July 22, 2013
By David Fiderer
To sabotage the SEC's case for securities fraud, Paolo Pellegrini audaciously lied under oath.
(Article changed on July 22, 2013 at 22:27)
(Article changed on July 22, 2013 at 14:27)
"So I met with Paulo last night," wrote Laura Schwartz in a series of email chains that read like an epistolary novella. "He may as much of a nerd as I am, since he brought a laptop to the bar and he also seemed to have a worksheet from DB [Deutsche Bank] and another manager."
Paulo was nothing like Laura. The story of a professional setup and seduction by a ruthless cad is familiar and depressing. And the aftermath three years later, wherein the world learns how Laura was played for a sucker in a highly immoral and unethical scheme, is pretty disgusting. Paolo Pellegrini, whose contempt for personal morality and business ethics seems boundless, essentially calls her a stupid prostitute. Stupid not to know his malign intent, and a prostitute who colluded with him to defraud investors. He doubled down in Federal Court last week, when he lied under oath.
[NYMag] by [NYMag]
A Disinformation Campaign Launched on CNBC
But the disinformation campaign to malign Schwartz goes back more than three years. It was launched on CNBC on April 20, 2010, four days after the SEC filed its complaint against Goldman and Fabrice Tourre, alleging securities fraud in the sale of Abacus 2007-AC1, a CDO that was designed to fail. Carrying water for Pellegrini and/or Goldman, Steve Liesman carefully cherry picked facts in ways that misled CNBC's viewers.
"Pellegrini testified that he told ACA Management, the main investor in a Goldman mortgage-securities transaction, that Paulson intended to bet against--or short--the portfolio of mortgages ACA was assembling," reported Liesman, who omitted Pellegrini's retraction.
"Later in the deposition, Pellegrini [said] he doesn't recall specifically telling her," reported New York Magazine, which had some respect for accuracy. "But [he] noted that he had walked her through the methodology Paulson and Co. had used to select the subprime securities. So, if she, "didn't know they were planning to take a short position in Abacus, he said, then she was just dim." Pellegrini, who was heavily lawyered and no fool, was trying to have it both ways. If he did tell Schwartz of his specific intent, then he was conspiring with her to defraud investors. So instead, he selectively recounted events so as to make Schwartz look stupid. It would "have been a little difficult to sort of miss the fact that we were trying to short this stuff," he said.
Pellegrini's intent is to deceive by cherry picking his facts. He leaves out the part where he tells Schwartz that he wants to exclude riskier triple-B-minus tranches, or when emails her that some of her proposed investments , "have some characteristics that make them too risky from our perspective." The signals he sent were decidedly mixed.
Which brings us to Liesman's second sleight of hand, which misled viewers about the nature of the meetings. Contrary to what he strongly insinuated, Schwartz never negotiated with Pellegrini as an investor; she was acting as the Selection Agent, an entity designated to act in an independent professional capacity on behalf of all purchasers of the CDO. She negotiated with Pellegrini because Goldman told her that his hedge fund, Paulson & Co., was taking the most most highly levered and deeply subordinated tranche in the deal, the equity tranche, and that securing a commitment from the "transaction sponsor," was the critical path to getting the deal done.
By claiming that Schwartz knew of his intention to short the portfolio, Pellegrini was essentially saying that she was prostituting her professional position, as Selection Agent, to mislead outside investors who believed that she was acting in their best interests. If he specifically told her of his intent, then he was conspiring with her to promote the same deception.
Since Goldman, the largest synthetic CDO underwriter, had never used a Selection Agent before, Schwartz was eager to establish a positive working relationship with the firm. So, after pushback in the preliminary discussion about the nature of the portfolio, she sent an email signaling her willingness to be flexible and reasonable. "I certainly hope I didn't come across too antagonistic on the call with Fabrice last week," emailed Schwartz to her Goldman contact on January 14, 2007. "I can understand Paulson's equity perspective but for us to put our name on something, we have to be sure it enhances our reputation." She clearly had no idea what kind of people she was dealing with.
Hiring ACA As An Unwitting Shill
Which was the entire point. Here the was sequence of events. First in late 2006, Tourre pitched his idea to Paulson: Goldman sells a CDO specifically designed fail so that the the credit default swap beneficiary, Paulson, can secure a quick $2 billion windfall. And for fabricating and selling this bogus transaction, which had no legitimate business purpose, Goldman would earn a $20 million fee for acting as a middleman, while taking no credit risk.
