The SEC filed a suit today (Friday, Apr. 16, 2010) against Goldman Sachs and Fabrice Tourre (a Goldman Sachs vice president who helped create the investment in question). See Story & Morgenson, U.S. Accuses Goldman Sachs of Fraud in Mortgage Deal, NY Times (Apr. 16, 2010). The suit accuses the huge investment bank of creating and selling a mortgage investment that it intended to fail, and betting against the investment. This involves Abacus 2007-AC1, one of 25 deals created to permit Goldman to bet against the housing makret in the months after the potential for catastrophe was becoming apparent to banks facing losses on their hitherto enormously lucrative mortgage securitization product.
According to the complaint, Goldman created Abacus 2007-AC1 in February 2007, at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst.
Goldman let Mr. Paulson select mortgage bonds that he wanted to bet against — the ones he believed were most likely to lose value — and packaged those bonds into Abacus 2007-AC1, according to the S.E.C. complaint. Goldman then sold the Abacus deal to investors like foreign banks, pension funds, insurance companies and other hedge funds.
But the deck was stacked against the Abacus investors, the complaint contends, because the investment was filled with bonds chosen by Mr. Paulson as likely to default. Goldman told investors in Abacus marketing materials reviewed by The Times that the bonds would be chosen by an independent manager.
"Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party." Id. (quoting Khuzami, director of SEC's division of enforcement).
Paulson, the hedge fund manager that wanted to short the housing bond market, was a good picker. 84% of the Abacus deal bonds, selected by Paulson as likely to default and good to go short against, were underwater within five months. These deals were synthetic CDOs --i.e., deals with junkier tranches from earlier CDO deals with mortgage loans and credit default swaps finangled to get high ratings from the ratings services; but where the "investor" in the deal was essentially buying the original subprime bonds underlying the embedded CDOs. Investors did not know they were investing in a group of bonds pre-selected for high likelihood of default.
Michael Lewis's book, the Big Short, mentions these types of deals as well. See, e.g.,the asterisked note on page 77, where Lewis notes: "Goldman was in the position of selling bonds to its customers created by its own traders, so that they might bet against them."
Goldman's stock has dropped 10% today, according to the Times. Maybe holding Wall Street's TBTF banks accountable for fraud will be a way to downsize them, supplementing whatever financial reform package can actually make it through Congress?