1 Boring Old Man

Reading through the SEC Filing against Fabrice Tourre and Goldman Sachs, it sure sounded like fraud to me. But I found this article, which fleshed out some of the legal issues in the case and made things clearer ["clearer" is a relative term with me when it comes to matters legal]:

 

Inside the SEC’s Legal Case Against Goldman Sachs
Daily Finance
By ABIGAIL FIELD
04/16/10

…Since all of the conduct at issue involves the sale of a security created and sold by Tourre and Goldman, the two key elements are whether Goldman/Tourre made material misstatements or omissions, and whether they had sufficient intent — SEC must prove at least recklessness — to deceive or defraud. So let’s look at what the SEC alleges. The commission alleges that Goldman/Tourre didn’t tell investors material information, specifically that the CDO it was selling had been deliberately constructed out of residential mortgages backed securities (RMBS) likely to experience "credit events" (i.e., become worthless or virtually so) at the request of, and with the active participation of, a Goldman client named Paulson & Co. That is, Goldman/Tourre allegedly didn’t tell purchasers of the CDO it marketed that the CDO was designed to lose value.

What could Goldman say in return? Perhaps that Paulson and Goldman weren’t alone in structuring the CDO. Goldman hired ACA Management LLC (ACA) to evaluate the RMBS securities put into the CDO. Why would ACA allow the CDO to be structured out of RMBS that were likely to experience credit events? The problem with this defense is that the SEC alleges, and has at least email to support it, that Goldman/Tourre deceived ACA into thinking that Paulson’s interests were aligned with the potential CDO investors rather than diametrically opposed to them. ACA apparently believed that Paulson was investing a significant amount of money in the riskiest slice of the CDO, something that couldn’t have been further from the truth.

Why does the SEC claim the RMBS were chosen precisely because they were likely to lose value?

• First, the SEC says Paulson approached Goldman specifically to create a way for Paulson to bet against RMBS, meaning Paulson was looking to make money on RMBS that lost value.
• Second, according to the SEC, Paulson invested in credit default swaps (CDSs, a form of credit insurance) on the CDO it helped Goldman issue, positioning itself to make money if the mortgage securities underlying the CDO defaulted — those same securities that Paulson helped select.
• Third, within six months of the deal closing, 83% of the underlying securities had been downgraded, and less than a year later, 99% had.
• Fourth, the complaint includes email supporting this narrative. In all, the CDO buyers lost about $1 billion, and Paulson made about $1 billion. Goldman made $15 million.

What does it mean for omitted information to be material? In 1988’s Basic Inc. v. Levinson, the U.S. Supreme Court explained: "an omitted fact is material if there is a substantial likelihood that its disclosure would have been considered significant by a reasonable investor." If the SEC really can prove that Goldman/Tourre structured the CDO so that the CDO would lose value, benefiting Paulson & Co. — even going so far as to allow Paulson to participate in structuring the CDO so that outcome could be virtually assured — and if the SEC can show that Goldman/Tourre failed to disclose that information to investors, it’s hard to imagine a more material omission.

The SEC has to show that Goldman/Tourre intended to deceive, or at least were reckless about deceiving, investors by failing to disclose the material information. Common sense suggests the mere fact that no one would likely buy a CDO if they knew that it had been deliberately designed to lose value might be enough to prove that the failure to disclose the information was a deliberate effort to deceive investors. However, the SEC alleges more than that.  The SEC claims that to make the CDO attractive to the market, Goldman/Tourre brought in ACA and deceived ACA about Paulson’s interests in order to persuade ACA to put its name on the securities. Those actions, if true, suggest a very deliberate effort to misrepresent the process for selecting the underlying securities, and thus the potential value of the CDO being sold…

Today, there was a follow-up article by the same lawyer. It seems that Tourre’s and his pals’ testimony today was under oath, so it’s relevant in the SEC case. There are a number of places where he’s in a bind, because if they can prove he or they lied today, they’ve added some perjury to the mix. It comes down to did Tourre deceive ACA about Paulsen’s going short? Tourre said, "No" today, but if you read the indictments, that "no" seems very questionable. And then there are some other inconsistencies.

