The SEC claims Goldman Sachs created and sold a mortgage investment that was secretly devised to fail. The claim is that this was a deal, secretly arranged by Goldman and hedge fund manager John Paulson, that helped his (Paulson's) investors capitalize on the collapse of the housing market. Indeed, Goldman also profited, by also betting against the very mortgage investments that it sold to its customers.
The financial "instrument' in this deal was known as "Abacus' and was one of 25 deals that Goldman created so that it, and select clients, could bet against the housing market.
As the Abacus deals plunged in value, Goldman and certain hedge funds made money on their negative bets, while the Goldman clients, the suckers who made the mistake of buying the $10.9 billion in investments, lost billions of dollars.
Goldman created Abacus 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," according to the SEC 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. The problem is, Goldman told investors, in its Abacus marketing materials, that the bonds would be chosen by an "independent manager," namely ACA Management. This was a lie. Hence Goldman is guilty of fraud.
In short, it appears that Goldman created, and sold to its clients, mortgage-linked securities that it expected to go bad, and that it stood to make a handsome profit from, in the event that they did go bad.
Actually, Goldman was one of many Wall Street firms that created complex mortgage securities -- known as synthetic collateralized debt obligations (CDOs) -- as the housing wave was cresting. At the time, traders like Mr. Paulson, as well as those within Goldman, were looking for ways to short the overheated market. Such investments as Paulson and others made, in their attempt to short the market, consisted of insurance-like policies written on mortgage bonds. If the mortgage market held up and those mortgage bonds did well, investors who bought Abacus notes would have made money from the insurance premiums paid by investors like Mr. Paulson, who were negative on housing and had bought the insurance on those mortgage bonds. Instead, however, defaults spread and the mortgage bonds plunged, generating billion of dollars in losses for Abacus investors -- and billions in profits for Mr. Paulson and his fellow gamblers and speculators.
Goldman structured mortgage bundles like Abacus and other, similar instruments, with a sharp eye on the credit ratings assigned to the mortgage bonds associated with such instruments, the SEC claims. In the Abacus deal, Mr. Paulson specified those mortgage bonds that he believed carried much higher ratings than the underlying loans deserved. At Mr. Paulson's request, Goldman then placed AIG-obtained insurance on those bonds (called credit-default swaps), which allowed Mr. Paulson to short them (i.e. bet against Meanwhile, clients on the other side of the trade were essentially betting that the bonds would not fail. them).
But when Goldman sold shares in Abacus to the soon-to-be-fleeced investors, it only disclosed the (favorable) ratings of those bonds, but did not disclose that the notoriously successful Paulson hedge fund was on other side of the bet, licking its chops because of Paulson's certainty that those ratings were wrong. Also not disclosed was that Goldman had to twist some arms at a rating agency (Moody's) to obtain the favorable ratings that had to be stamped on these junk bonds if they were to successfully masquerade as quality bonds.
Mr. Tourre of Goldman Sachs at one point even admitted to someone, by email, that he was having trouble persuading Moody's to give the deal the rating he desired it to have this according to the email recipient's notes, which were provided to The NY Times by a colleague of the recipient, who asked for anonymity because he was not authorized to release them.
In seven of Goldman's Abacus deals, the bank went to the American International Group (AIG) for insurance on the bonds. Those deals have led to billions of dollars in losses at AIG, which was the subject of a $180 billion taxpayer rescue.
Quite significantly, the deals' marketing documents do not mention Mr. Paulson or say that Goldman was in fact shorting (betting against) the very bonds it was selling to its customers.
Not surprisingly, the Abacus deals deteriorated rapidly when the housing market hit trouble. For instance, in the Abacus deal in the SEC complaint, 84 percent of the mortgages underlying it were downgraded by rating agencies just five months later.
It takes time for such mortgage investments to pay out for investors like Mr. Paulson, who short them. Each deal is structured differently, but generally, the bonds underlying the investment must deteriorate to a certain point before short-sellers get paid. However, by the end of 2007, Mr. Paulson's hedge fund was up 590%. Nice work if you can get it. Insurance company AIG paid for some of that hefty profit. And guess who reimbursed AIG? The American taxpayer of course, who Mr. Paulson and his hedge fund investors thank from the bottom of their hearts.