When
President Obama signs the new financial regulation act the
government will assume sweeping new powers over Wall Street.
The passage of this bill did not occur in a vacuum. The
administration carefully laid the groundwork by inculcating
public fear that the great financial houses betray investors
by rigging securities to fail. Exhibit A: the SEC's recent
fraud case against Goldman Sachs.
The agency's complaint alleges that Goldman Sachs defrauded
the investors in its Abacus 2007-AC1 fund by not disclosing
the role played in the fund's creation by John Paulson,
a hedge fund operator who stood to make an immense profit
if the fund failed. It might be a great conspiracy case-if
the SEC could come up with a plausible conspiracy.
Mr. Paulson wanted to make a billion dollar wager that subprime-backed
mortgages would collapse. So he went to Goldman Sachs, which,
like the other major financial houses, is in the business
of creating such customized gambling products for clients.
For a $15 million fee from Mr. Paulson, Goldman created
Abacus 2007-AC1. It provided exposure to a portfolio of
90 subprime home mortgage-backed securities. If the underlying
securities did not default, those who took the long side
of Abacus would collect handsome profits. If the housing
bubble burst, those who took the short side would win heavily.
Goldman found three participants to bet long-ACA Capital
Holdings, a bond insurer, IKB Deutsche Industriebank (a
Germany-based specialist in mortgage securities), and itself.
ACA went long on the deal. It sold a $900 million credit
default swap on Abacus and even invested most of the $40
million it got from selling the swap to Goldman in the Abacus
deal itself. ACA's wholly owned subsidiary, ACA Management,
had sole authority to pick every one of the 90 securities
in the portfolio. IKB bought $150 million worth of Abacas's
notes, and Goldman put up $90 million to complete the financing.
Mr. Paulson was the lone short, buying ACA's credit default
swap from Goldman. All four participants in the Abacus deal
had the same data about the 90 underlying securities. What
separated them was their opinion of the direction of the
housing market. Mr. Paulson felt it was headed toward a
collapse; ACA considered this so unlikely that it gave nearly
20 to 1 odds on its credit default swap. Mr. Paulson won
the bet.
So where is the fraud? The SEC says Goldman withheld material
information from ACA and IKB by not disclosing the history
of the deal, including Paulson's role in the creation of
Abacus. Of course, ACA knew someone was short the deal,
since it sold Goldman a $900 million credit default swap
precisely for that purpose. Goldman did not say that Mr.
Paulson was that counterparty. But his identity may not
have been a mystery to ACA.
Mr. Paulson's top lieutenant in the deal, Paolo Pellegrini,
testified to the SEC in its investigation of the matter
in 2008 that he had informed ACA Management that Paulson's
hedge fund was betting against the transaction. If so-and
Mr. Pellegrini had no reason to perjure himself since he
had no obligation to disclose anything-ACA possessed the
information that Goldman withheld, and went ahead with the
deal. IKB bank, which bought Abacus's AAA-rated notes, may
not have known about Mr. Paulson's role in Abacus.
The real issue here turns on the term "material,"
which the SEC defines as facts an investor would reasonably
want to know before making an investment. The agency contends
that Mr. Paulson's role in suggesting securities to ACA
was "material." Prior to this case, the SEC did
not always consider a deal's history material, taking the
position in hundreds of other such deals that how a fund
was constructed, including how its rating was achieved with
rating agencies, did not require disclosure. That was before
Wall Street became a political bete noire.
Nevertheless, the SEC voted in split decision (all the Republicans
voting against) to accuse Goldman of civil fraud. It alleges
that Mr. Paulson "heavily influenced" ACA Management
to pick losers but provides no theory as to why ACA Management,
whose corporate parent was risking $940 million, would do
anything but pick the least risky subprime bonds. As it
turned out, the subprime securities ACA picked for the portfolio
failed. But so did the vast majority of securities based
on subprime mortgages. Since 99% of them were marked down
by the rating agencies by the end of 2008, Abacus would
have likely suffered the same fate had ACA picked 90 other
such securities.
ACA's losses on Abacus were less than 5% of the $22 billion
in losses it suffered in its other subprime funds (in which
Mr. Paulson was not involved). When the time came to pay
off the Abacus wager, ACA, hit by $68 billion in credit
default swaps, couldn't make good. Its Abacus debt fell
to the Dutch bank ABN-AMRO, which had back-stopped ACA.
The Royal Bank of Scotland, which had the misfortune of
merging with the Dutch bank, paid Mr. Paulson.
No one can fault the SEC for wanting to restore faith in
Wall Street by ferreting out financial frauds. But its case
against Goldman Sachs does not add up. It implies a conspiracy
without co-conspirators. If Goldman had designed its own
fund to fail, it could have retained the credit default
swap it got from ACA for its own account rather than selling
it to Mr. Paulson. Instead, it invested $90 million of its
own money into Abacus. Goldman's records showed it lost
$75 million (after taking its $15 million fees into account).
The SEC has issued no complaint against Mr. Paulson in this
deal.
Not only is there no motive or logic for Goldman to have
sabotaged its own fund, but the SEC complaint fails to cite
any evidence it did. Nevertheless, it has brilliantly succeeded
in implanting that idea in the media. On April 18, Paul
Krugman stated in his New York Times column that "the
S.E.C. is charging that Goldman created and marketed securities
that were deliberately designed to fail, so that an important
client could make money off that failure. That's what I
would call looting." In fact, the SEC complaint never
alleges that Goldman deliberately designed any securities
to fail.
Even though the widely echoed "designed to fail"
charge is an invention, it helped convert a civil case of
nondisclosure into one of Grand Theft Wall Street in the
public imagination. The message-Wall Street deliberately
betrays investors-served a political end. It helped provide
cover for the government's desire to manage the financial
universe.
|