Goldman Sachs / SEC: political witch-hunting is no way to change a market

Reading the allegations against Goldman Sachs and Fabrice Tourre in the case of structured CDO scandal (aka Abacus), I am reminded of Spitzer and how a General Attorney used a witch-hunt as a political tool, only to be later exposed himself in the company of barely clad ladies.  I suppose the SEC is under intense pressure to deliver some scalps, and that going after the unapologetic and sometimes arrogant leader of the investment banking world delivered the biggest bang for the buck.  On the face of it, I have the distinct feeling that they are trying to play on the fear of financial innovation and need to find a culprit but actually do not have much of a leg to stand on.

In fact, they are in my mind polluting an important underlying debate about the sustainability of financial markets by trying to pin the blame on guys who benefited from the market exuberance.  A bit like blaming the CDS market for Greece’s credit trouble, it’s just misguided.  One should have a real societal debate about what constitutes sustainable growth, what leverage is acceptable for individuals and companies, understand that no amount of financial innovation can create profits out of thin air and just stop being so short-term focused.  In other words, we need to hack finance, not some random financiers who just happened to be the smartest guys in the room at the time.

There is a tendency to reduce the world to black and white complexity (such as the ridiculous “great vampire squid wrapped around the face of humanity” paranoia inducing article from Rolling Stone, now offline) which in my mind ends up diluting responsibility.  Everyone shares responsibility in the financial crisis, including those who thoughts they could live on debt forever.  It’s a societal failure that started a long, long time ago with a culture of irresponsible spending and leverage that spread everywhere.  I can understand why people are feeling good that there’s a bit of retribution (see DailyKos) but come on…  Pro-life / pro-choice type debates lead nowhere.  Complexity may not be satisfying, but it’s how the world works (e.g. read this).

When you look at Goldman’s role, it seems to have done what it usually does: matched opposite risk views and organised the transaction and its marketing.  You really need to dig into the details to get it but the vociferous press (including bizarrely a vociferous Felix Salmon at Reuters) seemed intent on spreading the news fast rather than do its journalistic job.

I like how Michael Hiltzik captures it, without throwing morality into it:

The real issue isn’t what Goldman knew or didn’t know about the larger economy. The issue is that Wall Street’s business model has become corrupted into one dependent on creating transactions that spin financial wheels to virtually no economic end, merely to generate fees and profits.

Business Insider (and Henry Blodget would know) predicts that Fabrice Tourre will be thrown under the bus and that GS will setlle.  He’s probably right.  Maybe he can give Fabrice a job.  Don’t think we will hear Lloyd Blankfein saying GS was doing God’s Work anytime soon…

Anyway, for those so enclined, here is my detailed review of this case:


First let’s look at the transaction: a synthetic CDO was put together based on a selection of Mortgage-Backed Securities and invested in by ACA Capital Management and German bank IKB.  At the origin of the transaction was Paulson & Co using a vehicle designed by GS.  Paulson & Co. took exposure on the synthetic CDO as a way to short the market through Credit Default Swaps.  Paulson proposed a large set of underlying instruments which ACA whittled down a selection that they felt comfortable with.  ACA then invested and also marketed the transaction to some of its clients, including IKB, with the help of GS as arranger.


The SEC papers do not disclose exactly how Paulson played it but I assume they did the following:

  • took some or zero long exposure on the equity piece of the CDO transaction (this is the first loss tranche that takes immediate hits from credit defaults).  I suspect some of the equity was sold off, some retained by Goldman, some by Paulson probably.  This is an unanswered question right now.
  • took short exposure on the more senior tranches of the transaction through credit default swaps (also arranged by Goldman)
  • made money on the discrepancy between the premium it was getting paid for the equity tranche and how cheap it was to get insurance on the senior tranches (i.e. meltdown risk mispricing) whilst both were going to default, or used the discrepancy to create principal default exposure in their favour.
  • Optically it may have looked like they were going long but in fact they were taking a short overall position on the portfolio.
  • Nasty ?  Maybe.  Intent is clearly hidden here.  Illegal ? No.  Like high stakes poker, this is for real pros only.

