Goldman Sachs under the gun

CAPITAL MARKETS REPORTER

The filing of civil fraud charges against Goldman Sachs Group Inc. will cast a long pall over major banks that dealt in subprime-backed securities, as the U.S. regulator works to repair its image in the wake of the Madoff scandal.

Goldman denies the charges by the U.S. Securities and Exchange Commission that it committed fraud by not disclosing the role that hedge fund Paulson & Co. played in structuring a mortgage-backed investment that was sold to investors.

According to the SEC, Paulson wanted the investment to fail because the fund manager was betting against it.

But no matter the outcome in the jury trial the SEC has requested, the hit to Goldman and the financial sector is already huge.

Investors wiped $12.4-billion (U.S.) off the firm's market value in trading yesterday, and hammered shares of other firms such as Bank of America Corp., JPMorgan Chase & Co. and Morgan Stanley, all of which dealt in the same type of derivatives that are at the heart of the SEC's allegation of fraud at Goldman.

The charges are viewed as a signal that the SEC, which rebuilt its investigative unit in the wake of its embarrassing failure to detect the Ponzi scheme run by Bernard Madoff, is going to be more aggressive with Wall Street.

The other message is that the biggest firms won't be spared.

"The SEC has really been trying to rehabilitate its image and I think here is a perfect example of that effort, with a very high-profile case - [Goldman] is one of the biggest players on the Street in a very complicated space," said Scott Meyers, a Chicago-based securities litigator with Ulmer & Berne LLP.

"In a certain sense, this is the SEC saying 'See, we can do complicated cases. Madoff was an aberration. We're back, and we're bad.' "

After the Madoff ordeal, when it was revealed that the SEC had been handed evidence but still failed to act, the agency changed the way it runs investigations. It created five groups to probe different areas of the market, including the unit that delved into the allegations against Goldman.

That group, the structured and new products unit, was tasked specifically with understanding and policing markets for "complex derivatives and financial products, including credit default swaps, collateralized debt obligations (CDOs), and securitized products."

In addition, the SEC tried to make co-operating in investigations more attractive.

Investigators were given the power to negotiate non-prosecution agreements and deferred prosecution deals that reward people who help in investigations.

That may have played a role in the Goldman investigation, as Reuters reported that Paolo Pellegrini, who co-managed Paulson & Co.'s credit opportunities funds, aided the SEC in its case against Goldman.

The SEC signalled that there may be more charges to come against other players. The agency's head of investigation, Robert Khuzami, said only that it was the first case brought by the structured and new products unit, which some analysts took to mean it won't be the last.

Kenneth Lench, who heads the structured and new products unit, said the enforcement agency "continues to investigate the practices of investment banks and others involved in the securitization of complex financial products tied to the U.S. housing market as it was beginning to show signs of distress."

For that reason, the shadow may hang over the other big investment banks that dealt in collateralized debt obligations for some time, said Gerard Cassidy, a banking analyst at RBC Dominion Securities.

"It's the unknown that has everybody very concerned," he said.

"Because of what has gone on with structured products on Wall Street, it's very hard to believe that this was the only instance that this happened."

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ABACUS 2007-AC1 CDO

GOLDMAN SACHS

Goldman Sachs works with Paulson & Co to create a derivative based on U.S. subprime mortgages, which Paulson wants to bet against.

PAULSON & CO. INC.

Paulson bets against the derivative, called ABACUS, using a credit default swap - a form of insurance that will pay out if ABACUS implodes.

WHAT THE SEC SAID

"The deal closed on April 26, 2007. Paulson paid GS&Co approximately $15-million for structuring and marketing ABACUS 2007-AC1".

The hedge fund (Paulson) paid Goldman $15-million to create and market the bad derivative, or CDO ("collateralized debt obligation").

ABACUS 2007-AC1 CDO

To create the derivative, Paulson picks bonds that are backed by low-quality mortgages given to borrowers with poor credit scores.

WHAT THE SEC SAID

"By October 24, 2007, 83% of the RMBS in the ABACUS 2007-AC1 portfolio had been downgraded and 17% were on negative watch. By January 29, 2008, 99% of the portfolio had been downgraded".

WHAT IT MEANS

During the dark days of the subprime mortgage crisis, this is the slow degradation of the assets contained in the CDO. They're losing value, and investors are losing money.

ACA?

Goldman hires another company called ACA to be the 'portfolio selection agent', which the SEC alleges was a sham to hide the fact that Paulson had really played a big role in the mortgage bonds that went into the derivative.

INVESTORS

ABN-AMRO

IKB

Lose $1-billion

WHAT THE SEC SAID

"As a result, investors in the ABACUS 2007-AC1 CDO lost over $1-billion. Paulson's opposite CDS positions yielded a profit of approximately $1-billion for Paulson".

WHAT IT MEANS

Those who invested in the CDO lose $1-billion. The hedge fund makes $1-billion by buying insurance (called a "credit default swap") against the devaluing of the assets in the investment.

NINIAN CARTER/BOYD ERMAN/THE GLOBE AND MAIL