The GOP had better not carry Wall Street’s water

Whatever its ultimate merits, the SEC complaint against Goldman Sachs makes fascinating reading. Essentially, Goldman is alleged to have bilked its own customers by not disclosing that the deck was stacked against them from the get-go, because the securities in the fund (ABACUS 2007-AC1) were being selected precisely for their weakness:

GS&Co marketing materials for ABACUS 2007-AC1 -– including the term sheet, flip book and offering memorandum for the CDO -– all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management LLC (“ACA”), a third-party with experience analyzing credit risk in RMBS. Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc. (“Paulson”), with economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO, played a significant role in the portfolio selection process.

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…

The deal closed on April 26, 2007. Paulson paid GS&Co approximately $15 million for structuring and marketing ABACUS 2007-AC1. By October 24, 2007, 83% of the RMBS in the ABACUS 2007-AC1 portfolio had been downgraded and 17% were on negative watch. By January 29, 2008, 99% of the portfolio had been downgraded. As a result, investors in the ABACUS 2007-AC1 CDO lost over $1 billion. Paulson’s opposite CDS positions yielded a profit of approximately $1 billion for Paulson.

We are not persuaded of the merits of the SEC case after reading the complaint. Unless it can be shown that the portfolio selection agent, ACA, was acting inappropriately, we don’t see the problem with the deal. (If ACA did do bad things, then game over, however.) Paulson was betting that certain adjustable sub-prime mortgages in places like California and Florida were going to have problems. He was right and made a lot of money, but what if he had been wrong? Only in retrospect do we know that Jon Paulson was almost immediately to be proven right and that plenty of other sophisticated investors were spectacularly wrong. At the time of the deal in question, it was unclear what was happening in the markets. (Goldman has its own set of responses to the complaint.)

In a way, the merits of the case are beside the point. It’s a good story with winners and losers and lots of money, so it has legs. More importantly, it’s a good political story, and we bet there are more of these waiting in the wings as 2010 heads towards November. (We note that observers like Tom Maguire, Barry Ritholtz, and Bloomberg see big problems ahead for Goldman.) Whatever the ultimate outcome of this and similar cases, it’s likely to be a big political loser for the GOP to be seen as carrying Wall Street’s water — no matter how awful the financial reform legislation turns out to be (and it’s probably going some very negative elements).

The Obama administration and the Democrats have a popular issue if the Republicans make themselves look like shills for unscrupulous bankers. It’s no accident that Obama’s first target is Hank Paulson’s Goldman Sachs — the GOP ought to recognize the shot across its bow and act accordingly.

2 Responses to “The GOP had better not carry Wall Street’s water”

  1. Steve Says:

    Last week Mitt Romney and Michael Steele headlined an RNC fundraiser at the home of John Paulson. Yeah, that John Paulson, the one whose investment scheme led to the fraud charges leveled by the SEC at Goldman Sachs on Friday.

  2. Lawrence J. Kramer Says:

    I don’t see how ACA’s conduct enters into this. ACA was (allegedly) a victim, along with IKB. ACA may owe IKB on account of ACA’s negligence in not figuring out that Paulson was a short, but that’s not fraud. The fraud lay in GS not telling either ACA or IKB that the portfolio suggester was a short seller.

    It makes no difference that Paulson might have been wrong. If his shortness was irrelevant, why did GS hide it? The answer is simple: if ACA knew about it, they would not have let him in the room, and he would have had to live with the best pool ACA could structure. If IKB had known of Paulson’s interest, their whole reason for bringing in ACA would have been thwarted, and they would not have done the deal. (They went to ACA in the first place because they knew GS was bearish and so might pick bad paper. Not likely they’d want a pool picked by another short.)

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