The SEC’s fraud case against Goldman boils down to two key questions:
- Was Paulson & Co.’s involvement in the security selection process for the Abacus CDO a “material fact” that should have been disclosed to investors?
- Did Goldman (via Fabrice Tourre) mislead the security selection agent, ACA, into thinking that Paulson & Co was intending to BUY the CDO instead of shorting it?
There is intense disagreement among pundits and practitioners about the first question, so let’s think it through in detail.
First, some important background to keep in mind:
- In securities fraud cases like this, prosecutors and plaintiffs always have a huge advantage, one that often goes unrecognised by pundits and other observers after-the-fact. What’s the advantage? Unlike those who made the bets (and disclosures) on the securities at the time of the alleged fraud, the world now knows what happened. If Paulson & Co. had been wrong about the housing market and the buyers of the CDOs had made money, we would not be having this conversation. Rather, Paulson & Co. would have suffered the same fate as dozens of other investors who bet against the housing market from 2003-2007 (huge losses) and ACA, IKB, and the other buyers would still be congratulating themselves on their investing acumen. Paulson & Co. might even be suing Goldman for retaining a long position in the CDO and, thus, betting against its client Paulson & Co, something that Goldman has said it doesn’t do. (Remember, Goldman retained an ownership stake in the CDO and lost money on it).
- In 2007, Paulson & Co. had not yet been anointed the smartest firm in the world–the one that made billions betting against the housing collapse. Back then, it was just another hedge fund. So Paulson’s involvement in the security selection process seems more meaningful now than it probably did then. (Plenty of firms had been betting on the collapse of the housing market for years, and they’d all been wrong).
- In 2007, the housing market had not yet collapsed, and everyone who had bet on it collapsing had lost huge amounts of money, gone bankrupt, and/or otherwise been rendered fools. So much money had been made betting on further appreciation of the housing market, meanwhile, that investors were DESPERATE for vehicles that allowed them to make these bets in a more efficient fashion. That’s why the buyers of Goldman’s CDO bought the CDO: They thought housing prices were headed higher, and they wanted to make a killing on it. (These buyers turned out to be wrong, but no one knew that at the time.)
- As Goldman has observed, with CDOs like the one in question, there is ALWAYS a short side and a long side: The buyers of the CDO knew that someone was going to be betting against them.
OK, now let’s think about Paulson’s involvement in the security selection process.
The most persuasive argument as to why this was a material fact is the idea that Paulson was choosing the WORST securities it could find, so that the CDO’s value would plummet if the housing market collapsed. The investors in the CDO, meanwhile, presumably thought that the securities in the CDO were the BEST that could be found (or at least good), because an independent portfolio selection agent (ACA) had been tapped to select them.
Given this, if Paulson had had control over which securities were selected for the CDO, this would OBVIOUSLY be fraud: Paulson wanted BAD bonds in the CDO, not good ones. The buyers of the CDO, meanwhile, wanted GOOD bonds. That would be a direct conflict of interest that should obviously have been disclosed.
- Paulson did NOT have control over which securities were selected for the CDO.
This is critical. It’s also a fact that is clearly visible in the evidence the SEC provided.
The firm that DID have control over which securities were selected, ACA, was a highly sophisticated firm that analysed securities like this for a living. It had FULL CONTROL over which securities were included in the CDO. We know this because, of the 123 bonds that Paulson proposed for the CDO, ACA only included 55 of them. In other words, ACA dinged more than half of the bonds Paulson wanted in the CDO, presumably because they did not meet ACA’s quality hurdle.
Now, did Paulson influence which securities ACA selected? Yes, he probably did. But any time someone says or does anything with respect to a security, there are lots of things that influence decisions. Company managements, for example, which plead their (bullish) cases until they are blue in the face. The opinions of other investors, which are hard to ignore, especially if the other investors are viewed as smart. PR flacks. The media. Stock screeners. Personal experience. Personal worldview (bullish or bearish). Analytical styles and models. Etc. All of these things influence opinions about securities. None of them are considered material facts that merit disclosure (if they did, the disclosure section in every prospectus would be 200 pages long).
