Another Black Swan has crashed into Wall Street, this time hitting the HQ of Goldman Sachs. This wasn’t happenstance. This was a precisely aimed ballistic missile fired by the Obama administration via the SEC in order to force through a banking reform bill and (just maybe) curb the power and influence of Goldman Sachs.
At this point, one cannot underestimate the potential effect of this action. Goldman Sachs is the worlds’ most powerful merchant bank. It is more influential than most countries with an alumni list that includes three US Treasury Secretaries, two national bank governors and a Prime Minister.
The SEC announced that it was to charge Goldman Sachs with fraud only hours after holdout Senator Susan Collins (R-Maine) chose to change her mind & join her 40 other fellow senators in signing a letter to the Democratic Majority Leader asking for further negotiation in order to weaken the legislation. It meant that a filibuster proof 60-40 majority was not going to happen.
However, this note is not concerned with Washington infighting but with the potential financial fallout from the SEC charges.
To understand the possible implications for investors, we must look at the specific charges;
The Commission brings this securities fraud action against Goldman, Sachs & Co. and a GS&Co employee, Fabrice Tourre ("Tourre"), for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation ("CDO") GS&Co structured and marketed to investors. This synthetic CDO, ABACUS 2007AC1, was tied to the performance of subprime residential mortgage-backed securities ("RMBS") and was structured and marketed by GS&Co in early 2007 when the United States housing market and related securities were beginning to show signs of distress. Synthetic CDOs like ABACUS 2007-AC1 contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.
Basically, it is alleged that a GS client, ACA Management was courted and encouraged by GS to invest in a synthetic CDO, ABACUS 2007-AC1. It is also alleged that unbeknownst to ACA that hedge fund Paulson & Co Inc. was a significant participant in the construction of the RMBS portfolio. The indictment continues:
After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps ("CDS") with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure. Given its financial short interest, Paulson had an economic incentive to choose RMBS that it expected to experience credit events in the near future. GS&Co did not disclose Paulson's adverse economic interests or its role in the portfolio selection process in the term sheet, flip book, offering memorandum or other marketing materials provided to investors.
In sum, GS&Co arranged a transaction at Paulson's request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson's role in the portfolio selection process or its adverse economic interests.
Tourre was principally responsible for ABACUS 2007-AC1. Tourre devised the transaction, prepared the marketing materials and communicated directly with investors. Tourre knew of Paulson's undisclosed short interest and its role in the collateral selection process. Tourre also misled ACA into believing that Paulson invested approximately $200 million in the equity of ABACUS 2007-AC1 (a long position) and, accordingly, that Paulson's interests in the collateral section process were aligned with ACA's when in reality Paulson's interests were sharply conflicting.
A good definition of a conspiracy is two or more people acting in an illegal manner in order to achieve a legal outcome. If the SEC allegations are proven correct, then GS could be in a world of hurt.
Fabien Tourre is probably just the first Goldman Sachs executive to be named. There could be others, after all, the well heeled do tend to crack under questioning!
So how serious could this be? The implications could be massive. Firstly, should Goldman’s be found guilty in the civil SEC case, it is more than possible that criminal prosecutions could ensue. Remember that back in 1986, Rudi Guiliani used a RICO indictment against Drexel Burnham Lambert on the basis that they were involved in an organised criminal conspiracy. Drexel was also potentially liable under the doctrine of respondeat superior, which holds that companies are responsible for an employee's crimes.
Ultimately, this may not be just about the SEC complaint.
From the Huffington Post: “The Welt am Sonntag newspaper quoted Chancellor Angela Merkel's spokesman, UIrich Wilhelm, as saying that German regulator BaFin will ask the U.S. Securities and Exchange Commission for information.
"After a careful evaluation of the documents, we will examine legal steps," he said, according to the report”.
Gordon Brown ordered a special investigation into Goldman, accusing the bank of "moral bankruptcy". He threatened to block multimillion-pound bonus payouts if the firm is found guilty of wrongdoing.
This potential case against GS may redefine counterparty risk, particularly if other governments (such as Greece) join the feeding frenzy. Additionally, what of the other banks around the world that have also lost vast amounts of money with Goldmans? Will they be observing this case and exploring their legal options? I think so.
Could this also be the end for Goldman Sachs? Probably not. But if they are ultimately found guilty of the SEC charges, then what is to stop even ordinary householders from threatening class action law suits?
John Paulson’s problems are potentially even more dire in the short term. Paulson & Co are the largest institutional investor in SPDR Gold Trust (GLD), the world's largest physically backed gold exchange-traded fund--with 31.5 million shares valued at $3.38 billion. After the announcement on Friday of the GS indictment, gold dropped 2%. Goldman’s are also one of the biggest brokers and traders of raw materials in the world.
From BusinessWeek.com
“This is not good for commodities,” said Michael Pento, the chief economist at Delta Global Advisors. He correctly predicted the 2008 price collapse in raw materials. “It could be the case that traders stop making trades with Goldman.”
John Paulson’s much vaunted Paulson Gold Fund has woefully underperformed the market. But if you are presently an investor in the $10bn Paulson Advantage hedge fund what would you do? After all, Paulson & Co have not been named on the indictment as a co-conspirator. They did not market CDO’s to ACA. But are Paulson possibly vulnerable to future legal action should Goldman be found guilty? The answer has to be yes. The assets of Paulson & Co could be seized in a civil/criminal action. If that is so, then some people may be tempted to redeem their investments. That scenario is fatal for any fund manager.
However, we need to look beyond the indictments and see the bigger picture. The most Keynesian of all Presidents is taking on the most powerful financial institution in the world in a battle for survival.
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