SEC v Goldman -Who Wins and Why? Part 1

Let's start with a disclaimer.   Actually many disclaimers, sort of a Goldman therapy session.  I own a little stock in Goldman and a few shares of funds managed by Goldman.   I normally root for the underdog and against teams like the Yankees, and Goldman.    I think stories are more interesting when they have a villain.  I am irritated by most general interest media stories on financial topics, especially first day stories,  because in the drive to produce an elegant, black and white story  – they just get it horribly wrong.

In 2007, John Paulson (now a gazillionaire hedge fund rock star, back then, just another hedge fund billionaire) recognized that many mortgage backed securities were about to head south, fast.  Paulson went to Goldman looking for a vehicle that would allow him to short selected pools of mortgage backed securities.  Goldman proposed participation in a new synthetic collateralized default obligation (CDO), one in a series of synthetic CDOs Goldman had been sponsoring for three years.  At this point, we'll turn to a description from Bob Rice writing for the Huffington Post, with our own parentheticals to introduce points made elsewhere in his original post:

“ like betting on a sporting event, with the SPV (special purpose vehicle, a company set up by Goldman just for the synthetic CDO) as the bookie. An entity known as a "selection agent" picks the pile of CDOs (pools of real, not synthetic, mortgage loans)  on which wagers will be taken, known as the "reference" securities. Investors, who think this group of CDOs will pay off as scheduled (again, to whoever really owns them, not the investor in the synthetic... he's just a spectator) go "long" by buying bonds from the SPV. Folks who want to take the "short" side of the bet buy a CDS (credit default swap – a contract in which the short collects from the SPV if the reference securities are not paid off as scheduled) from the SPV. The SPV, our bookie, holds the proceeds from the long and short sides, and pays out to the winner.”

In SEC v Goldman, the longs are sophisticated institutional investors, including ACA.  The selection agent is also ACA.  The short is our friend Paulson.  Paulson participated  significantly in the selection of reference securities, although ACA had the final say.

The case seems to hinge entirely on Goldman's disclosure of Paulson's role.  Remember, Paulson was going short, his goal was to get the worst of the worst selected as reference securities.   The SEC claims Goldman led ACA to believe that Paulson was going to be a long.  This would explain why ACA (which was going long for big money, not just functioning as a reference selection agent) accepted many of Paulson's proposed reference securities.  Goldman denies misleading ACA about Paulson's role and argues that it had no duty to disclose who the short(s) would be.

Did Goldman suggest Paulson was a long?  Laura Schwartz of ACA noted her confusion on Paulson's role.  Then came an e-mail from Goldman's fabulous Fabrice Tourre to Laura Schwartz:

“Transaction Summary” in which Fab stated that the transaction was “sponsored by Paulson” and included the line: “ – %: pre-committed first loss,” (GS MBS E-003504901) which the SEC  Staff stated described as the equity tranche;
The e-mail's meaning is not crystal clear, but, as the SEC staff noted, normally only a long would take a loss on the reference securities underperfomance and only a long buying the high risk/high return equity tranche would take the first loss.

Goldman is now claiming other evidence that at least one person at ACA and one of ACA's advisors knew Paulson was going short.  If true, this still doesn't mean the ACA personnel managing selection of the reference securities knew, but it would help Goldman's case.

If Fab did mislead ACA on Paulson's position (or maybe just delayed a little in clearing up some confusion at ACA), is that fraud?  Even if ACA thought Paulson was a fellow long, ACA still had the responsibility and the capability to assess the quality of the reference securities.  ACA also knew that someone, if not Paulson then some other knowledgeable shark,  had to be taking the short side of the transaction.  Without equal money on both sides  the deal couldn't work and wouldn't close.  In other words, if ACA had understood the big picture and stayed on top of its duties in selecting the reference stock, then Paulson's recommendations would not have meant much.  Paulson's position as long or short then becomes immaterial, and the fraud claim loses.

More to come - see Part 2 here at Justmeans Sustainable Finance

Photo credit: Robert Brook