The whole case rests on the fact that marketing materials prepared by GS did not disclose the role and intent of Paulson in the transaction but only relied on ACA’s reputation as an experienced CDO agent.  Indeed, ACA previously had constructed and managed numerous CDOs for a fee. As of December 31, 2006, ACA had closed on 22 CDO transactions with underlying portfolios consisting of $15.7 billion of assets.

The SEC document can be found here whilst the Goldman Sachs placement document can be found here.

Have a look at the opening statements and how the SEC makes explicit reference to systemic risk:

The Commission brings this securities fraud action against Goldman, Sachs & Co. (“GS&Co”) and a GS&Co employee, Fabrice Tourre (“Tourre”), for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) GS&Co structured and marketed to investors. This synthetic CDO, ABACUS 2007AC1, was tied to the performance of subprime residential mortgage-backed securities (“RMBS”) and was structured and marketed by GS&Co in early 2007 when the United States housing market and related securities were beginning to show signs of distress. Synthetic CDOs like ABACUS 2007-AC1 contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.

ACA clearly played its role in selecting the assets

On January 22, 2007, ACA sent an email to Tourre and others at GS&Co with the subject line, “Paulson Portfolio 1-22-10.xls.” The text of the email began, “Attached please find a worksheet with 86 sub-prime mortgage positions that we would recommend taking exposure to synthetically. Of the 123 names that were originally submitted to us for review, we have included only 55.”

“GS&Co’s marketing materials for ABACUS 2007-AC1 were false and misleading because they represented that ACA selected the reference portfolio while omitting any mention that Paulson, a party with economic interests adverse to CDO investors, played a significant role in the selection of the reference portfolio.”

I think this argument is weak at best — you choose a respected manager in a segment to help you market assets, there is per se nothing wrong with not disclosing Paulson’s role.

Was a disclosure of Paulson ultimate intentions required ?

On January 10, 2007, Tourre emailed ACA a “Transaction Summary” that included a description of Paulson as the “Transaction Sponsor” and referenced a “Contemplated Capital Structure” with a “[0]% – [9]%: pre-committed first loss” as part of the Paulson deal structure. The description of this [0]% – [9]% tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche.

I believe it is probably that Paulson in fact did take the first loss risk (someone had to take it) but then hedged the exposure with credit default swaps on more senior tranches which were priced too agressively (cheaply) and did not capture the default risk appropriately.  Hence the arb.  But that’s what hedge funds do (the name may hold a clue :-)).

The SEC is making assertions that appear speculative at best, and has no smoking gun

“Tourre also misled ACA into believing that Paulson invested approximately $200 million in the equity of ABACUS 2007-AC1 (a long position) and, accordingly, that Paulson’s interests in the collateral section process were aligned with ACA’s when in reality Paulson’s interests were sharply conflicting.”

The crux of the argument is based on the following information which you should read attentively:

“On January 12, 2007, Tourre spoke by telephone with ACA about the proposed transaction. Following that conversation, on January 14, 2007, ACA sent an email to the GS&Co sales representative raising questions about the proposed transaction and referring to Paulson’s equity interest. The email, which had the subject line “Call with Fabrice [Tourre] on Friday,” read in pertinent part:  “I certainly hope I didn’t come across too antagonistic on the call with Fabrice [Tourre] last week but the structure looks difficult from a debt investor perspective. I can understand Paulson’s equity perspective but for us to put our name on something, we have to be sure it enhances our reputation.”

And then:

“On January 16, 2007, the GS&Co sales representative forwarded that email to Tourre. As of that date, Tourre knew, or was reckless in not knowing, that ACA had been misled into believing Paulson intended to invest in the equity of ABACUS 2007-AC1.”

