Goldman Sachs, which emerged relatively unscathed from the financial crisis, was accused of securities fraud in a civil suit filed Friday by the Securities and Exchange Commission, which claims the bank created and sold a mortgage investment that was secretly devised to fail.
The move marks the first time that regulators have taken action against
a Wall Street deal that helped investors capitalize on the collapse of
the housing market. Goldman itself profited by betting against the very
mortgage investments that it sold to its customers.
The suit also named Fabrice Tourre, a vice president at Goldman who helped create and sell the investment.
The instrument in the S.E.C. case, called Abacus 2007-AC1, was one of
25 deals that Goldman created so the bank and select clients could bet
against the housing market. Those deals, which were the subject of an
article in The New York Times in December, initially protected Goldman from losses when the mortgage market disintegrated and later yielded profits for the bank.
As the Abacus deals plunged in value, Goldman and certain hedge funds
made money on their negative bets, while the Goldman clients who bought
the $10.9 billion in investments lost billions of dollars.
According to the complaint, Goldman created Abacus 2007-AC1 in February 2007, at the request of John A. Paulson,
a prominent hedge fund manager who earned an estimated $3.7 billion in
2007 by correctly wagering that the housing bubble would burst.
Goldman let Mr. Paulson select mortgage bonds that he wanted to bet
against — the ones he believed were most likely to lose value — and
packaged those bonds into Abacus 2007-AC1, according to the S.E.C.
complaint. Goldman then sold the Abacus deal to investors like foreign
banks, pension funds, insurance companies and other hedge funds.
But the deck was stacked against the Abacus investors, the complaint
contends, because the investment was filled with bonds chosen by Mr.
Paulson as likely to default. Goldman told investors in Abacus
marketing materials reviewed by The Times that the bonds would be
chosen by an independent manager.
Mr. Paulson is not being named in the lawsuit.
In recent months, Goldman has repeatedly defended its actions in the
mortgage market, including its own bets against it. In a letter
published last week in Goldman’s annual report, the bank rebutted
criticism that it had created, and sold to its clients, mortgage-linked
securities that it had little confidence in.
“We certainly did not know the future of the residential housing market
in the first half of 2007 anymore than we can predict the future of
markets today,” Goldman wrote. “We also did not know whether the value
of the instruments we sold would increase or decrease.”
The letter continued: “Although Goldman Sachs held various positions in
residential mortgage-related products in 2007, our short positions were
not a ‘bet against our clients.’ ” Instead, the trades were used to
hedge other trading positions, the bank said.
In a statement provided in December to The Times as it prepared the
article on the Abacus deals, Goldman said that it had sold the
instruments to sophisticated investors and that these securities “were
popular with many investors prior to the financial crisis because they
gave investors the ability to work with banks to design tailored
securities which met their particular criteria, whether it be ratings,
leverage or other aspects of the transaction.”
Goldman was one of many Wall Street firms that created complex mortgage securities — known as synthetic collateralized debt obligations
— as the housing wave was cresting. At the time, traders like Mr.
Paulson, as well as those within Goldman, were looking for ways to
short the overheated market.
Such investments consisted of insurance-like policies written on
mortgage bonds. If the mortgage market held up and those bonds did
well, investors who bought Abacus notes would have made money from the
insurance premiums paid by investors like Mr. Paulson, who were
negative on housing and had bought insurance on mortgage bonds.
Instead, defaults spread and the bonds plunged, generating billion of
dollars in losses for Abacus investors and billions in profits for Mr.
For months, S.E.C. officials have been examining mortgage bundles like
Abacus that were created across Wall Street. The commission has been
interviewing people who structured Goldman mortgage deals about Abacus
and other, similar instruments. The S.E.C. advised Goldman that it was
likely to face a civil suit in the matter, sending the bank what is
known as a Wells notice.
Mr. Tourre was one of Goldman’s top workers running the Abacus deal,
peddling the investment to investors across Europe. Raised in France,
Mr. Tourre moved to the United States in 2000 to earn his master’s in
operations at Stanford. The next year, he began working at Goldman,
according to his profile in LinkedIn.
He rose to prominence working on the Abacus deals under a trader named
Jonathan M. Egol. Now a managing director at Goldman, Mr. Egol is not
being named in the S.E.C. suit.
Goldman structured the Abacus deals with a sharp eye on the credit
ratings assigned to the mortgage bonds associated with the instrument,
the S.E.C. said. In the Abacus deal in the S.E.C. complaint, Mr.
Paulson pinpointed those mortgage bonds that he believed carried higher
ratings than the underlying loans deserved. Goldman placed insurance on
those bonds — called credit-default swaps
— inside Abacus, allowing Mr. Paulson to short them while clients on
the other side of the trade wagered that they would not fail.
But when Goldman sold shares in Abacus to investors, the bank and Mr.
Tourre only disclosed the ratings of those bonds and did not disclose
that Mr. Paulson was on other side, betting those ratings were wrong.
Mr. Tourre at one point complained to an investor who was buying shares in Abacus that he was having trouble persuading Moody’s
to give the deal the rating he desired, according to the investor’s
notes, which were provided to The Times by a colleague who asked for
anonymity because he was not authorized to release them.
In seven of Goldman’s Abacus deals, the bank went to the American International Group
for insurance on the bonds. Those deals have led to billions of dollars
in losses at A.I.G., which was the subject of an $180 billion taxpayer
rescue. The Abacus deal in the S.E.C. complaint was not one of them.
That deal was managed by ACA Management, a part of ACA Capital
Holdings, which changed its name in 2008 to Manifold Capital Holdings.
Goldman at first intended for the deal to contain $2 billion of
mortgage exposure, according to the deal’s marketing documents, which
were given to The Times by an Abacus investor.
On the cover of that flip-book, it says that the mortgage bond portfolio would be “selected by ACA Management.”
In that flip-book, it says that Goldman may have long or short
positions in the bonds. It does not mention Mr. Paulson or say that
Goldman was in fact short.
The Abacus deals deteriorated rapidly when the housing market hit
trouble. For instance, in the Abacus deal in the S.E.C. complaint, 84
percent of the mortgages underlying it were downgraded by rating
agencies just five months later, according to a UBS report.
It takes time for such mortgage investments to pay out for investors
who short them, like Mr. Paulson. Each deal is structured differently,
but generally, the bonds underlying the investment must deteriorate to
a certain point before short-sellers get paid. By the end of 2007, Mr.
Paulson’s credit hedge fund was up 590 percent.
Mr. Paulson’s firm, Paulson & Company, is paid a management fee and
20 percent of the annual profits that its funds generate, according to
a Paulson investor document from late 2008 titled “Navigating Through