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SEC charges Goldman Sachs with fraud over USD1bn sub-prime mortgage CDO losses

The Securities and Exchange Commission has charged Goldman, Sachs & Co and one of its vice-presidents with defrauding investors by misstating and omitting key facts about a financial product tied to sub-prime mortgages launched as the US housing market was beginning to falter.

The SEC alleges that Goldman Sachs structured and marketed a synthetic collateralised debt obligation that hinged on the performance of sub-prime residential mortgage-backed securities. When many of the securities defaulted, the regulator claims, investors in the CDO lost more than USD1bn.

The US regulator says Goldman failed to disclose to investors vital information about the CDO, in particular the role that hedge fund manager Paulson & Co played in the portfolio selection process and the fact that one of Paulson’s hedge funds had taken a short position against the CDO.

“The product was new and complex but the deception and conflicts are old and simple,” says Robert Khuzami, director of the SEC’s enforcement division. “Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party.”

Kenneth Lench, chief of the SEC’s structured and new products unit, adds: “The SEC continues to investigate the practices of investment banks and others involved in the securitisation of complex financial products tied to the US housing market as it was beginning to show signs of distress.”

In a statement, Goldman said: “The SEC’s charges are completely unfounded in law and fact, and we will vigorously contest them and defend the firm and its reputation.”

The SEC alleges that Paulson & Co, which made as much as USD15bn in profit for its funds in 2007 betting that US sub-prime mortgage market would collapse, paid Goldman to structure a transaction in which Paulson could take short positions against mortgage securities chosen by itself, based on a belief that the securities would experience ‘credit events’ – that is, defaults.

According to the SEC’s complaint, filed in the US District Court for the Southern District of New York, the marketing materials for the CDO known as Abacus 2007-AC1 claimed that the portfolio of residential mortgage-backed securities underlying the CDO was selected by ACA Management, a third party with expertise in analysing credit risk in such securities.

The regulator alleges that undisclosed in the marketing materials and unknown to investors, Paulson, which was poised to benefit if the underlying securities defaulted, played a significant role in selecting which securities should make up the portfolio.

The complaint alleges that after participating in the portfolio selection, Paulson effectively shorted the portfolio it helped select by entering into credit default swaps with Goldman to buy protection on specific layers of the Abacus capital structure.

Given its financial short interest, Paulson had an economic incentive to select securities that it expected to default in the near future. Goldman Sachs did not disclose Paulson’s short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors.

The SEC alleges that Goldman vice-president Fabrice Tourre was principally responsible for the Abacus CDO, structuring the transaction, preparing the marketing materials and communicated directly with investors.

Tourre allegedly knew of Paulson’s undisclosed short interest and role in the collateral selection process. In addition, the SEC says, he misled ACA into believing that Paulson was investing approximately USD200m in the equity of Abacus, indicating that the hedge fund manager’s interests in the collateral selection process were closely aligned with ACA’s own, when in fact they were sharply conflicting.

According to the complaint, the deal closed on April 26, 2007, and Paulson paid Goldman approximately USD15m for structuring and marketing Abacus. By October 24, 83 per cent of the securities in the Abacus portfolio had been downgraded and 17 per cent were on negative watch, and by January 29, 2008, 99 per cent of the portfolio had been downgraded.

Investors in the liabilities of Abacus are alleged to have lost more than USD1bn. The SEC has charged Goldman and Tourre with violations of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Exchange Act Rule 10b-5. The regulator is seeking injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.

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