AMFI Registered Mutual Fund Distributor | SEBI registered Investment Adviser
FSM LOGO

                    


titl_l_gif
Research
title_r_gif
Share | Email Print more
SEC charges Goldman Sachs with fraud
April 20, 2010

On 16 April 2010, the SEC filed a lawsuit against Goldman Sachs, charging the securities firm with fraud in structuring and marketing of CDO tied to subprime mortgages.


Author : iFAST Research Team



Untitled Document

What’s going on:
On 16 April 2010, stock markets were shocked by the Securities and Exchange Commission (SEC)’s move to charge securities firm Goldman Sachs with fraud relating to the creation of a collateralised debt obligation (CDO). The SEC alleges that Goldman Sachs failed to disclose vital information relating to the CDO to investors, and did not reveal the role of a major hedge fund in selecting the CDO portfolio, nor the short position that the hedge fund had taken against investors in the CDO.

Goldman Sachs plunged 12.8% at the close of the trading session, while US financials (represented by the S&P 500 Financials index) collectively declined 3.8% (returns in USD terms).

The CDO – the security in question
The SEC’s allegations relate to a synthetic CDO called ABACUS 2007-AC1, which was structured by Goldman Sachs in early 2007. A CDO is a structured security whose value is derived from a portfolio of underlying fixed income assets. CDOs are structured to allow for different tranches, which represent different levels of risk (and hence different potential returns). Higher risk tranches offer the highest potential returns, but these get impacted first (and suffer the first capital losses) in the event of any underlying security defaults. While some CDOs hold the actual securities, synthetic CDOs are created by simply referencing fixed income assets to replicate exposure, instead of actually holding the assets.

What happened
According to court filings, a hedge fund, Paulson & Co. had the intention to take short positions in selected subprime mortgage bonds in the belief that these securities would default or lose a substantial portion of their value (Paulson & Co. would go on to gain approximately US$1 billion from shorting these bonds). Discussions with Goldman Sachs yielded the creation of the synthetic CDO (ABACUS 2007-AC1), where investors in the security took the long position in the basket of subprime mortgage bonds, offsetting Paulson & Co.’s short position in those securities.

To improve the credibility of the CDO’s underlying security selection, ACA Management LLC was roped in as a third-party collateral manager (portfolio selection agent) to approve the selected securities in the product’s creation. According to the court filing, ACA was not aware that Paulson & Co. intended to take the short position in the CDO, and was led to believe that the hedge fund instead intended to invest in an equity tranche (a long position with the highest risk), considered normal procedure in CDO structuring. Goldman Sachs received approximately US$15 million in structuring fees from Paulson & Co. for marketing and structuring.

When the product went bad As the subprime mortgages collapsed in value in 2008, notes related to the CDO lost almost all of their value. IKB, a German commercial bank purchased US$150 million worth of notes from two tranches of the CDO (and lost almost its entire investment), while the portfolio selection agent’s parent company, ACA Capital Holdings, sold insurance on US$909 million of a super senior tranche of the CDO (thus assuming the risk). However, this exposure was transferred to ABN AMRO Bank, which was later acquired by a consortium of banks which included Royal Bank of Scotland (RBS). In August 2008, RBS unwound its exposure in the CDO at a cost of US$841 million.

Going forward
The SEC’s lawsuit seeks “injunctive relief, disgorgement of profits, prejudgment interest, civil penalties and other appropriate and necessary equitable relief” from the defendants. Put simply, the SEC is looking for Goldman Sachs to return the US$15 million it earned in structuring the product, and perhaps also to provide compensation to investors (RBS, IKB) in the ABACUS 2007-AC1 CDO (which amount to just over a billion US dollars).

Our Take
The primary concern for investors in the banking sector is that if the courts rule that Goldman Sachs has to compensate the investors in the ABACUS 2007-AC1 CDO, this could set a precedent for investors in other subprime mortgage CDOs to seek recourse from the banks which structured these products. Considering the huge amount of CDOs which were structured and sold during the US housing boom, any mass recourse activity would be a devastating hit to the structuring banks like Goldman Sachs.

Such a scenario, we think, will not materialise for one simple reason. The charges absolve all the other parties (the investors like IKB, as well as the insurer, ACA Capital Holdings) of their responsibilities, despite these parties earning fees or returns in various roles. It is ludicrous that ACA Capital would claim that knowledge of Paulson and Co.’s short exposure would make a difference in its decision to insure the CDO (an examination of the portfolio’s underlying securities apparently did not appear to be an important consideration!).

The court filings suggest some misrepresentation on Goldman’s part, but also serves to highlight the lack of due diligence by the other parties. It is worth noting that ACA’s analysis of the list of 123 securities that Paulson & Co. intended to short showed that the company had previously purchased 62 of them at the same or lower ratings. Compensating the investors in the ABACUS 2007-AC1 CDO would be akin to bailing out investors who have made extremely poor investment decisions.

Impact largely on sentiment, repercussion fears overblown
It is unlikely that the courts will award full compensation to the investors in the ABACUS 2007-AC1 CDO, but Goldman Sachs will likely be subjected to a fine of sorts for its failure to disclose information relating to the CDO’s structuring. Even if full compensation is awarded, the amount is small compared to Goldman’s profits, and will simply be a minor one-off charge. If authorities in Europe move in to investigate Goldman, it would be very difficult to justify “bailing out” other investors in similar products, given their institutional status (which indicates that these investors should have professional knowledge of the products that they were buying).

The main impact will be on investor sentiment on the financial sector, as the Goldman fraud case has created an element of uncertainty. We think that repercussion fears are overblown, and with US banks continuing to report a strong set of results, the sector is already on the mend (Citigroup recently reported 1Q 10 profit of US$4.4 billion, its largest quarterly profit since 2007). At this juncture, investors with a strong appetite for volatility and who seek higher returns can look to increase exposure to global financials in the supplementary portion of the portfolio.

related articles:
US Financials - PB ratios matter
Global Financials to drive the new bull market


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


Comments (0) | Comment on this Article
 (Click on Comments/Comment on this Article to show or hide comments/post a comment)
USEFUL LINKS
Recommended Funds
Recommended Portfolios
Chart Centre
Risk Profiler