In a word

I’ve been following the unraveling of the GS fraud case and the most interesting information that I’ve found to date is in this Bloomberg link. It has pretty good coverage of the possible links between folks in the White House covering the bailout and GS itself as well as a good simple explanation of the current suit.

I hesitate to go too far into depth as so much of this stuff is written in legalese which is beyond my understanding as a finance person but Bloomberg is reporting that the fraud case may hang on the interpretation of the word “selected”. As you recall, Paulson & Co.–a hedge firm–was allowed to select the loans going into the tranches for a CDO and was preparing to place sidebets against the CDO. The relevant CDO is referred to as Abacus 2007-AC1. This marketing material around the CDO made no mention of who specifically was selecting the loans.

The banks that bought up the mortgages are the usual suspects. That would be BOA, Citigroup, and UBS. (We also know how lax the due diligence on things like income and credit checks was on the part of originators at the time.) All of three have had tremendous financial problems and have relied on tax payer funds since the markets fell apart. Also, remember, this is a Collateralized Debt Obligation. Investors bear the risk inherent in these loans. The loans were supposedly sorted by credit risk (based on the loan documentation) into tranches so you should know which tranche has the riskier loans by the rating assigned by an ‘impartial’ rater.

Senior tranches have lowest credit risk but there are tranches that contain highly risky loans. The lowest tranche is likely to be filled up with loans unlikely to repay so the GS argument that hinges on the word “selected” is based on the argument that even though the prospectus (Abacus 2007-AC1) didn’t specify Paulson & Co. in the selection process, the selection process would’ve been similar regardless of who did it. You know the stinkers go into the subordinate tranches and you know that there is another party out there betting against you. Does it make any difference who it is and if they told you they were going to bet against it because that’s just the nature of the beast any way?

That’s undoubtedly why there was an interesting insider leak that says that the SEC vote to go after GS was split. The two Republicans sitting on the SEC voted no while the two Democrats voted yes. SEC chair Mary Schapiro cast the deciding vote to file the suit. The leak undoubtedly stopped any complete freefall of GS stock. That information muddies the water.

“The fact that SEC members are said to be split suggests the story is not going to be catastrophic for Goldman Sachs,” said Eric Teal, who oversees $5 billion as chief investment officer at First Citizens BancShares Inc. in Raleigh, North Carolina.

Republicans in Congress are still fighting regulation of the derivatives markets. Interestingly enough, the first Bloomberg link also states that two democrats are looking at possible conflicts of interest in the White House. While Rahm’s connection to Magnetar is known and Magentar is mentioned as one possible hedge fund with similar problems, so far, everything surrounding it remains speculation. I did find this particular part of the article interesting, however.

While Magnetar avoided ordering managers to buy specific securities, it often pushed them to select ones with higher yields, according to a person who participated in some of the transactions and declined to be identified because the deals were private. The firm told banks and asset managers what its strategy was, the people said.

Bringing anything closer to AIG, however, gets one into the Treasury Department.

Democratic Representatives Elijah Cummings and Peter DeFazio said today they would ask SEC Chairman Mary Schapiro to review whether Goldman Sachs CDOs insured by American International Group Inc. were improperly created. AIG, rescued by the U.S. in 2008, covered $6 billion of assets through Abacus deals.

Another Hedge Fund of interest is Tricadia that also has some west wing connections. It evidently was also in the market for some of the questionable CDOs.

Tricadia, which also said it would buy some of the CDOs’ most junior slices, was created in April 2003 as an affiliate of Marnier Investment Group, a hedge-fund firm whose management included Lee Sachs, now a counselor to Treasury Secretary Timothy F. Geithner. Tricadia co-founder Michael Barnes didn’t respond to messages seeking comment.

The CDO at the center of the SEC case is one of at least 23 Abacus deals created by Goldman Sachs, and one of the only ones for which the firm hired an outside asset manager, according to prospectuses. The others were managed by Goldman Sachs.