Out of concern that the market might become saturated by the tsunami of similarly bogus synthetic CDO deals entering the marketplace, Paulson suggested hiring an outside investment manager, a name like ACA, to lend the deal some verisimilitude to suckers, who would be deluded by fraudulent triple-A ratings.
Before hiring ACA, the people at Goldman went back and forth as to which firm they might select as their dupe, or, as they say in Wall Street code, "is easy to work with." All day on December 18, 2006, from 9:33 am until 5:48 pm, the emails went back and forth as to prospective candidates. David Gerst explained how potential candidates should be ranked:
There are more managers out there than just____. The way I look at it, the easiest managers to work with should be used for our own axes [i.e. investments to be unloaded or shorted]. Managers that are a bit more difficult should be used for trades like Paulson given how axed Paulson seems to be, (i.e. I'm betting they can give on certain terms and overall portfolio increase). In plain English, Gerst says lets save the dumbest managers for own synthetic CDOs, and assign Paulson a not-so-dumb, but dumb enough, manager. As Tourre told David Lehman, Abacus 2007-AC1 was his idea, it was Paulson's idea to hire a manager, and it was Tourre's idea to hire ACA.
ACA was hired by Goldman and Paulson & Co. for one reason and one reason only, to delude potential investors into the false belief that the portfolio was selected by an outside party unhampered by conflicts of interests. So while everyone at Goldman and at Paulson was in on the sham, Schwartz and ACA were kept in the dark.
What Insiders Knew and What Outsiders Didn't
So let's take a step back to get a sense of the big picture at the time. In late 2006 and early 2007, there were two types of investors, the insiders and the outsiders. The insiders like Pellegrini, who were able to penetrate the veils of secrecy around CDOs and credit default swaps and receive investor presentations from Greg Lippmann of Deutsche Bank, were made aware that Standard & Poor's, Moody's and Fitch were assigning patently fraudulent ratings to residential mortgage-backed securities and their progeny. They also knew that the recent data on declining home prices made it almost as certain as death and taxes that any triple-B tranches of those securities would be wiped out.
The chasm between the insiders, like Pellegrini, and the outsiders, like Schwartz, was made evident in the two email messages they sent, almost simultaneously, just after 4:00 pm on January 14, 2007.
This was just around the time that the second Paulson Credit Opportunities Fund was about to be launched, so Pellegrini sized up the situation for another insider, a prospect from 3A Investors. He said the insiders were perpetuating the sham as long as they could:
It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while "real-money" investors have neither the analytical tools nor the institutional framework to take action before the losses that one could anticipate based the "news" available everywhere are actually realized. To put it mildly. The math was pretty simple. If home prices stopped appreciating, triple-B bonds got wiped out. Or as Pellegrini put it:
The probability of writedown of BBB (not just BBB-) RMBS bonds is bond-specific, although some key inputs are common. The most important common input is home price appreciation (HPA) nationally, regionally and at the "metropolitan area" level... (it is very difficult for subprime borrowers to refinance if their property has not appreciated)...
By January 2007, home prices were falling fast in California and Florida.
At almost the exact same time, Schwartz, an outsider, emailed Goldman to express concern about seeming too antagonistic. She had no idea that she was being played for a fool.
Softening Up Laura
Things seemed to work out exactly as expected. On December 20, Tourre explained to colleagues that they were looking for an asset manager which, "will be flexible w.r.t. portfolio selection (i.e. ideally we will send them a list of 200 Baa2-rated 2006-vintage RMBS bonds that fit certain criteria, and the portfolio selection agent will select 100 out of the 200 bonds)..."
And one month later, on January 22, Schwartz sent the kind of email response they were looking for:
From: Laura Schwartz
Sent: Monday, January 22,20071 :52 PM
To: Tourre, Fabrice; Kreitman, Gail; Gerst, David
Subject: proposed Paulson Portfolio
Attachments: Paulson Portfolio 1-22-07.xls
Attached please find a worksheet with 86 sub-prime mortgage positions that we would recommend taking exposure to synthetically. Of the 123 names that were originally submitted to us for review, we have included only 55. We do not recommend including the other 68 names because either: 1
1) we did not like them at the recommended attachment point;
2) there are lower rated tranches that are already on negative watch; and
3) some names (Le. Long Beach and Fremont) are very susceptible to investor push back.
The 31 new names are heavily weighted to new issue since we believe the underlying collateral to be of better quality. We provided a total of 86 names to give us some room since the term-sheet mentioned 80 names at 1.25% each.
