited $1 billion. Goldman acted as the middleman for this transaction and collected $15 million in fees.

These are all issues related to disclosure.  Had Tourre disclosed Paulson’s role in this scheme, neither ACA nor any intelligent investor would have purchased the CDOs Goldman was selling. But Goldman had large and lucrative market for these securities, so it omitted material facts about the nature of CDOs in order to sell them.   This is the underlying misconduct the SEC alleges.

The SEC accuses Goldman of violating three specific securities laws:  Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act and Exchange Act Rule 10b-5.  All three essentially forbid anyone from using fraud or deceit, including the omission of material facts, to profit from a securities sale.

The question is whether Paulson’s undisclosed role in portfolio selection was material.   In other words, would a reasonable investor want to know this information before investing in this security?    However, there is no clear and well-defined definition of what material information is and what you have to disclose in this type of transaction. 

Goldman argues that the facts about Paulson weren’t material.    That hedge-fund manager Paulson was nearly unknown when the securities were sold in early 2007, and participants were unlikely to have cared about his role.  Goldman also said in its response that its clients got the material information needed, including the types of mortgages going into the securities.  Finally, it argues that the investors in the CDOs were sophisticated enough to know that for every buyer of a CDO, somebody else out there is shorting that position (which is how these deals work).  

How do legal experts respond to this case?     They seem to be split on the issue.  Some securities lawyers said the SEC’s 22-page complaint offered strong evidence that Goldman should have disclosed information about Paulson.    Other lawyers not involved in the case said those buying the securities were sophisticated institutional investors presumably able to size up a product’s worth and should be judged by a different disclosure standard.

This legal battle is just about to unfold.   Most likely, U.S. District Judge Barbara Jones, who was assigned the case won’t dismiss the SEC complaint because materiality is what’s at issue.  

If the SEC’s case survives a dismissal motion, the case would probably proceed to discovery, when the agency may seek additional testimony or information from the firm. That process could provide incentive for private lawsuits, additional allegations from regulators, or media attention that would further damage Goldman’s reputation.    After that, Goldman’s risk will mount and its negotiating position will weaken.    

Finally, politicians rushed to tie the Goldman case to finance reform.   Lloyd Blankfein and other Goldman executives are scheduled to testify at a Senate hearing next week along with Fabrice Tourre.  The Permanent Subcommittee on Investigations will explore investment banks’ role in the financial crisis at the April 27 hearing.

The future of Goldman Sachs still uncertain, but it certainly will shape the future of the financial industry in the United States.

Anna Timone (195 Posts)


Comments

  1. People hate when pure speculators win a lot. And more if they do it shorting. That’s why they want to change rules to favor investors and not speculators. But it is not going to be easy.

  2. This is clearly a case of fraud and not ingenious speculating. They designed these things to fail and even the brightest investors could figure out how they worked. Plus you have a reputable name backing it up, so clearly this is a case that needs to be heard in court.

    Great post Anna!!!

  3. I meant “even the brightest investors COULDN’T figure out how they worked”.

  4. zekelogan says:

    Why anyone would place an ‘egg’ they didn’t fully understand into their ‘basket,’ is beyond me. Although, I admit I’m not surprised in the least. People want, even demand products they don’t understand or need all the time. Funny thing too, is they get angry if you try to warn them of risks or recommend some alternative. They also get angry when a product doesn’t work they way they think it should or causes them some form of harm, even when they’ve been warned of the risks or complexity ahead of time. This is just experience from the land of retail, the fact that it sounds like things are quite similar in the investment world make sense to me. I wish it weren’t so, but… hey, what am I to do?

  5. There are so many levels to the game. Lehman had a balance sheet of 600b and a hole in it of 150b. That’s serious fraud. AIG too. There are a lot of heads that need to roll- this is just the beginning. And politically, Obama might be a ‘modern day Thomas Jefferson’ who moves more power (financial, in this case) to his backyard, in Chicago, where deals can clear on exchanges and be more ‘transparent’. It’ll be interesting to see what’s next for Obama’s SEC and CFTC. I’m guessing that position limits for oil contracts have to be on the table somewhere too, and that impacts Goldman in a different way…

  6. zekelogan says:

    I agree JR, dialogue and debate is exactly what needs to happen. I’m not opposed to regulation, I’m all for anything that increases transparency, etc… I think the question of whether or not Investment Banks should be allowed to operate as publicly-owned co.’s is a good one. Why rating’s agencies are getting tricked (or are they?) more often than we would like, is another. I’m not saying I know the right answers to them, but I think it’s something that should be discussed ;) I’d feel better if I heard more questions like those.

  7. Hey Zeke, There was so much balance sheet shenanigans going on at Enron, Citi, AIG, PNC, Lehman etc. that you have to conclude that Wall St was just one big commercial culture of fraud. You can’t legislate morality, but you can throw some of the buggers in jail, the modern day version of a public hanging, and let people know that there’s a new sheriff in town. At the end of the day, if guys like Langone and Grasso can do what they supposedly did to Spitzer (setup, honeytrap…), then the regulators don’t really stand a chance against the schemers. The SEC needs to start acting like a pitbull to protect the public financial markets- that’s the only way the clever, sneaky you-know-what’s on Wall St will stop playing the games that they play. To me, it’s simple: when the fraud is that extensive, obvious, and harmful to the public interests, you prosecute those who are responsible severely enough so that others are discouraged. Of course, it’s even more simpler than that. Back in the day, Keating et al knew they could get away with stuff because they had Senators like McCain in their pockets and guys like Neil Bush in their network, just like Enron had Bush I and II.

  8. Hey now watch your words about PNC. They only had a little bit of off balance sheet problems. They got caught paid their fines and cleaned up their act. They had a great balance sheet when this mess happened.

  9. zekelogan says:

    I’m most certainly anti-shenanigans ;)

  10. Annie, PNC were crooks. They were in it with Cassano and AIG.

  11. I’m from Pittsburgh, Jr. Thems fighting words. Smiley face since I don’t have them

  12. Cliff Barnes is also from Dallas- but that doesn’t mean that he isn’t a scoundrel :)

  13. Regulation of financial markets is needed, but not over regulation of Forex. Obviously, I am talking my book, but I would hate to see the proposed leverage rule go into effect. Also, I would like to see the FIFO and hedging rules repealed. Then, retail FX traders could enjoy better regulated markets AND the freedom to trade as they see fit, at a reasonable 100:1 or less leverage.

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