The Government's Civil Suit Against Goldman Sachs

The weekend edition of the Wall Street Journal contained several articles pertaining to the SEC's recently-announced fraud suit against Goldman Sachs in the matter of mortgage-backed securities allegedly designed to the specifications of hedge fund manager John Paulson, so the latter could bet on the securities' expected declines in value.

According to the articles in the Journal, Paulson, seeking ways to short the housing bubble, approached Goldman in late 2006 with a list of mortgage portfolios to securitize, against which he could bet using CDOs. Goldman recruited ACA Management to construct Abacus, the security Paulson desired, without informing the company that the security's designer, Paulson, expected it to lose value. Goldman then sold the securities to customers, apparently in 2007, allowing Paulson to buy credit-default swaps from Goldman on the Abacus securities.

If this is all true, there appear to be two aspects to the dealings which cause consternation.

The first is Goldman's accepting an underwriting assignment from Paulson to design and sell securities intended to lose their value. The second is Goldman's implementing this plan without informing the firm they tasked to construct the security, or the customers to whom it sold the instruments.

The Journal article contends that at least one other investment bank, Bear Stearns, declined to do Paulson's bidding in this matter.

Most observers would probably characterize Goldman as being cynical and perhaps unethical in its dealings in the Abacus/Paulson matter. But fraud? I don't think so.

In a prior post concerning regulation, I wrote that one is naive to think any sort of regulatory "reform" will ever curb ruthless practices among trading and underwriting businesses in the pursuit of profits. Mind you, I don't mean illegal. Simply sharp, brazen activities which may leave counterparties with heavy losses, or bankrupt.

That's the way it is in capital markets. It's just business.

It's tempting to believe Goldman is somehow guilty of something for having sold securities which John Paulson believed would plummet in value. However, I can't recall any underwriters of securities ever guaranteeing that the value of the securities in question would rise.

The sophisticated institutional investors whom Goldman approached should all have done their own due diligence on the Abacus securities, as well as assured themselves that buying mortgage-backed securities in 2007 was astute.

Evidently, they didn't do this.

Is this Goldman's fault? No.

Granted, there are those institutions which will buy from Goldman because of the firm's reputation. I think it's a mistake, but, there you are. Some institutions do foolish things.

Was Goldman doing anything wrong in retaining ACA Management to create a security, Abacus, according to Paulson's criteria, while not telling ACA of this connection, and that Paulson expected Abacus to fall in value?

Technically, it would seem not. Unless Goldman's staff, when selling Abacus, gave assurances of the quality and prospects for the securities, it's unclear that Goldman defrauded anyone. I would be surprised if documents exist at Goldman Sachs indicating that senior executives knew of and shared Paulson's beliefs that the value of Abacus securities was highly probable to fall precipitously.

More astutely, it would seem that Goldman, having a ringside seat at the capital markets, used its knowledge of Paulson's plans and beliefs to do its own shorting of mortgage assets in its own proprietary trading.

Again, sharp practices, but, frankly, part of the benefits of deal flow accruing to a highly-ranked investment bank.

In capital markets, securities change hand due to differing outlooks and expectations. For every buyer, there must be a seller.

Could one not theoretically hold any investment bank liable for selling securities which, subsequently, declined in value?

Should every investment bank client verify that the seller of a security is retaining some for itself before buying any of the instrument? Probably so.

But investment banks, narrowly defined, aren't in the business of holding assets. Merely underwriting.

This brings up another point about Goldman, in particular. As I opined to someone last week, the Goldman Sachs of Lloyd Blankfein is an entirely different firm than that of John Whitehead.

Whitehead was scrupulous about keeping Goldman from competing against its underwriting and trading clients through excessive proprietary trading. That is no longer true.

To the contrary, Goldman runs a large asset management unit, as well as proprietary trading operations.

Frankly, it is naive for any institution to deal with Goldman on faith, alone, in any business dealing. Because of the various, substantial conflicts of interest among Goldman's businesses, between the firm and some of its clients, who are often counterparties of proprietary trades by the firm, any firm purchasing securities from Goldman, whether as trades or through underwriting, should be independently certain of the value and prospects for the instruments.

On a related note, some years ago, a wealthy young friend, recently retired from Intel, sought high-end wealth management services. Without going into too much detail, I assisted her in contacting the appropriate Goldman Sachs Asset Management personnel. Their subsequent treatment of my friend, and cavalier, arrogant manner, surprised me at the time. Since then, it's become routine for Goldman. Anyone who expects Goldman to be looking out for them as a customer is a fool.

If Goldman had, internally, cooked up the Paulson idea, underwritten the securities themselves, and sold them to clients, then it may well have been guilty of fraud.

But Goldman, perhaps very carefully, avoided that. They only sold securities constructed by ACA.

I would guess that, ultimately, Goldman will depend upon the classification of Abacus buyers as "sophisticated investors." It will note that it never assured them of the securities' quality. Only the terms, composition and price of the instruments.

As to informing Abacus of Paulson's beliefs, what of it? Perhaps Goldman did not share Paulson's views of the underlying mortgages. Even if they did, what of it?

Like the broader market for mortgage-backed securities, which, we have regrettably learned, was full of naive, gullible institutions which trusted sellers too much, and failed to do their own research, Abacus' buyers appear to have had similar failings.

Goldman will doubtless have a public relations nightmare from this. And the affair may affect pending legislation in Washington to change regulation of the financial sector.

I do think this will severely damage Goldman. Remember, Bankers Trust never fully recovered from their dervatives trading scandal in the 1990s. They eventually had to be bought by Deutsche Bank to avoid collapsing.

Customers have a way of leaving vendors who are shown to be callously inconsiderate of their needs, taking advantage of them at every opportunity. Selling securities which Goldman suspected were designed to lose value will, I think, bring lasting damage to their firm- finally..

But in a market which expects sophisticated investors to be responsible for their own valuations and transactions, capable of doing their own research, it's hard to see how Goldman can be guilty of fraud in the Abacus case.

Unethical and expeditious, short-term minded business? Yes. Fraud? Hardly.