Please let me know if you have any questions.
Three days later, on Thursday, Schwartz was pleased to receive an engagement letter from Goldman that assured ACA's position as Selection Agent. Fortunately, she had a chance to review the document before she left town for the weekend, prior to attending a Morgan Stanley conference in Jackson Hole, Wyoming.
Soon after she arrived in Jackson Hole on Friday, serendipity. Early Saturday morning, she emailed everyone at Goldman:
I am in Jackson Hole and Paolo is out here with his family skiing for a week and we ran into each other last night. He called me this morning and wants to meet for a drink and discuss the deal this afternoon. Will keep you informed.
The next morning, she briefed everyone:
I don't think he wants the A3 names and wasn't too keen on the Baa3 names. Let's do the Baa3 names at Baa2. He also wanted to know if we had to have so many names - I said Goldman needed 100 to help sell the debt. He also wanted to talk about the super senior - I said we would definitely look at it if Goldman planned on placing it. We also talked about the auction call - he wants a 2 year. This may be tough to sell without a makewhole. We left it that we would both work on our respective engagement letters this week - I certainly got the impression the he wanted to go forward on this with us. He is also headed to ASF. Can we meet sometime on Feb 5th to discuss mechanics of this deal?
Jackson Hole was the setting for the he-said/she-said dispute. Here's how Steve Liesman reported the he-said version back in 2010:
Paolo Pellegrini met at least three times with Laura Schwartz, the head of ACA's CDO Asset Management. At those meetings they discussed either Paulson's recommendations for criteria to be placed in the CDO, for which ACA was to act as a Selection Agent, or the intention for Paulson to short the portfolio. He told ACA executives at least at one of the meetings, which took place by the way at a bar in Jackson Hole, Wyoming, that the hedge fund intended to short the portfolio.
In an interview with a government attorney Pellegrini was asked about one of those meetings with Schwartz: "Did you tell her that you were interested in taking a short position in Abacus."
C "Yes, that was the purpose of the meeting.
Government attorney: "And how did you explain that to her?"
Pellegrini: "That we wanted to buy protection on tranches of a synthetic RMBS portfolio."
Buy protection on a portfolio, well that's the same thing as a shorting.
That's right. Pellegrini "runs into Schwartz" in a ski lodge on Friday night. Calls her up on Saturday morning to say he wants to meet her later that day in a bar, and later that evening says that the purpose of the meeting was to inform her of Paulson's intention to short the portfolio.
And Schwartz, who kept her promise to keep Goldman informed, fails to mention this critical fact.
Pellegrini's Dissemblances, Half-Lies and Flat Out Lies
Then you have to consider the Pellegrini's word games, which are used to deceive. At three meetings, either they discussed investment recommendations, or they discussed Paulson's intention to short. Which means there could have been three meetings where the shorting strategy never came up. And, "wanting to buy protection on tranches of a synthetic RMBS portfolio," is not the same as wanting to buy protection on the portfolio being assembled for the ABACUS transaction.
And no, Steve, buying protection is very different from buying a naked short. Generally speaking, people buy protection on risk exposures they already own. Shorting something you do not own is altogether different.
Which is why Abacus 2007-AC1 and $100 billion other synthetic mezzanine CDOs just like it, were all deeply immoral and unethical transactions. They had no legitimate purpose, since they financed nothing. They never added "liquidity to the market," since everything about CDOs and credit default swaps is kept secret in order to protect the guilty. And they did not represent "a bearish view on housing," since this was money on a sure thing, the fatal flaws in the triple-B ratings of hyper-levered tranches of subprime bonds. Their singular purpose was to screw a bunch of suckers, the outsiders who never made it on to Greg Lippmann's email distribution list.
Here's an absolute must-read for anyone in business: George Orwell's, "Politics and the English Language," because corruption in finance is largely rooted in corruption in language.
Pellegrini Flaunts His Contempt For Ethics and the Rule of Law In Court
Eleven months after the SEC complaint was filed, Pellegrini working closely with defense lawyer Pamela Chepiga, sat for a deposition wherein they both worked hard to throw sand in everyone's face. Chepiga was relentless in her objections to each and every question. At that time, Pellegrini, who seemed to have the memory of a sieve, could not quite remember whether he contacted other potential CDO arrangers by stating his intention to purchase the CDO's equity, which was essentially a loss leader for people who bought shorts.
