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?
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
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
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
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
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
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
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.
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