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Journalism of Courage
Goldman Sachs Group Inc was charged with fraud by the US Securities and Exchange Commission over its marketing of a subprime mortgage product,igniting a battle between Wall Street8217;s most powerful bank and the nation8217;s top securities regulator.
The civil lawsuit is the biggest crisis in years for a company that faced criticism over its pay and business practices after emerging from the global financial meltdown as Wall Street8217;s most influential bank.
It may also make it more difficult for the industry to beat back calls for reform as lawmakers in Washington debate an overhaul of financial regulations.
Goldman called the lawsuit 8220;completely unfounded,8221; adding,8221;We did not structure a portfolio that was designed to lose money.8221;
The lawsuit puts Goldman Chief Executive Lloyd Blankfein further on the defensive after he told the federal Financial Crisis Inquiry Commission in January that the bank packaged complex debt,while also betting against the debt,because clients had the appetite.
8220;We are not a fiduciary,8221; he said.
The case also involves John Paulson,a hedge fund investor whose firm Paulson amp; Co made billions of dollars by betting the nation8217;s housing market would crash. This included an estimated 1 billion from the transaction detailed in the lawsuit,which the SEC said cost other investors more than 1 billion. Paulson was not charged.
Fabrice Tourre,a Goldman vice president whom the SEC said was mainly responsible for creating the questionable mortgage product,known as ABACUS,was charged with fraud.
Goldman shares slid 12.8 per cent on Friday,closing down 23.57 at 160.70 on the New York Stock Exchange. The decline wiped out more than 12 billion of market value,and trading volume topped 100 million shares,Reuters data show.
The news dragged down broad US equity indexes,which fell more than 1 percent. The perceived risk of owning Goldman debt,as measured by credit default swaps,increased. Treasury prices rose as investors sought safe-haven government debt.
MORE SEVERE THAN EXPECTED
8220;These charges are far more severe than anyone had imagined,8221; and suggest Goldman teamed with 8220;the leading short-seller in the industry to design a portfolio of securities that would crash,8221; said John Coffee,a securities law professor at Columbia Law School in New York.
8220;The greatest penalty for Goldman is not the financial damages 8212; Goldman is enormously wealthy 8212; but the reputational damage,8221; he said,adding that 8220;it8217;s not impossible8221; to contemplate that the case could lead to criminal charges. Coffee spoke on Reuters Insider.
Goldman vowed to defend itself.
8220;The SEC8217;s charges are completely unfounded in law and fact,8221; it said. 8220;We will vigorously contest them and defend the firm and its reputation.8221;
E-mails from former Washington Mutual Inc CEO Kerry Killinger read aloud during a congressional hearing this week illustrated clients8217; concerns about working with Goldman.
In 2007,Killinger discussed hiring Goldman or another investment bank to help Washington Mutual find ways to reduce its credit risk or raise new capital,according to one of the e-mails,which Michigan Democratic Sen Carl Levin read during the hearing.
8220;I don8217;t trust Goldie on this,8221; Levin quoted one of Killinger8217;s e-mails as saying. 8220;They are smart,but this is swimming with the sharks. They were shorting mortgages big-time while they were giving Countrywide Financial Corp advice.8221;
The SEC lawsuit announced on Friday concerns ABACUS,a synthetic collateralized debt obligation that hinged on the performance of subprime residential mortgage-backed securities,and which the regulator said Goldman structured and marketed.
According to the SEC,Goldman did not tell investors 8220;vital information8221; about ABACUS,including that Paulson amp; Co was involved in choosing which securities would be part of the portfolio.
The SEC also alleged that Paulson took a short position against the CDO in a bet that its value would fall.
In a statement,Paulson amp; Co said it did buy credit protection from Goldman on securities issued in the ABACUS program,but did not market the product.
Tourre was not immediately available for comment.
Goldman had not disclosed that the SEC was considering a lawsuit but had known charges were possible and had urged the SEC not to file them,people familiar with the situation said on Friday. The sources requested anonymity because the probe was not public.
To better understand CDOs,the SEC in 2008 approached some hedge funds,including Paulson amp; Co,whose investment Paulo Pellegrini was among those to talk with the regulator.
By betting against subprime mortgage-related debt,Pellegrini helped Paulson8217;s firm earn an estimated 15 billion in 2007. Pellegrini last year left to start his own firm.
COMING OUT SWINGING
The lawsuit is a regulatory and public relations nightmare for Blankfein,who has spent 18 months fending off complaints that Goldman has been an unfair beneficiary of taxpayer bailouts of Wall Street.
Blankfein became chief executive less than a year before the product challenged by the SEC was created.
8220;This could be the beginning of a period where you have a regulatory cloud over Goldman Sachs,and perhaps even the entire investment banking industry,8221; said Hank Smith,chief investment officer at Haverford Trust Co in Philadelphia.
John Paulson is not related to Henry 8220;Hank8221; Paulson,who was Blankfein8217;s predecessor as Goldman chief executive and later become U.S. Treasury secretary.
