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Goldman Sachs Fraud Charges Could Be Just The Beginning, Say Analysts

First Posted: 06/16/10 06:12 AM ET Updated: 05/25/11 05:10 PM ET

Wall Street

Securities fraud charges against Goldman Sachs are just the beginning as federal regulators and investigators comb through the wreckage of a fraud-induced recession, caused by a pervasive and systemic culture of deceit at Wall Street's biggest firms, say Wall Street analysts.

The firm, infamously dubbed the "great vampire squid wrapped around the face of humanity," was charged Friday by the Securities and Exchange Commission with fraud for selling securities to investors that were handpicked -- and destined -- to fail, without disclosing that to investors. The immediate losers were pension funds, foreign firms and private investors, who lost more than $1 billion on this single security.

But what happened to this particular security, a collateralized debt obligation named ABACUS 2007-AC1, is emblematic of Wall Street's role in fueling the housing boom, and then profiting off its bust, experts say. A hedge fund -- betting on a bursting of that bubble, knowing the home mortgages on which that security was based -- helped pick the worst of that lot to be included in that security. Goldman didn't disclose that to investors, who happily gobbled it up.

Meanwhile, that hedge fund, Paulson & Co. Inc, made $1 billion. The investors lost about an equal amount. Goldman, meanwhile, racked up the fees.

"In sum, [Goldman Sachs] arranged a transaction at Paulson's request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson's role in the portfolio selection process or its adverse economic interests," reads the SEC's complaint.

Knowingly selling junk to investors that you're expecting to go bust is fraud. Yet that's what happened during Wall Street's go-go years, as firms knowingly funded fraudulent and predatory mortgage lenders, packaged their loans into securities and sold them to the market. The bubble eventually popped, causing trillions to be lost worldwide. Millions of families lost their homes. More than 8 million U.S. jobs were lost. And the U.S. is in the midst of the worst economic downturn since the Great Depression.

The panel created by Congress to investigate the roots of the financial crisis also is investigating the matter, the panel's chairman said. Tucker Warren, the panel's spokesman, told the Huffington Post that the commission "was aware of the impending charges."

"This is an issue the Commission has expressed interest in, inquired about and believes is of serious concern," said Phil Angelides, chair of the Financial Crisis Inquiry Commission. "What the Commission sees as its central mission is whether practices like this were widespread
in the marketplace or isolated incidents."

The allegations against Goldman go to the "very trustworthiness of the marketplace," Angelides said.

"It's significant to investigate because they go to the question of whether practices destabilized the marketplace," he said, as opposed to what Wall Street firms and their federal overseers refer to the meltdown as a confluence of unanticipated events. "If you have a major market participant creating securities, then betting against them and not fully disclosing that to investors, that's significant."

Janet Tavakoli, a Chicago-based derivatives expert and founder of Tavakoli Structured Finance, also understood the serious consequences of the SEC action: "It's all related to activity of aiding and abetting fraudulent mortgage lending, creating phony securitizations and mis-selling them. Massive damage came from the massive risk of massively leveraging securities that could only go down in value, because they created those bad securities. It was malicious mischief."

"But the kind of damage that was done was so severe and pervasive that the entire U.S. economy was damaged, so it's extremely important that the SEC has filed a fraud suit.

"And by the way, this won't be the end of it," said Tavakoli, who blogs at the Huffington Post.

Christopher Whalen of the IRA Advisory Service said in a note to clients that "[t]he SEC move marks an escalation in the battle to expose conflicts of interest on Wall Street. The key issue was the duty of care firms had to buyers of securities vs. trading strategy/relationship[s]...

"Once upon a time, Wall Street firms protected clients and observed suitability, know your customer," Whalen wrote. "This litigation exposes the cynical, savage culture of Wall Street that allows a dealer to commit fraud on one customer to benefit another."

"It is time to compel dealers to go back to the old rule of putting the customer first and not taking advantage of one customer to advantage another," he noted.

Whalen anticipates hearings and more regulation on the presently unregulated over-the-counter (OTS) derivatives market.

Initially, Goldman responded to the charges with a one-sentence statement: "The SEC's charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation." The firm expanded on its statement late Friday afternoon. [SEE BELOW]

Tavakoli, while applauding the SEC's move, said the agency was likely compelled to act based on the credible experts calling for action.

"The SEC itself has shirked its responsibilities in these matters for years," she said. Referring to the extensively-documented nexus between "failed mortgage lenders, predatory lending, massive mortgage fraud and the creation of these securities," the SEC's "hands have been forced by public voices," Tavakoli said.

However, while the emerging consensus points to further action by the SEC, it's unclear how much further it will go. For example, the agency was publicly rebuked by a federal judge in New York for levying an insignificant fine on Bank of America for disclosure issues pertaining to its takeover of Merrill Lynch.

But in going after Goldman Sachs, the SEC is sending a message, Tavakoli said. Firms like JPMorgan Chase are reserving more of their cash for an expected onslaught of lawsuits, according to regulatory filings. JPMorgan set aside an additional $2.3 billion for "increased litigation reserves, including those for mortgage-related matters," according to its first quarter filings released this week.

"It's a matter of public policy," Tavakoli said.


Goldman's full statement below:

Goldman Sachs Makes Further Comments on SEC Complaint


The Goldman Sachs Group, Inc. (NYSE: GS) said today: We are disappointed that the SEC would bring this action related to a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact.

We want to emphasize the following four critical points which were missing from the SEC's complaint.

*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.

Background

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's substantial long position in the transaction lost money for the firm.

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