ACA, furthermore, did not just pick the securities. It BOUGHT THE CDO. ACA’s parent invested more than $900 million in the CDO. So ACA’s parent presumably had confidence in ACA’s analytical judgement. (ACA is now claiming that it bought the CDO in part because it thought Paulson was buying the CDO, too. Given that ACA was supposed to be expert in evaluating the securities it picked and bet almost $1 billion, this seems lame, but that’s the second part of the SEC’s case, which we’re not discussing here).
And here is another point to consider on the materiality question:
- Goldman argues that the Abacus process was the same process used to construct all of these securities, not just at Goldman–in other words, it was a standard industry practice. A transaction sponsor (in this case Paulson), paid for the CDO to be created, the bank created it and sold it, someone went long and someone went short, and everyone knew all of that. According to Goldman, the identities of the buyers and sellers were not disclosed as a matter of practice.
Now, after every market crash, regulators and the public re-evaluate standard industry practices, and some of these practices are criminalized in hindsight (case in point: research analyst involvement in IPOs in the 1990s). It may be that the SEC now decides that in every case like this, the BUYERS of CDOs should have been told everything that might have influenced the security selection process and who was betting against them.
When the dust settles, the SEC may create new rules that force CDO creators to disclose to buyers who is betting against them. If so, this will be highly unusual in the securities world: When you buy a stock, you have no idea who is selling it to you. You do know (or should) that the entity selling it to you thinks you are a fool. That entity may be Warren Buffett–or it may be your idiot day-trader neighbour. You would presumably LIKE to know who is selling you the stock (to better assess whether you are being a fool), but that’s just not information you’re entitled to have, even though you may consider it material.
So, the SEC may criminalise this lack of disclosure in hindsight, but if it was a standard industry practice at the time, Goldman likely has a solid defence. Lots of lawyers at lots of firms presumably blessed it. The SEC was probably consulted (it usually is). The SEC may even have blessed it.
Again, this does NOT mean that the SEC can’t criminalise the practice in hindsight. But it would seem to be a strong point in Goldman’s defence.
In hindsight, Paulson’s involvement in the security selection process–proposing securities to be included, of which ACA then accepted some and rejected others–now seems like a material fact.
However, at the time, it likely seemed a lot less material. This is because, in hindsight, several new factors are being considered:
- We now know that Paulson was right about the housing market and the buyers of the CDOs were wrong. This colours a lot of dialogue on the issue, but it is important to remember that it was NOT KNOWN at the time.
- We now know that housing was a gigantic bubble. It’s easy to forget that this was not obvious at the time. In fact, what seemed obvious to most analysts, including Greenspan, Bernanke, et al, was that housing was NOT a bubble and that prices would go up forever.
- Paulson is now viewed as one of the smartest investors in the world (as opposed to just another hedge fund who might be right or might be wrong). At the time, he was a nobody.
- Goldman itself bet against housing and won. This makes it seem like Goldman KNEW the housing market would collapse. But of course itt didn’t. In fact, at the time, it would have seemed like Goldman was making a risky bet that the majority of people would have thought was foolish. (The great trades always strike most people this way).
And then there’s the broader point that really colours everyone’s view on this:
- Goldman won the financial crisis and is now making record profits after being bailed out by the taxpayer while the rest of the country is collecting unemployment checks. This seems criminally unfair. Given this colossal unfairness, there isn’t a person in the world who doesn’t work at or for Goldman who doesn’t want to believe that Goldman is, in some respect, guilty.
So, was Paulson’s involvement material? Was it really different than your not knowing who is selling stocks to you on a daily basis (again, Warren Buffett may be on the other side of those trades, he may think you’re stupid, and he may be right).
Weigh in below….
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