The SEC lawsuit represents an aggressive expansion of regulatory efforts to hold people and companies responsible for the nation8217;s financial crises.
It could help the regulator rehabilitate its reputation after missing other high-profile cases,including Bernard Madoff8217;s Ponzi scheme.
8220;The SEC has come out swinging,8221; said Cary Leahey,senior managing director of Decision Economics in New York.
Robert Khuzami,head of the SEC8217;s enforcement division,said John Paulson was not charged because it was Goldman that made misrepresentations to investors,not Paulson.
Still,Khuzami called Paulson8217;s firm 8220;a hedge fund that had a particular interest in the securities performing poorly.8221;
MORE LAWSUITS TO COME?
It is unlikely that criminal charges will be brought,a person close to the matter said. Representatives for the Justice Department declined to comment.
Yet the lawsuit is widely expected to spur other lawsuits,and is 8220;probably the first of several,8221; according to Doug Kass,president of hedge fund Seabreeze Partners Management.
8220;Regulators and plaintiffs8217; lawyers are going to be looking at other deals,to what kind of conflicts Goldman has,8221; said Jacob Zamansky,a lawyer who represents investors in securities fraud lawsuits.
8220;I8217;ve been contacted by Goldman customers to bring lawsuits to recover their losses,8221; he added. 8220;With the SEC bringing fraud charges it8217;s going to expose what8217;s behind the curtain.8221;
E-MAIL TRAIL
According to the SEC,Goldman marketing materials showed that a third party,ACA Management LLC,chose the securities underlying ABACUS,without revealing Paulson8217;s involvement.
The SEC complaint quotes extensively from internal e-mails and memos,noting that in early 2007 it had become difficult to market CDOs tied to mortgage-backed securities.
It quoted a Jan. 23,2007,e-mail from Tourre to a friend as saying: 8220;The whole building is about to collapse anytime now 8230; Only potential survivor,the fabulous Fab 8230; standing in the middle of all these complex,highly leveraged,exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!8221;
Another e-mail,to Tourre from the head of Goldman8217;s structured product correlation trading desk,complained: 8220;The CDO biz is dead we don8217;t have a lot of time left.8221;
INDEPENDENCE MATTERS TO CLIENTS
Other communications detail the importance of hiring ACA.
The SEC said Goldman reached out to German bank IKB to buy securities that Paulson was selling,knowing it would buy only securities selected by an independent asset manager.
8220;We expect the strong brand-name of ACA as well as our market-leading position in synthetic CDOs of structured products to result in a successful offering,8221; a March 12,2007,Goldman e-mail said.
IKB ultimately took on exposure to ABACUS,as did the Dutch bank ABN Amro Holding NV.
The German government ultimately bailed out IKB in the summer of 2007,in part because of the bank8217;s investments,while lenders that eventually bought much of ABN Amro were also subjected to their own government bailouts.
In a statement after U.S. markets closed,Goldman said it lost more than 90 million on the transaction,six times the 15 million fee it received,and provided 8220;extensive disclosure8221; on the securities involved.
It also said it never represented to ACA Capital Management,which invested 951 million in the transaction,that Paulson was going to be a 8220;long8221; investor,meaning that Paulson was betting the securities would gain in value.
Paulson amp; Co paid Goldman 15 million to structure and market the ABACUS CDO,which closed on April 26,2007,the SEC said. Little more than nine months later,99 per cent of the portfolio had been downgraded,the SEC said.
Janet Tavakoli,president of Tavakoli Structured Finance Inc in Chicago and author of a book on synthetic CDOs,said it may have been common on Wall Street for hedge funds to play big roles in picking mortgage-backed securities for use in CDOs.
8220;Many investors were not aware of how disadvantaged they were by these CDO structures,8221; she said.
WASHINGTON IMPACT
The charges are expected to fuel anti-Wall Street sentiment on Capitol Hill where sweeping financial industry reforms are expected to soon arrive on the Senate floor for a vote.
A Democratic bill,strongly supported by President Barack Obama,would slap new restraints on major banks,likely curtailing their opportunities for profit and revenue growth.
Similar legislation was approved in the House of Representatives in December. Analysts believe a bill could be signed into law by Obama by mid-year.
8220;Banks were getting their mojo back,successfully fighting the regulatory reform bill,8221; said James Ellman,president of Seacliff Capital in San Francisco. 8220;Clearly,such malfeasance could help get the bill to go through.8221;
Goldman in 2008 won a 5 billion investment from Warren Buffett8217;s Berkshire Hathaway Inc.
Last month,Buffett praised Goldman as a 8220;very,very strong,well-run business,8221; and said of Blankfein,8221;You cannot find a better manager.8221;
Buffett had no immediate comment,his assistant Carrie Kizer said.
The SEC lawsuit was assigned to US District Judge Barbara Jones,who was appointed to the bench in 1995 by President Bill Clinton. She presided over the 2005 criminal trial of former WorldCom Inc Chief Executive Bernard Ebbers over an 11 billion accounting fraud at the phone company.