Pardon me ?  An experienced CDO investor needs to be held accountable for its own investment decisions.  Paulson did probably take the first loss piece, what their overall view of the market is and what they did in related transactions is no-one’s business except Paulson’s. 


On the one hand is a counterparty (Paulson) who wants to short the market.  Said counterparty needs to find people in the market who have the opposite view and uses a bank (Goldman) to intermediate and find a sponsor (ACA) who is willing to put its name on it and market it to its investor base.  Paulson does not disclose its ultimate intentions, and neither does Goldman.  Because Paulson is apparently taking the equity portion, ACA seems to believe the Paulson is going long in the transaction, and the GS banker does nothing to disprove that assumption. 

Was he fraudulent in doing so, or doing his job and protecting the confidentiality of his client ?  Unless more details at to emerge from meetings and notes to point in that direction, I believe from what I read that Fabrice Tourre did nothing wrong.  At no point was Fabrice Tourre asked by his client ACA to confirm what Paulson’s  market view was to ensure their interests were aligned; they seem to have assumed that was the case. 

There is nothing in the documents to suggest Tourre made fasle representations, only that he did not disclose to them the overall intent of Paulson.  Yet that is preceisly the role of the bank: to intermediate between counterparties who have opposing views and interests. 

I don’t think you can sue people for being smart; here is what a Paulson employee wrote:

“It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytical tools nor the institutional framework to take action before the losses that one could anticipate based [on] the ‘news’ available everywhere are actually realized.”

The financial world is not pretty, because it’s all driven by short-term incentives and personal optimisation.   It’s the naked face of profit making and I can see why it would make people angry.  I left investment banking in 1999 when I realised that what is was doing was taking money off folks that were less sophisticated than myself.  But before taking the moral high ground, you need to think carefully through all this.  TAfter all, the first derivatives were futures used to help farmers protect against changes in the prices of crops.  

For reference, here is the Goldman Sachs line of defense:

  • Goldman Sachs Lost Money On The Transaction.  Goldman Sachs, itself, lost more than $90 million.  Our fee was $15 million.  We were subject to losses and we did not structure a portfolio that was designed to lose money.
  • Extensive Disclosure Was Provided.  IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities.  The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side.
  • ACA, The Largest Investor, Selected The Portfolio.  The portfolio of mortgage backed securities in this investment was selected by an independent and experienced portfolio selection agent after a series of discussions, including with Paulson & Co., which were entirely typical of these types of transactions.  ACA had the largest exposure to the transaction, investing $951 million.  It had an obligation and every incentive to select appropriate securities.
  • Goldman Sachs Never Represented To ACA That Paulson Was Going To Be A Long Investor.  The SEC’s complaint accuses the firm of fraud because it didn’t disclose to one party of the transaction who was on the other side of that transaction.  As normal business practice , market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor.

In 2006, Paulson & Co. indicated its interest in positioning itself for a decline in housing prices.  The firm structured a synthetic CDO through which Paulson benefitted from a decline in the value of the underlying securities.  Those on the other side of the transaction, IKB and ACA Capital Management, the portfolio selection agent, would benefit from an increase in the value of the securities.  ACA had a long established track record as a CDO manager, having 26 separate transactions before the transaction.  Goldman Sachs retained a significant residual long risk position in the transaction.
IKB, ACA and Paulson all provided their input regarding the composition of the underlying securities.  ACA ultimately and independently approved the selection of 90 Residential Mortgage Backed Securities, which it stood behind as the portfolio selection agent and the largest investor in the transaction.
The offering documents for the transaction included every underlying mortgage security.  The offering documents for each of these RMBS in turn disclosed the various categories of information required by the SEC, including detailed information concerning the mortgages held by the trust that issued the RMBS.
Any investor losses result from the overall negative performance of the entire sector, not because of which particular securities ended in the reference portfolio or how they were selected.
The transaction was not created as a way for Goldman Sachs to short the subprime market.  To the contrary, Goldman Sachs’ substantial long position in the transaction lost money for the firm.

