Goldman Sachs: A Moral but Profitable Dilemma
Washington, D.C., April 16, 2010 — The Securities and Exchange Commission today charged Goldman, Sachs & Co. and one of its vice presidents for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter. SEC Press ReleaseGoldman Sachs brings me out of my cave today (back soon).
The Securities and Exchange Commission brought a civil fraud complaint today against Goldman Sachs. At the root of the charges is the role that subprime mortgages underlying mortgage-backed securities and other complicated financial instruments, played in bringing down our economic house of cards in 2008.
In 2007 when the housing and mortgage markets were first showing signs of distress, Goldman structured a synthetic collateralized-debt obligation (CDO) based on toxic residential mortgage-backed securities. The crux of the SEC complaint charges that Goldman defrauded investors by selling those subprime mortgage-backed securities in a CDO while failing to disclose that a large hedge fund that had selected and sold the MBSs to them, was shorting, or trading against, those same securities.
“The Financial Crisis Inquiry Commission chairman, Phil Angelides, likened the practice to selling a car knowing it has bad brakes and then buying a life insurance policy on the buyer.” New York Times
John Paulson, the heretofore unknown hedge fund manager and soothsayer of the painful end to the housing boom, handpicked poor quality B-rated mortgages to package as securities and sell to Goldman. Goldman did not disclose to investors that the collaterized-debt obligation they structured was populated with MBSs that were likely to fail and were chosen by Paulson who had “economic interests directly adverse to investors.” Goldman misled investors by representing that the securities "were selected by an independent, objective third party."
Goldman supposedly had knowledge that Paulson’s hedge fund was going to short the trade. Paulson - $10B: Investors - screwed. Goldman – the jury's still out - CNBC reported today that according to some sources Goldman was long the CDO they structured from the dubious MBSs which would make them NOT the smartest guys in the room but it might disprove their culpability. Hmmm…interesting.
Goldman denied the charges and said it will "defend the firm and its reputation."
Paulson did not directly market the securities to investors and was not charged in the SEC complaint. The SEC also named Goldman employee Fabrice Tourre in the complaint, saying he was "principally responsible" for creating the CDO. Tourre is a 31-year-old VP that referred to himself as the "Fabulous FAB." Oh yeah, and Master of the Universe.
Testifying in front of the Financial Crisis Inquiry Commission in January, Lloyd Blankfein, Goldman CEO, admitted his firm did no in-house due diligence on the underlying mortgages packaged into financial products, but rather relied on the rating agencies which slapped AAA ratings on many securities with underlying toxic loans. Rating agencies - more issues...
Are politicians set on making Goldman the “whipping boy” for Wall Street? The fraud charges against Goldman come right before financial industry earnings reports which are expected to be exemplary. The Washington Post describes the profits as an appearance of bad manners. Bad timing. In January, Obama called Wall Street's uncanny earnings as “obscene profits.”
Goldman Sachs, long known as the smartest, and most arrogant guys on Wall Street, are today the poster child for the economic crisis of 2008. Whether this case is a one-off situation or the prevalence of corporate duplicity is still to be determined. For now the stage is being set for a financial Spoon River Anthology – players yet to be chosen. Lloyd Blankfein, Fabulous FAB, and John Paulson (not to be confused with Hank Paulson, our hero) wander the stage waiting for the SEC director to appear. Stay tuned. This promises to be drama extraordinaire.
While the SEC charges are rocking Wall Street today with expectations of more heads to roll, Washington flexes political muscle and forges ahead with financial regulatory reform. They may even push a vote within two weeks. Remember the financial securities instruments heretofore have not been subject to any regulation. Caveat emptor, etc.
While this is a serious fraud case, the ramifications to the housing industry will be felt for years to come. The press coverage of the fraud case against the Wall Street firm that Main Street loves to hate can't help but further deflate the appetite for investors for these financial instruments backed by questionable mortgages. With the government pulling out of the business of buying mortgage-backed securities as of the end of March, the market will have to stand on its own shaky merits. Without a secondary market of private investors, credit will refreeze before a thaw shows results.
The Goldman fraud case will negatively affect investor appetite for mortgage-backed securities.
The Federal Reserve’s program to purchase mortgage-backed securities from Fannie Mae and Freddie Mac (which kept interest rates low and loosened credit for home loans) ended March 31. No extension is on the table.
Ronald Temple, portfolio manager at Lazard Asset Management predicts that rates could rise by a full percentage point after the Treasury's purchases end and it would precipitate further downward pressure on house prices and more uncertainty.
It is doubtful that the private capital markets will reenter the MBS market with much enthusiasm, even with the current conservative lending practices. Moody’s recently released their worsening opinion of the value of 2005-07 RMBS products and although the 05-07 securities are a different animal from the worthiness of recent mortgages, the appetite for MBSs is still sour to many investors.
Federal reform and regulation for the mortgage-backed securities market promises to be a slow go. Capital generated by mortgage-backed securities is essential for the real estate industry’s recovery, both residential and commercial. And, before financing can regain a substantial foothold for real estate, a monumental remodeling will have to effected on the MBS market.
It is the fear of the unknown that will plague the market. And many fear that Congress, the FDIC and other regulators will impose such harsh restrictions on securitization that they will prevent it from regaining its role as a major provider of credit to to the U.S. real estate markets.
In all likelihood, it will take years to unravel the current MBS debacle and restructure a palatable new securitization model. Likewise, it may take years to peel the layers off the various levels of fraud or misdeed involving mortgage-backed securities of 2004-2007 vintage.
For now bets are being placed on whether Goldman will continue it's long lucrative run through SEC headwinds and financial reform. No doubt this will play out to a packed house.
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