Global Trends by Martin Khor

Monday 19 April 2010

At last, a case to expose misdeeds that led to the crisis?

Last Friday, US authorities charged the biggest investment bank with fraud in a sub-prime mortgage security scheme that led investors to a billion-dollar loss.  Is it first shot in a battle to discipline and regulate Wall Street firms?

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New and potentially devastating evidence of financial manipulation by Wall Street firms has emerged, just as the United States Senate is preparing to consider a bill this week to tighten the regulation of financial institutions.

Last Friday, the biggest US investment bank, Goldman Sachs, was charged by the US Securities and Exchange Commission (SEC) of committing fraud that led to investors losing over US$1 billion. 

The case involves the sale to investors in 2007 of securities linked to sub-prime house mortgages – the kind of financial products that triggered the global financial crisis.

In a 22-page lawsuit, the SEC charged Goldman Sachs and its Vice President Fabrice Tourre with failing to disclose that the hedge fund Paulson & Co. had a major role in working with the bank to create a security backed by sub-prime mortgages, while Paulson at the same time took a “short position” on the same mortgages to bet that their value would go down.

The security, named Abacus 2007-AC1 and which is known technically as a collateralised debt obligation (CDO), was created and sold by Goldman Sachs in 2007 just before the start of the financial crisis. 

Abacus did very badly for those who invested in it.  Within 9 months of its sale, 99% of the set of mortgages in the security had been downgraded.  Investors lost more than US1 billion while Paulson which made a bet against the mortgages profited also by US$1 billion.

A major loser is the Royal Bank of Scotland (now largely owned by the UK government). It had to pay US$841 million to Goldman (which passed most of it to Paulson) in August 2008 because it had taken over Dutch bank ABN Amro which in turn had taken on the credit risk or insurance over a significant tranche of the security that turned sour.  A German bank, IKB, also lost US$150 million.

The SEC's enforcement officer Robert Khuzami described the fraud as follows: “Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio...The product was new and complex but the deception and conflicts are old and simple.”

The SEC accused Goldman of making statements and omissions when constructing a CDO, and failing to disclose that Paulson & Co. was involved in creating the CDO (including selecting the mortgages that went into its portfolio) that it was shorting.

Instead, Goldman informed investors that an independent firm, ACA Management, had selected the CDO portfolio, said the SEC. 

It also alleged that Goldman Vice-President Mr. Fabrice Tourre misled ACA Management to believe that Paulson had invested US$200 million in the equity of the Abacus CDO and had thus taken 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.”

According to the SEC:  “In sum, Goldman Sachs 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 SEC court document quoted an email to a friend from Goldman Vice President Fabrice Tourre, who had coordinated the Abacus product, as saying that “with more and more leverage in the system, the whole building is about to collapse” and the only potential survivor is the fabulous Fab (himself), “standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding the implications of all these monstrosities.”

This email has come back to haunt Goldman and Tourre and is destined to become one of the most cited quotations when the history of the financial crisis is written, as both   a confession and a correct prophecy by a major player who helped to engender the crisis.

According to a Business Week article, the SEC’s accusations may fuel critics’ claims that Goldman put its own interests ahead of clients’ and profited from practices that led to the financial crisis.

It also quotes Christopher Whalen, an analyst at US-based Institutional Risk Analytics, as saying:  “This litigation exposes the cynical, savage culture of Wall Street that allows a dealer to commit fraud on one customer to benefit another.”

Meanwhile, Goldman Sachs has denied the charges. It said it provided “extensive disclosure” to IKB and ACA about the risk of the underlying mortgage securities, and that ACA selected the portfolio.  It also denied it told ACA that Paulson was going to be an investor in the CDO.

Paulson also said that it did not “sponsor or initiate” the Abacus programme and that ACA had sole authority over the selection of all collateral in the CDO.

The SEC case against Goldman will be important for exposing the mechanics of the financial institutions and instruments, speculation and manipulation that lay at the heart of the financial crisis.  There is an expectation that this is only the first case and that more cases involving other banks may follow.

But as Financial Times columnist Gillian Tett points out, the subprime and CDO markets were so opaque and it was often very unclear what was legal or not, and bankers were adept at “innovating” to get around the law.

In other words, what may be grossly unethical may actually not be illegal.  It remains to be seen whether the SEC will succeed in this case or other cases. 

Thus, given the weaknesses in the law, it is all the more important that the US Senate and administration devise and adopt new laws that reform the present extremely weak regulation of the financial markets and their instruments.