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8 Responses to Goldman Sachs / SEC: political witch-hunting is no way to change a market

  1. Airelon says:

    “One should have a real societal debate about what constitutes sustainable growth, what leverage is acceptable for individuals and companies”

    1) You need to find people intelligent enough to do so, with the proper motive.

    2) Just that leverage of immense scale is permitted _ _ AND HOW THAT SCALE OF LEVERAGE CAME TO BE LEGAL _ _ illustrates a portion of mens rea in the case of Goldman Sachs in and of itself.

    3) Why have such a ‘debate’ – when large scale fraud can be committed, and leverage of 100 to 1 is still legal?

    One just needs to be a trader long enough to talk shop with guys from the street to hear all sorts of horror stories. Heck … I have a few of my own when the trading pits were finally being removed … the shenanigans that went on inside the pits. No one was prosecuting since the pits were going away, so no one would pay attention to the rules in their final days.

    On paper, one can make almost anything look legit. Especially when a firm does so on purpose. It doesn’t take long in this industry, to know how the crimes are actually perpetrated. You’d have to be a fool or naive to the innocence of a child not to understand what went on here.

    First you make immorality legal, and then you’re right … it’s just a “political witch hunt”. Morality becomes a side issue.

    Which is the whole problem. You need to change human nature. Which will NOT happen.

  2. Kevin says:

    Thanks Fred. I have been explaining this to some of my friends and I will just send them to this blogpost from now on! :-)

    Unlike what you hear on the news all day long… finally someone who understands that GS was matching supply & demand… which is the job of Wall Street. In other words: intermediate (in a confidential manner) parties that want to go long with parties that want to go short. ACA & IKB clearly liked the risk whilst Paulson was bearish. And GS did not lie about Paulson’s intentions.

    By the way, Paulson was most likely shorting the individual reference entities into GS… and GS just intermediated with the vehicle. On the other hand, Paulson bought the 0-10% as a hedge to manage their “downside” if the property market would not crash. (so in scenarios where there are no losses, they pay themselves the CDS premiums and just loose operating expenses and interest paid on the debt tranches…)

  3. Tim Ogilvie says:

    Interesting analysis – lots of great detail.

    That said, even if it turns out that Goldman did nothing wrong and the SEC has nothing, I think it’s become crystal clear that working with Goldman is like sitting down at a high-stakes poker game: if you’re not clear who the sucker is, it’s probably you.

  4. Pascal says:

    Thank you Fred for this detailed explanation. Reading the SEC document I had missed the fact that Paulson not just hinted that they bought the 0-9%, but very likely did buy it, both to hedge itself and as a bait for its naive counterparts. So Paulson was indeed long on a small part of the portfolio, but short overall. They did nothing wrong, except being smart, and identifying people who weren’t. And GS kept confidential information from its customers, as it should. You cannot blame people for legally doing what suits their best interest, and it is probably the global structure of finance which needs to be rebuilt, in order to avoid smart guys to rip off stupid ones.

    Hubris was probably as present at ACA and IKB as elsewhere, because they did look blind on this matter, when they should at least have realized that they were dealing with smart and better informed entities. When you are long on one billion $, either you know what you are doing or you hedge yourself. If you do not, it means that you are both overconfident and “under-intelligent”.

    I was an investor in a private company, the management of which offered me to exit. They had arguments justifying the “fair value” they were proposing, sustained by two well-known Private Equity firms whose interests where adverse but whose estimations for share price were similar. The guys were smart and better informed than me. And the timing was strange. Had I not been able myself to evaluate a sensible price for my shares (let’s say, twice higher (;-)) in spite of the lack of official information, I would nevertheless have let down the deal offer, because when there is a drought and when you are an antelope, you do not accept a glass of water from the lion next door…

  5. Alex says:


    I love the analysis and need to spend more time with understanding the full nature of the transaction.

