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SEC files civil fraud suit against Goldman Sachs in connection with selling of synthetic CDO which Paulson & co was shorting

Monday, April 19, 2010
Opalesque Industry Update – A move by the U.S. Securities and Exchange Commission (SEC) to charge Goldman Sachs, the world’s most powerful investment bank, with fraud, opened a whirlwind of calls to expand investigation from across Europe amid fears of new era of litigation that could entangle Goldman and other banks for years to come. Asian stocks also stumbled Monday on the back of Goldman’s investigation.

On Friday, the SEC charged Goldman Sachs & Co and one of its employees, Fabrice Tourre, with securities fraud for allegedly making material misstatements and omissions in connection with a synthetic collateralized debt obligation (CDO) that GS&Co structured and marketed to investors. This synthetic CDO, ABACUS 2007-AC1, was linked to the subprime mortgage crisis that hit the U.S. housing sector in 2007 (SEC’s report here).

SEC’s complaint
The SEC's complaint said the marketing materials for ABACUS 2007-AC1 represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management LLC, a third party with expertise in analyzing credit risk in RMBS. Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc., with economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO played a significant role in the portfolio selection process.

After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into CDSs with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure. Given its financial short interest, Paulson had an economic incentive to choose RMBS that it expected to experience credit events in the near future. GS&Co did not disclose Paulson's adverse economic interest or its role in the portfolio selection process.

Tourre was principally responsible for ABACUS 2007-AC1. According to the SEC’s complaint, Tourre devised the transaction, prepared the marketing materials and communicated directly with investors. Tourre is alleged to have known of Paulson's undisclosed short interest and its role in the collateral selection process. He is also alleged to have misled ACA into believing that Paulson invested approximately $200m 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 deal closed on April 26, 2007. Paulson paid GS&Co approximately $15m for structuring and marketing ABACUS 2007-AC1. By October 24, 2007, 83% of the RMBS in the ABACUS 2007-AC1 portfolio had been downgraded and 17% was on negative watch. By January 29, 2008, 99% of the portfolio had allegedly been downgraded. Investors in the liabilities of ABACUS 2007-AC1 are alleged to have lost over $1bn. Paulson's opposite CDS positions yielded a profit of approximately $1bn.

Paulson not charged in Goldman Sachs’ controversy
Hedge fund billionaire John Paulson was dragged into Goldman Sachs’ fiasco as his investment vehicle was said to have benefited from the subprime mortgages. However, SEC enforcement chief Robert Khuzami said Paulson was not included in the charge sheet due to lack of evidence that he had violated any law when he bet against the CDOs.

Paolo Pellegrini, who used to co-manage Paulson & Co.'s credit opportunities funds, reportedlycooperated with the SEC in the case against Goldman Sachs.

Paulson & Co said it had no authority over the selection of assets linked to a Goldman Sachs mortgage security from whose decline it later profited.

Paulson, who made $15bn in 2007 by betting that Americans would default on their home loans in droves, is reported to be a major Democratic contributor. The Hill said that Paulson, founder and chairman of the hedge fund Paulson & Co., gave $30,400 to the Democratic Senatorial Campaign Committee in June last year.

Tip of the iceberg
The SEC suit sent Goldman's stock down 12.8%, and the broader equity markets down more than 1% said Alibaba.com. There were fears the suit could cast a regulatory cloud over the entire investment banking industry. The value of Warren Buffett’s options to buy Goldman Sachs Group Inc. shares dropped by $1.02bn.

This suit is the agency's biggest assault on a Wall Street firm in a matter stemming from the credit crisis, said the Wall Street Journal. A successful outcome for the SEC could go a long way in repairing its reputation, which was damaged by its failure to discover Bernard Madoff's Ponzi scheme and other shortcomings that emerged during the crisis. The paper added that Goldman will be judged on whether the information it failed to tell its clients was material, meaning important or relevant, something a buyer would want to know before buying. But Bloomberg said the case against Goldman may turn on the meaning of the word “selected.”

Industry experts said that the charges against Goldman Sachs were based on weak evidence and would not hold water in court, but the allegation could entangle Goldman and other banks for years to come. The SEC is investigating whether other mortgage deals arranged by some of Wall Street's biggest firms may have crossed the line into misleading investors, said the Wall Street Journal.

James Hackney, professor at Northeastern University School of Law, described the charge as “just a tip of the iceberg.” He was quoted by AP as saying: "There are a lot of folks out there in different deals who played similar roles, and once it starts building steam, plaintiffs' lawyers will figure out this is where the money is and there should be a lot of action,” referring to the feared torrent of lawsuits to follow.

But even as the ink of SEC’s fresh accusation against Goldman Sachs is drying, U.S. lawyers are already busy looking for investors who lost money on Goldman’s Abacus products to file a possible class action against the bank, reported Timesonline.co.uk.

Richard Blumenthal, the Connecticut attorney-general, said that he had begun a review of the case. And Keller Rohrback, from a class action firm, said: “We are investigating other synthetic collateralised debt obligations marketed by Goldman Sachs in which Goldman or persons acting in concert with Goldman bet against securities Goldman sold to its client.”

Germany, UK mull legal action against Goldman
The backlash against Goldman Sachs immediately drew potential new lawsuits as the UK and Germany said they were considering taking legal action against the investment bank. British Prime Minister Gordon Brown called on the Financial Services Authority (FSA) to conduct a formal inquiry into Goldman. Brown accused Goldman Sachs of “moral bankruptcy” over plans to pay substantial bonuses as he ordered the FSA to coordinate with its U.S. counterpart, the SEC, to ascertain whether the bank had tricked investors into buying bogus mortgage securities.

Ulrich Wilhelm, spokesman for the German government said they were considering legal actions against the bank. He said German regulator BaFin would ask the SEC for more information on its securities fraud charge against Goldman Sachs.

Asian stocks plunged on Goldman Sachs probe
The Asian markets stumbled on Monday, dragged by Goldman Sachs’ controversy, said Business Week. The MSCI Asia Pacific Index fell 1.3% to 126.61 as of 10:42 in Tokyo, with 13 stocks declining for each one that advanced.

Japan’s Nikkei 225 Stock Average declined 1.7% and South Korea’s Kospi Index dropped 1%. China’s Shanghai Composite Index declined 1.7% after the government stepped up measures to curb gains in real-estate price gains.

The Australian dollar and the New Zealand dollar both fell against the U.S. dollar too.

North American stocks hit too
The North American markets were the first to be hit by the probe into Goldman Sachs, said Business Week. The U.S. stock futures fell, extending the biggest one-day decline in more than two months as contracts on the Standard & Poor’s 500 Index expiring in June slipped 0.4% to 1,185.9 as of 8:13 a.m. in Tokyo. The benchmark index for American equities retreated 0.2% last week, halting the longest streak of gains in a year. Nasdaq 100 Index futures dropped 0.3% to 2,004.5.

On Friday, Canada’s dollar posted its biggest five-day decline in seven weeks as stocks and crude oil tumbled.

But the fraud suit is unlikely to send hedge funds scrambling to reduce gold holdings, Superfund Financial Singapore Pte told Bloomberg today. Gold for immediate delivery was little changed at $1,136.57 an ounce at 11:57 a.m. in Singapore after slumping by the most in more than two months on April 16.
–Dumlao & Gravrand


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