Sunday, April 18, 2010

Why Goldman Sachs Did Not Commit Fraud in the Paulson CDO Case

by Henry Blodget

The SEC's fraud case against Goldman boils down to two key questions:
  • Was Paulson & Co.'s involvement in the security selection process for the Abacus CDO a "material fact" that should have been disclosed to investors?
  • Did Goldman (via Fabrice Tourre) mislead the security selection agent, ACA, into thinking that Paulson & Co was intending to BUY the CDO instead of shorting it?
There is intense disagreement among pundits and practitioners about the first question, so let's think it through in detail.

First, some important background to keep in mind:
  • In securities fraud cases like this, prosecutors and plaintiffs always have a huge advantage, one that often goes unrecognized by pundits and other observers after-the-fact. What's the advantage?  Unlike those who made the bets (and disclosures) on the securities at the time of the alleged fraud, the world now knows what happened.  If Paulson & Co. had been wrong about the housing market and the buyers of the CDOs had made money, we would not be having this conversation.  Rather, Paulson & Co. would have suffered the same fate as dozens of other investors who bet against the housing market from 2003-2007 (huge losses) and ACA, IKB, and the other buyers would still be congratulating themselves on their investing acumen.  Paulson & Co. might even be suing Goldman for retaining a long position in the CDO and, thus, betting against its client Paulson & Co, something that Goldman has said it doesn't do.  (Remember, Goldman retained an ownership stake in the CDO and lost money on it).
  • In 2007, Paulson & Co. had not yet been anointed the smartest firm in the world--the one that made billions betting against the housing collapse.  Back then, it was just another hedge fund.  So Paulson's involvement in the security selection process seems more meaningful now than it probably did then.  (Plenty of firms had been betting on the collapse of the housing market for years, and they'd all been wrong).
  • In 2007, the housing market had not yet collapsed, and everyone who had bet on it collapsing had lost huge amounts of money, gone bankrupt, and/or otherwise been rendered fools.  So much money had been made betting on further appreciation of the housing market, meanwhile, that investors were DESPERATE for vehicles that allowed them to make these bets in a more efficient fashion.  That's why the buyers of Goldman's CDO bought the CDO: They thought housing prices were headed higher, and they wanted to make a killing on it.  (These buyers turned out to be wrong, but no one knew that at the time.)
  • As Goldman has observed, with CDOs like the one in question, there is ALWAYS a short side and a long side: The buyers of the CDO knew that someone was going to be betting against them.  
Okay, now let's think about Paulson's involvement in the security selection process.
The most persuasive argument as to why this was a material fact is the idea that Paulson was choosing the WORST securities it could find, so that the CDO's value would plummet if the housing market collapsed.  The investors in the CDO, meanwhile, presumably thought that the securities in the CDO were the BEST that could be found (or at least good), because an independent portfolio selection agent (ACA) had been tapped to select them.
Given this, if Paulson had had control over which securities were selected for the CDO, this would OBVIOUSLY be fraud: Paulson wanted BAD bonds in the CDO, not good ones.  The buyers of the CDO, meanwhile, wanted GOOD bonds.  That would be a direct conflict of interest that should obviously have been disclosed.
  • Paulson did NOT have control over which securities were selected for the CDO. 
This is critical.  It's also a fact that is clearly visible in the evidence the SEC provided.
The firm that DID have control over which securities were selected, ACA, was a highly sophisticated firm that analyzed securities like this for a living.  It had FULL CONTROL over which securities were included in the CDO.  We know this because, of the 123 bonds that Paulson proposed for the CDO, ACA only included 55 of them.  In other words, ACA dinged more than half of the bonds Paulson wanted in the CDO, presumably because they did not meet ACA's quality hurdle.

Now, did Paulson influence which securities ACA selected?  Yes, he probably did.  But any time someone says or does anything with respect to a security, there are lots of things that influence decisions.  Company managements, for example, which plead their (bullish) cases until they are blue in the face.  The opinions of other investors, which are hard to ignore, especially if the other investors are viewed as smart.  PR flacks.  The media.  Stock screeners.  Personal experience.  Personal worldview (bullish or bearish).  Analytical styles and models.  Etc.  All of these things influence opinions about securities.  None of them are considered material facts that merit disclosure (if they did, the disclosure section in every prospectus would be 200 pages long).

ACA, furthermore, did not just pick the securities.  It BOUGHT THE CDO.  ACA's parent invested more than $900 million in the CDO.  So ACA's parent presumably had confidence in ACA's analytical judgement.  (ACA is now claiming that it bought the CDO in part because it thought Paulson was buying the CDO, too.  Given that ACA was supposed to be expert in evaluating the securities it picked and bet almost $1 billion, this seems lame, but that's the second part of the SEC's case, which we're not discussing here).

Read the rest here.


  1. You're missing the real problem here. Frankly, if the SEC charges are fraud or not, let alone if Goldman gets convicted or not, are truly secondary. Why? Goldman got PUBLICLY caught betting against a client *AGAIN*. This company is looking to take clients down, not help them make money.

    The market is based on a degree of trust. If you don't trust a company (enough) you don't do business with them. Between incidents like Goldman's involvement with Greece, to the city of Birmingham's bribery, to this. On and on it goes. Goldman Sachs was supposed to be the best of the best. These acts CONFIRM PUBLICLY they are low-life pondscum. Considering how much power and money they have, that is a major problem. If the market decides not to do business with them, the U.S. economy has a BIG problem.

  2. You're wrong, Bob.

    There were material facts that ACA ASKED FOR that Goldman lied about.

    ACA only approved the selection because they were TOLD several times that Paulson had a long interest and that he would take a hit if things went bad.

    Goldman was fully aware that the CDOs were bad and that they could market them only because of ACA's branding of them.
    Tourre says so in his emails.

    That's pure and simple on its face fraud.

  3. @Lila and Annonyous

    Goldman was LONG the CDO, THEY LOST MONEY ON THE DEAL. They thought Paulson was an idiot.

    What fact did ACA ask for that Goldman lied about that would help ACA in its evaluation? Simply saying Paulson was going to buy in, doesn't mean anything. Are you saying that ACA thought Paulson was a better evaluator of CDO's than ACA so ACA simply then failed to carry out on its fiduciary obligation to evaluate the CDO.

    Let me repeat Goldman and ACA took the opposite side of Paulson in the trade. They thought Paulson was an idiot.