    That said, given your perspective, how would you counter the argument that this just resembles your typical “pump and dump” investment scheme? (Where a series of analysts, 3rd parties, etc, put out lots of positive information on more thinly traded securities, then wait unsuspecting investors to buy in, raising the price, before ultimately dumping their shares for huge gains and screwing over the unsuspecting investors)

    I might say that a savvy investor should always due his/her due diligence, but I’d love to hear your thoughts.

  6. Davy Stevens says:

    Is it a fact that Paulson took the equity layer 0%-9%? That is not clear from the SEC filing in my view.

  7. It seems unlikely to me that JP bought an equity tranche. ABACUS was a synthetic CDO. In a synthetic, no one has to take an equity tranche. The only tranches that exist are the ones that are actually sold. I can bet GS that the Mets will win at least twenty games this year without someone betting that they will win more than that. Or I could bet that 85% of certain mortgage pools will pay off without someone betting that 100% will pay off.

    The term sheet showed an equity tranche, but that does not mean that anyone actually bought one. But even if Paulson did buy the equity tranche, only his net position matters to the fraud claim, as only his net position would, if known, have mattered to IKB or ACA.

    Whether GS had a duty to disclose JP’s position to IKB or ACA is a real question, but if GS had such an obligation, it is not satisfied by the fact that what it did say was true if what it did not say was more relevant.

    I agree that GS does not have to disclose who its counterparties are, if any. What GS did have to disclose, I think, was that the guy they put in the room to help to pick the portfolio was looking for trash. Not that he was short, and not that he was a counterparty, but that he was looking for trash. That’s a wholly different disclosure that has nothing to do with JP’s privacy as a client. He checked his client privacy rights at the door when he entered the portfolio selection room.

    ACA’s stupidity in accepting JP as a long is irrelevant. Yes, there’s no crying in baseball, but cheating should be punished for the sake of the game. The SEC represents the markets, not the victims of any particular scam. The foolishness of the victim says nothing about the danger that the thief poses to the system.

    ACA was acting as an insurer of the portfolio. Non-insurance types sometimes do not realize that objectively available information is not all that goes into an insurance underwriter’s decision. Insurers know better than to rely entirely on how things look. Every insurer considers the possibility of adverse selection. What does this guy who’s asking for insurance know that I don’t know? Does he have an insurable interest? Who is this guy helping to select the portfolio? Are we working together to select the best reference portfolio, or are we negotiating one? These are matters that insurance underwriters routinely consider to bolster their confidence in their own assessment. Or at least they should, and it just strains credulity that ACA did not tumble to Paulson’s position absent some intentionally misleading cues to the contrary.

    Of course, if Paulson’s CDS were treated as the insurance contract that it was, it would have been illegal for lack of insurable interest. CFMA 2000 purports to preempt state insurance laws, but I wouldn’t be surprised to find judges apply principles of tort law to do what insurance law would have done if it were not preempted. It’s really hard for the Feds to take away a state’s rights to protect people from tortious conduct. CDS’s without an insurable interest should be illegal.

    Finally, I believe you ask too much of IKB as a shopper. IKB was a foreign investor who came to a gilt-edged investment bank, demanded that an independent agent select the portfolio of US RMBS, and further demanded that their tranches be rated AAA. If that’s not enough, who needs investment banks, selection agents, and ratings agencies? And what foreign entity will want to hold dollars if the US financial services industry cannot be trusted to deliver good paper when asked – and paid! – to do so?

  8. Joe Cohen says:

    The defences being written for Goldman increasingly read like the defences of Phillip Morris, circa 1997. Logical, salient points of law that demonstrate a tin ear for the mood of the times.

    Most non wall-streeters believe GS has being getting over at their expense for a while and now it’s payback time. This case, more than the melt-down itself will permanently alter wall street’s place in our society.

    Unfair, inconsistent with the rule of law, specious? Yep on all three but still the reality of the day.