What happened
On April 16th, 2010 Goldman Sachs was charged with civil fraud by the Securities and Exchange Commission (SEC). The DOW might have taken a hit that day – but what this unsavory event hides is much more disturbing.
Another Wall Street scandal
The market collapse was triggered when news surfaced that a wealthy New York investor named John Paulson, during the height of the US real-estate boom, decided to bet that a national housing market crash was just around the corner. As early as 2005 he turned to banks for help structuring a deal that would allow him to make billions of dollars if he were right. Goldman Sachs was willing to help.
Over the course of 2006 and 2007, Goldman and Paulson assembled together something called a collateralized debt obligation (CDO). Basically they created a portfolio full of bad investment ideas all related to the housing market. They then made wagers against the portfolio which contained mortgage-backed bonds that were doomed to fail as the housing market collapsed. Paulson was right because this is just what happened the next year in 2008.
The NBA team, the coach and the bookies
To put it in perspective, imagine Phil Jackson putting together a new Lakers roster comprised of players who all are extra buff and seven feet tall, but can’t make a basket if their lives depended on it.
Only Phil knows that. Yet he tells LA’s most prominent bookies to go about town hyping the new team to the max by telling fans how great the season is going to be. They lure everyone to bet 10-to-1 on the Lakers winning the title – when in fact they, as insiders, know with certainty the team is going to lose every game they play. Of course, Phil places his own 10-to-1 bet against his own team – and makes himself and the bookies a fortune when, sure enough, the ill-fated team loses. It was a surefire but not very honest way to make quick cash on the back of others!
This is exactly what happened when Goldman Sachs (the bookies) started packaging and selling Paulson’s (in the role of Phil Jackson) sub-prime mortgage-ridden portfolio (the rotten Lakers team) to unsuspecting investors (the Lakers fans)!
A wise ploy to get away with it
Now it was a little more complex in reality. Before they could market the idea, Goldman Sachs had to first give it credibility. So the bank approached a firm called ACA Management. ACA happens to be a firm with lots of experience analyzing risky investments related to the housing market. Goldman and Paulson knew that wealthy investors would see ACA’s involvement in helping to select what went into the portfolio as a “stamp of approval” which would make it easier to sell to clients.
After some back and forth between Paulson and ACA Management, they eventually agreed to include 90 highly risky mortgage bonds to go inside the portfolio. ACA however was unaware that Mr. Paulson was planning on shorting it. It should be noted that ACA Management has not been charged in the SEC suit.
After the investment vehicle was created, Goldman Sachs began selling the product by assuring clients the portfolio was selected by a party with “similar economic interest” as investors who are buying into it. What Goldman failed to mention is that John Paulson was the architect and was planning on selling it short. However they did not fail to mention ACA’s involvement because ACA’s good name helped lend the package authority. How convenient!
Like shooting fish in a barrel
Almost immediately the portfolio began to lose value when sub-prime borrowers could no longer pay their mortgages. Had people continued paying their mortgages in 2008 and on, Goldman Sachs and John Paulson would have lost a fortune, because their bet would have gone against them! Nevertheless they knew in a few months that the housing crisis would cause thousands of home owners to begin defaulting on their loans.
The investors in the Paulson/Goldman portfolio lost over $1 billion, which translated into profits for Paulson of about $1 billion. Royal Bank of Scotland (RBS) was one of several institutional investors in the ill-fated CDO. It lost more than $800 million in the process. Goldman on the other hand was paid a handsome $15 million for its work, according to the SEC.
The SEC isn't alleging that Paulson did anything wrong, or that Goldman was wrong in working with Paulson. The alleged fraud happened, the agency says, because Goldman never told its investors of Paulson's role in creating the security. Also, the SEC alleges, Goldman misled ACA about Paulson being short on the deal.
Trial court vs. court of public opinion
Basically this is a case of misrepresentation. Goldman Sachs failed to reveal to some of its clients that another customer with a contrarian bearish view of the market had an active hand in assembling the portfolio. Goldman Sachs argues it was not compelled to disclose another party’s involvement in a deal, and that anonymity is crucial when creating fluid and dynamic markets – and is, in fact, at the very heart of trading.
Goldman Sachs’ motto is that the business of investment banking depends on trust, integrity and putting clients’ interests first. No matter what happens inside the court room, the bank now has a serious PR problem! Even more so, it’s hard to imagine the damage done to their reputation inside the court of public opinion. Time will tell whether they’re guilty or not. But for America’s middle class and all investors, small or big, the verdict is guilty as charged.
Goldman Sachs’ PR nightmare
For Goldman Sachs to regain investor trust, they should abandon tried and true public relations strategies that call for a blitz defense. Instead of saying it will fight the charges aggressively and that the SEC’s suit is “completely unfounded”, the bank should view this matter from the perspective of clients, small individual investors and the general public who already feel the game is rigged against them. Instead of fighting, Goldman should follow the play book Johnson and Johnson used during the 1982 Tylenol murders: lay low and cooperate fully with investigators.
When a firm the size and reputation of Goldman Sachs, which depends on trust and integrity, is suddenly accused of wrongdoing, it needs to get ahead of the story. It needs to find out the facts early on, share them with the public, impose accountability on its employees, and take any steps necessary to correct the problem. We should have learned about the Paulson deal from Goldman Sachs itself, not from the SEC!
Atonement
John Paulson was certainly smart to bet against sub-prime mortgages. Still, the amplitude and the secrecy around the creation of the Paulson-customized security (which was called "Abacus 2007-AC1" in Goldman Sachs lingo) are astonishing, if not disturbing.
This raises several uncomfortable and necessary questions. Can the bank explain why a short seller the caliber of Paulson was allowed to assemble a portfolio he was planning to bet against? Who was really responsible for giving John Paulson such incredibly privileged access, but chose to keep investors in the dark? Was it Fabrice Tourre, the 31-year-old Stanford graduate named as a defendant in the SEC suit? Or was it the person he reported to? What was the hierarchy of oversight? What did Goldman Sachs really receive in return?
Hopefully these are isolated incidents confined to a group of rogue individuals. One can dream, but Goldman Sachs needs to show humility by acknowledging the problem with the deal it structured and take whatever steps are necessary to prevent it from happening again. Anyone with a bit of common sense can see that the deal revolving around Abacus 2007-AC1 lacked integrity, fairness and professionalism – the exact mantra Goldman Sachs ironically prides itself on.
Someone has to be held accountable, even if it’s a highly valued and esteemed Goldman executive. To save its tarnished reputation, the bank needs to disclose if there are other investigations we should know about. Executives must take these steps and act quickly without being ordered to do so by regulators or Congress. Some of the decisions they’ll have to make will hurt and Goldman could (and should) face tough criticism. But it will make them a stronger and better company in the end.
