How Goldman lost its glitter

Goldman Sachs, the most profitable securities firm in Wall Street history, released more than 70 pages of email and other documents on Sunday ahead of a US Senate subcommittee hearing on the firm’s actions throughout the mortgage meltdown. The firm disputes the US Securities and Exchange Commission’s (SEC’s) claim that Goldman Sachs misled investors in a 2007 collateralised debt obligation (CDO) about the role played by hedge fund Paulson & Co, which bet the CDO would collapse. What is the entire issue and what are SEC’s allegations? What are the issues that have shrouded Goldman Sachs? Business Standard brings you a ringside view of the entire issue.

What is the charge against Goldman?
SEC has accused Goldman Sachs and its employee, Fabrice Tourre, of “making materially misleading statements and omissions” in connection with a synthetic collateralised debt obligation (CDO) — Abacus — that the firm structured and marketed to investors.

What had happened?
Goldman Sachs is said to have created marketing material about Abacus and invited its clients — investment managers of banks, insurance companies, pension funds, etc — to invest in the CDO. It is said to have given an impression to the investors that the residential mortgage-backed securities that made up the CDO were hand-picked by ACA Management — then seen as a reputable fund manager, looking after dozens of CDOs. Goldman clients invested in the CDO, believing these loans were of good quality.

What happened after that?
The SEC complaint alleges that John Paulson, a famed fund manager who was looking to bet against the subprime market, was involved in the process of selecting assets for the CDO and heavily influenced the portfolio that made the Abacus CDO. Moreover, he subsequently purchased through Goldman Sachs insurance that would pay out if the CDO failed. It did fail and Paulson made $1 billion from the mess — roughly the same amount the investors lost.

What more?
Paulson allegedly paid Goldman a fee for putting the CDO together. His firm is said to have paid about $15 million. So, at the risk of repetition, he pays a fee for Goldman to create an instrument, which fails within a year, and his firm makes $1 billion.

So, Goldman colluded with Paulson to help him make money?
SEC claims Goldman deliberately hid from its clients Paulson’s involvement, which was a huge conflict of interest. Since Paulson was looking to short the subprime market, he was most likely to have picked the worst possible bonds.

Within a year, 99 per cent of the assets within Abacus were downgraded. Paulson, who was by this time betting against Abacus by buying $15 million worth of credit default swaps (CDS) on Abacus, earned around $1 billion from the trade.

Now, ACA Management was to vet the portfolio and it did not accept all of Paulson’s recommendations. But SEC also claims Goldman misled ACA into believing Paulson was going to be an investor and that he wanted it to go up in value. Goldman, however, refutes this.

But why did investors buy the CDO?
Because Goldman Sachs and ACA management — both prestigious firms — were involved in it. Besides, the CDO or parts of it attracted AAA or Aaa ratings from agencies.

Were people aware of Paulson’s short-selling business?
The SEC suit points out Paulson created two funds — Paulson Credit Opportunities I and II — for shorting the subprime market through CDS on various debt securities. This was before this particular episode with Goldman Sachs.

How did Paulson’s profits come by?
He bought CDS from Goldman. CDS is like fire insurance on a house. If the house does not catch fire, you lose some amount that you paid as premium. But if it does happen to catch fire, you get the house’s entire value back.

By allegedly allowing Paulson to pick some of the underlying content of Abacus, Goldman was essentially allowing him to build a house incorporating the most flammable materials in the market, ensuring that any rise in temperature — read subprime market overheating — led to a mighty fire.

Why did Goldman allow Paulson to do this?
Paulson was part of Goldman’s “select” clientele.

In January 2007, Fabrice Tourre attended a meeting with Paulson’s representatives to discuss the proposed transaction, starting a chain of events that would eventually lead to a prosecution by SEC.

Why did Goldman Sachs keep Paulson’s involvement a secret?
Goldman Sachs and Tourre “knew it would be difficult, if not impossible” to sell the Abacus CDO to investors if they disclosed that a renowned hedge fund manager was not only shorting it, but was also involved in the construction of the portfolio.

SEC also alleges that Goldman and Tourre knew many institutional clients like AKB Deutsche Industrebank would not buy the CDO without an independent third-party manager being in the selection of the portfolio.

By late January 2007, Goldman Sachs had drafted in ACA Management to lend it a strong brand name and credibility.

Were Paulson and Goldman Sachs the only ones doing the trade?
No. According to Michael Lewis’ book ‘The Big Short’, several other hedge funds were doing this trade. Likewise, several other investment banks — Deutsche Bank, UBS and Merrill Lynch — were active in this field. Whether or not they sold synthetic CDOs in the same manner is not known.