But in fact, if you were an insider, you knew that everyone was doing it, not just Paulson, Goldman or Magnetar. Here's what the FCIC uncovered in its hedge fund survey:
Investors, usually hedge funds, often used credit default swaps to take offsetting positions in different tranches of the same CDO security; that way they could make some money as long as the CDOs performed, but they stood to make more money if the entire market crashed. An FCIC survey of more than 170 hedge funds encompassing over $1.1 trillion in assets as of early 2010 found this to be a common strategy among medium-size hedge funds: of all the CDOs issued in the second half of 2006, more than half of the equity tranches were purchased by hedge funds that also shorted other tranches. The same approach was being used in the mortgage-backed securities market as well. The FCIC's survey found that by June 2007, the largest hedge funds held $25 billion in equity and other lower-rated tranches of mortgage-backed securities. These were more than offset by $45 billion in short positions.
Once again, CDOs and CDS are used with the explicit purpose of exploiting secrecy, of keeping outsiders in the dark. As Pellegrini testified:
It was implicit in the relationship between Paulson and Goldman Sachs that Paulson would not disclose that Goldman Sachs was involved in transactions involving Paulson and vice versa.
At that time, almost a year after his first effort to smear Schwartz, Pellegrini also testified that he could not remember whether he informed her or anyone from ACA of his intent to short the entire CDO portfolio. Again, Pellegrini has good reason to speak out of two sides of his mouth. If he says he told her, then he was colluding with her to perpetrate a fraud, which was why it was wise not to remember. But if he says he told her, then he undercuts the SEC case. He also undercuts the fraud case
filed by ACA against Paulson on January 3, 2013. So why not split the difference and say she was too dumb not to understand what he was saying?
After reviewing a lot of testimony by a lot of players in the financial crisis, its apparent that they lie under oath a lot. But they lie with an awareness that its almost impossible to hold them legally accountable. Think of it this way. If you asked a dozen middle aged New Yorkers what they remember about 9/11, and they all say nothing comes to mind, then, by my reckoning, somebody is lying. But it's impossible to prove what people know or don't know. Pellegrini, who partnered up with Chepiga once again, lied relentlessly, sometimes in ways that failed the laugh test. For instance, Pellegrini said he wasn't sure what CDO stood for.
Let's put it this way. If CNBC doesn't explain on the air what CDO stands for, it's because everyone knows that it stands for collateralized debt obligation. For a Harvard MBA like Pellegrini, who works with CDOs, to say that he isn't sure what the letters stand for, is like a Federal prosecutor saying he doesn't know what FBI stands for.
In his obnoxious and dishonest performance on the witness stand, aided and abetted by Chepiga, acted sometimes like he just fell off the cabbage truck, and other times like a meek little mouse, who had not been heavily coached by lawyers prior to giving testimony. So even though Pellegrini is not sure of anything much, he was absolutely certain that he told Laura Schwartz of Paulson's intention to fabricate a CDO that was designed to fail.
Pellegrini said that his testimony for the March 2011 deposition was false because he was afraid of the big mean SEC lawyers, who asked him, "hostile questions, intimidating questions." "I thought you tried to trick me in some way," he said.
Here's how The Wall Street Journal explained his about face:
Mr. Pellegrini said he spoke with Ms. Schwartz about the Abacus transaction at a structured-finance "shindig" in Jackson Hole, Wyo., in late January 2007, but initially couldn't remember specifics of the conversation. [Pellegrini never attended the structured finance conference. He just made a point to "run into," Schwartz.]
Mr. Tourre's lawyer Pamela Chepiga pointed to other excerpts of his deposition and email exchanges to show that the former Paulson executive had, in fact, remembered telling Ms. Schwartz his firm was interested in shorting, or betting against, mortgage-linked deals.
"I think I told her we like to short things," Mr. Pellegrini said, recalling the Jackson Hole meeting. [Liking to short things is not the same as fabricating a CDO in order to short the entire portfolio.]
The SEC questioned that response.
"Now, 5 - years later, prompted by Ms. Chepiga, helped you remember?" Mr. Martens, the SEC lawyer asked.
"Yes," Mr. Pellegrini said.
Of course she could help him remember. No one can go after Chepiga for suborning perjury.
For over 20 years, David has been a banker covering the energy industry for several global banks in New York. Currently, he is working on several journalism projects dealing with corporate and political corruption that, so far, have escaped serious scrutiny by mainstream media. He is trained as a lawyer.