The Impact of the Tourre Panel on the SEC Goldman Case
Daily Finance
By ABIGAIL FIELD
04/27/10

The Securities and Exchange Commission got some gifts from today’s grilling Fabrice Tourre. Most important for the SEC is that everything he said was under oath. Now he’s locked into his positions, and he made some pretty sweeping statements. If the SEC can find documents or witnesses that contradict today’s testimony, the SEC gains a powerful lever in its case against Goldman Sachs.

The Risk of Testifying Under Oath: Tourre is at the center of the SEC’s case, particularly the allegation that Goldman deceived ACA into believing Paulson was long in the Abacus deal instead of short. Since the issue is so crucial to the SEC’s case, and the SEC’s complaint makes clear it thinks Tourre did the deceiving, I can only imagine the SEC is confident in its evidence on the point. Given that, Tourre’s money quote was: "I never told ACA… that Paulson & Company… would take any long position in the deal…. I recall informing ACA that Paulson’s fund was expected to buy credit protection on some of the senior tranches…. This necessarily meant that Paulson was expected to take some short exposure in the deal." In response to Senator Coburn’s direct questions, Tourre doubled down and insisted he never suggested that Paulson was an equity investor and reiterated that he had communicated that Paulson was buying protection, and thus going short.  If the SEC really can prove Tourre deceived ACA, his testimony today gave the SEC a powerful weapon to compel cooperation: threaten a perjury prosecution. And if Tourre does flip, Goldman’s in trouble.

On the Issue of Who Chose the Abacus Securities: In Goldman’s public statements, Goldman has claimed that IKB, one of the buyers of the Abacus CDO, also had input into the underlying securities. Tourre reiterated that point in his written testimony, which he read into the record under oath: "Paulson’s fund made suggestions to ACA, as did IKB and Goldman Sachs." Under questioning by Senator McCaskill, however, Tourre said that IKB "wasn’t in the room" when Paulson and ACA were selecting the securities for the CDO.

Exhibit 119 is perhaps a little helpful to Goldman on this issue, in that it shows that IKB made at least one request regarding the content of the securities portfolio — to remove securities serviced by two particularly notorious subprime lenders — but the email suggests Tourre was more concerned with Paulson’s view than IKB’s: "…Paulson will likely not agree to this unless we tell them nobody will buy these bonds if we don’t make that change." A Goldman person asked Tourre what he should tell IKB in response to its request, and Tourre replied that IKB should be told that Goldman "was taking its feedback into account and once we have gotten more feedback from accounts across the cap structure we will decide what the best cours[e] of action is".

In a preview of how Tourre will respond to questions about some of the documents cited by the SEC in its complaint, Senator Levin asked Tourre about documents in which Tourre referred to the securities as having been chosen by "ACA/Paulson." Tourre said the documents "could have been more accurate;" in the interests of speed he’d written down only ACA/Paulson, but he should have written ACA/Paulson/Goldman Sachs/IKB. I’m not sure a jury will find that self-serving explanation as persuasive as a document written contemporaneously.

Goldman’s Common Sense Defense Further Undermined: One of Goldman’s main talking points — that it lost a lot of money on the Abacus deal and so couldn’t have been structuring it to fail was shot down by Tourre when he conceded that Goldman had always intended to sell the part it ended up holding on to; that is, at the time its structured and did the deal, Goldman had no intention of holding a long position. I wonder if, after that under oath statement, Goldman will continue pushing this talking point. Or rather, I wonder if journalists will let Goldman keep pushing that talking point.

"Ratings-Based Buyers" Undermined "Big Boys" Defense: Goldman’s "big boys" defense — the idea that IKB and ACA were sophisticated investors who knew what they were buying with Abacus — was at least implicitly undermined by Tourre’s comments about a proposed list of customers to focus on in the next year to pick up additional revenue. Tourre wrote: "this list might be a little skewed towards sophisticated hedge funds with which we should not expect to make too much money since (a) most of the time they will be on the same side of the trade as we will, and (b) they know exactly how things work and will not let us work for too much $$$, vs. buy-and-hold rating-based buyers who we should be focused on a lot more to make incremental $$$ next year …"

According to Tourre’s email, then, some "big boy" buyers relied heavily on the ratings assigned to securities and didn’t know exactly how things worked, and Goldman could and should exploit their weakness for profit. Asked about the email at the hearing, Tourre predictably denied that’s what the email meant, but again, I’m not sure a jury would find his explanation as persuasive as his plain English email.