Justice Litle, Editorial Director, Taipan Publishing Group
By now you’ve likely heard the news… the SEC (Securities and Exchange Commission) has charged Goldman Sachs with fraud. Goldman (GS:NYSE) stock plunged in response, dropping more than $14 billion in total market value.
Rest assured, this fraud accusation is a very big deal…
Of course, you won’t see Goldman execs frog-marched to jail in handcuffs anytime soon. And Goldman might even succeed in beating the SEC’s rap. (They’ll surely hire the best lawyers on the planet to help them do it.)
Nonetheless, the news is hugely important, due to all the behind-the-scenes factors involved. (For one thing, political risk on the investment banking side and the hedge fund side has just shot through the roof. That’s very bad news for the market.)
We’ll get into the complex question of just how this news could impact markets in another post. Today, though, we want to focus on another question. Just what did Goldman do?
A Brand-New F.I.A.S.C.O.
Perhaps the best way to understand the charges against Goldman Sachs is to first read a book more than 10 years old. The name of the book is F.I.A.S.C.O.: Blood in the Water on Wall Street, by Frank Partnoy. It was first published in February 1999.
The book is Partnoy’s tell-all description of his former life as a Morgan Stanley derivatives salesman. F.I.A.S.C.O., the acronym in the book’s title, stands for “Fixed Income Annual Sporting Clays Outing.” Every year, Morgan Stanley’s rough-and-tumble bond trading derivatives team would get drunk and go shooting. In their minds, they were probably shooting at clients.
Partnoy, long out of the investment banking biz, revealed things in the book that clients were never supposed to know. Like the lingo of “ripping a client’s face off,” for example, or the game of “blowing up” a client.
In Morgan Stanley terms, to “rip a client’s face off” meant to sell them a booby-trapped derivative trade. The client, for whatever reason, thinks he’s getting a lucrative deal on a highly exotic derivative product that will provide capital gains, steady income, or both. But in reality the client has just signed on for a fancy mugging.
When the trades blew up (as they inevitably did), Morgan Stanley would be on the other side – ready to collect all the money that the client lost. In this, the one-time white shoe investment bank was like a dynamite-rigged bucket shop.
Basically, the Morgan Stanley derivatives department of the 1990s was focused on finding gullible clients who had no clue as to the risk of what they were actually buying… selling them booby-trapped time bombs… and then profiting on the other side of the trade when the client blew up.
This is what Goldman Sachs did to its clients for a fee. In exchange for a hefty sum, Goldman convinced some of its less-than-bright customers to load up on a subprime deal that was engineered to fail. The clients thought they were making a sound investment that would provide them with steady income. In reality, they were being set up to get their faces ripped off.
The main difference is that, this time, Goldman was only acting as middle man. Whereas Morgan Stanley itself was on the other side of the trade in the 1990s, this time a giant hedge fund was the one looking to make a big score. Goldman Sachs acted as matchmaker for a fee.
The “Fabulous Fab”
On the Goldman Sachs side, the player at the center of the mess is an obnoxious 31-year-old Frenchman named Fabrice Tourre. The SEC has filed civil charges against both Tourre as an individual and Goldman Sachs on the whole.
It doesn’t look too good for Goldman or Tourre. Even if they win the case, the bank’s reputation has been severely damaged. The following e-mail excerpt was shown on the front page of The Wall Street Journal weekend edition:
The whole building is about to collapse anytime now. …Only potential survivor, the fabulous Fab… standing in the middle of all these complex, highly leveraged, exotic trades he created…
In the same e-mail, “the fabulous Fab” admitted he created the trades “without necessarily understanding all of the implications.”
So here we have a hotshot trader who sold toxic waste to a bunch of rube-like clients… saw the blow-up coming in advance… and then bragged about side-stepping the carnage.
Built to Spill
It’s not a crime for an investment bank security to go belly up. Clients can and do lose money on a regular basis. The crime, in the eyes of the SEC, had to do with the fact that Goldman Sachs packaged and sold a deal that was intentionally designed to fail by the hedge fund that dreamed it up.
The fact that Goldman failed to warn its investors – saying to them “just so you know, this deal was put together specifically at the request of someone who wants to short it” – was a breach of fiduciary duty.
The deal in question was known as Abacus 2007-AC1, or “Abacus.” Abacus was created at the request of John Paulson, the hugely successful hedge fund investor who made billions of dollars in profit from the subprime crisis (including a personal profit approaching $4 billion).
Paulson wanted Abacus created so he could buy credit default swap insurance against it – not unlike wanting a house built in a highly flammable brushfire zone, so that one could then take out fire insurance on that same house.
Abacus was something known as a “synthetic collateralized debt obligation.” In plain English terms, Abacus was a collection of highly risky subprime mortgage bonds. These bonds paid a high rate of interest, precisely because they were so risky. This high interest rate attracted institutional investors with more greed than sense.
Sharks and Minnows at the Poker Table
Another way to understand what happened is to picture a giant poker table. John Paulson turned out to be the “shark” at the table – the sharp, savvy pro who knew exactly what he was doing in expecting the bubble to burst.
The gullible Goldman Sachs clients were the “minnows” at the table – i.e. the novice poker players who thought they knew what they were doing, but clearly didn’t. These minnows were players like the German bank IKB, which took on way too much risk in various subprime deals and went tapioca in result.
Paulson’s hedge fund brainstormed the Abacus deal as something to sell to the minnows. They wanted the minnows to buy and hold the toxic assets so that Paulson & Co. could bet against them. When subprime blew up, the minnows lost more than a billion dollars… and Paulson made a cool billion. (Plus billions more in other places.)
Minnows, meet shark.
Goldman Sachs played the role of gracious host for this little poker game. On the one hand, Goldman called in the seasoned pro (Paulson) to fill the key seat at the table. On the other hand, Goldman filled up the rest of the seats with “shark bait” – the less than savvy players who were destined to lose their shirts.
Fraud, or Something Else?
So is Goldman Sachs guilty of fraud as the SEC charges? You can read the full text of the SEC charges here:
The Commission brings this securities fraud action against Goldman, Sachs & Co (“GS&Co”) and a GS&Co employee, Fabrice Tourre (Tourre) for making materially misleading statements and omissions in connection with a synthetically collateralized debt obligation (“CDO”) GS&Co structured and marketed to investors…
The “materially misleading statements and omissions” have to do with the fact that Goldman knew Abacus was engineered to fail (by design of its savvy originator) yet failed to mention this to the “minnows” on the other side.
More evidence for the “fail by design” charge came from the fact that Paulson shopped around, looking for the worst mortgages possible to go into the deal. For instance, subprime mortgages from Wells Fargo, a rival bank, were rejected by Paulson because they were perceived as too high quality, i.e. not junky enough.
Some will say the out-of-luck Goldman clients – the ones who lost big, fueling Paulson’s massive gain – should have embraced the principle of “caveat emptor” (buyer beware). And all things being equal, that is true.
But still… if a public company were to create a spin-off for the express purpose of letting executives short the spin-off’s stock, wouldn’t you want to know?
Whether or not Goldman is guilty of fraud as the SEC asserts, they are certainly guilty of treating their clients (or at least half their clients) like sheep to be sheared – or rather chum for the sharks.
It’s like the old poker saying goes: “If you’ve been sitting at the table for half an hour and you still can’t tell who the fish is… then the fish is you.”
Tomorrow we’ll take a closer look at why the Goldman fraud charges have serious implications, and are not just a tempest in a teapot.