These kinds of lawsuits frequently rely on pulling one string from the fabric at a time and putting enough leaks out to the press to get enough inside but small fry players to think their necks may be on the line next. They also know they are small fry and most likely expendable and will be hung out to dry. This turns these folks on the inside to the SEC’s cause and frequently that grows the case into something more substantial which intrigues the Justice Department. SEC cases often have the same complex game strategies used to negotiate treaties and trade agreements. Trying to make small fry very nervous is frequently a first step. You have to cut the weakest out of the herd and see what it has to offer you.

I think many folks are noticeably disappointed that this investigation does not seem larger than the crash of the financial markets themselves. Again, fraud and insider trading are the mainstays of the SEC investigations and while a lot of what’s been announced shows bad faith with customers, it’s difficult to prove the intent was to defraud. The prospectus must report things that are germane to an investor in as forthright way as possible. Arguing over the choice of one word over another, if it comes to that, seems like more of a wild hair than a strategy. But again, part of the deal is to go in and start poking around the right places and making the right people very nervous. You could tell they were ready to play psych ops just based on the Friday afternoon filing. No one can assemble a good response to anything in NYC on a Friday afternoon.

The biggest thing that makes me nervous about this is why so many pension plans, etc. were guided towards these assets. I still think the ratings companies need to take a major hit on this one. Here’s one good quote from the Bloomberg article that should let you know why without explaining the entire rationale behind a synthetic asset. What the argument is here, is that these pension plan managers should’ve known better even with the stellar ratings had they known anything about financial engineering. So, you’re not defrauding them in this case, just taking advantage of their professional ignorance.

Remember, Larry Summers got the Harvard portfolio caught in the mess. Summers must have either felt that housing prices would never fall and the subprime market was pretty secure or he got caught up in the greed or got in over his head or some combination of all three. (Just right now I’m thinking I may asked my ex who used to do investing of pension and life insurance funds for Mutual/United of Omaha about how to set up a synthetic hedge and see if he can give me the details as a test case. He’s been out of academia and into fund management for some time. I wonder how up to date he is with these kinds of things?)

Buyers of deals involving default swaps are foolish if they don’t realize someone had picked securities to bet against them, said David Castillo, a senior managing director at San Francisco-based broker Further Lane Securities, a trader of structured securities.

“In a synthetic transaction involving any asset, the participants know upfront that there is someone who believes the opposite side of the trade,” Castillo said. “It’s unreasonable to participate in this type of transaction and expect any other scenario.”

Still, what Goldman Sachs didn’t tell investors included the fact that Paulson was betting against the Abacus CDO’s senior pieces, the SEC said, meaning the firm only stood to profit if many of the securities it helped pick went bad and not just a few. In addition, the regular sales of synthetic and hybrid CDO notes to other CDOs and into $400 billion market for structured investment vehicles, or SIVs, such as Axon Financial Funding Ltd. that funded themselves with commercial paper means that not all debt buyers were aware they were taking the opposite side of some investor’s bets.

The involvement of default swaps in the Goldman Sachs case may make it harder for the SEC to win, said Todd Henderson, a law professor at the University of Chicago.

Anyway, my guess is they are just trying to find the right thread to pull. The entire market seems to made up of a lot of bad players so it seems to me they should find the right one sooner or later. This is because their actions say to me that some folks believe the intent to defraud was there and they are willing to stake the SEC’s reputation on it. (And they are willing to go to court on it.) The one thing that you do need to know is that an investment bank is only as good as its reputation. There are all kinds of academic studies on how important the reputation of an underwriter is when pricing things like IPOs (i.e. initial public offerings of stocks). It also has a lot to do with actually getting an IPO to sell out. If they can damage a bunch of these firms, you may find out that Goldman Sachs–even though it comes through with few lawsuits on its hands–could have a reputation that makes it the next Arthur Anderson. Guess, time will tell.