SEC Sues Goldman for Fraud

The SEC’s civil fraud suit against Goldman Sachs and Goldman employee Fabrice Tourre, filed yesterday in federal court in New York, alleges the defendants made “materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) GS&Co structured and marketed to investors.”   The structured-investment’s value was tied to performance of a portfolio of subprime mortgages selected, according to Goldman’s marketing materials, by ACA Management.  According to the Complaint Goldman failed to disclose to investors that hedge fund Paulson & Co., Inc. “played a significant role in the portfolio selection process” while maintaining “economic interests directly adverse to investors”–in other words, while shorting the portfolio.  The SEC alleges Paulson entered into credit-default swaps with Goldman on specific tranches of the CDO.  According to the complaint Tourre was responsible for structuring the investment, knew of Paulson’s undisclosed short interest, knew Paulson’s role in selecting the portfolio, and misled ACA that Paulson had a $200 million equity stake in the deal.  Goldman earned $15 million in fees for structuring the investment.  Six months after the April 2007 closing 83% of the portfolio’s mortgages had been downgraded; by January 2008 downgrades stood at 99%. The SEC alleges investors lost over $1 billion in the deal, while Paulson made over $1 billion.   Goldman called the complaint’s allegations “completely unfounded” and claims its long position lost over $100 million.

The 22-page complaint crisply describes structured securities, synthetic CDOs, compromising internal correspondence, and this entertaining email from Tourre to a friend three months before the deal closed:

“More and more leverage in the system, The whole building is about to collapse anytime now. . . Only potential survivor, the fabulous Fab[rice Tourre]…standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!”

In another email before the deal closed Fabulous Fab wrote “the cdo biz is dead we don’t have a lot of time left.”  All together the complaint paints an ugly picture, but that’s what complaints do.

Why is Paulson not a defendant?  Because Paulson did not communicate anything to investors.  Investor disclosure, not deal structure, is the heart of the alleged fraud.

Missing Notes

Real estate mortgage foreclosure is pretty simple.  The borrower gives a promissory note to the lender to evidence the loan, the borrower fails to pay debt service when due, the lender accelerates the outstanding principal balance of the mortgage loan, obtains a court order to sell the real estate securing the loan, and auctions the property to the highest bidder.  The process rests on two plain-vanilla legal instruments, a promissory note and a mortgage.

Simple.  But take that mortgage loan, bundle it with 10,000 mortgage loans, sell the bundle to an investment bank, securitize the 10,000 debt service obligations, create A, B, and C tranches, and through financial alchemy you have new investment securities.  These securities can be an essential cog in the generation of capital for new mortgage loans or they can contribute to and exacerbate financial free-fall.  About 15 years ago I helped put together the first-of-its-kind (and, as far as I know, last of its kind) securitized pool of defaulted non-rated tax-exempt multifamily housing bonds. It was innovative, created a high tax-exempt yield for its purchaser, and worked.  Securitization can be a valuable tool.

Valuable, if the financial risks are handled properly and the mundane details don’t get lost in the shuffle.  Securitizing those 10,000 mortgage loans requires that the mortgage loan originator–a bank or mortgage company–assign the 10,000 promissory notes and related mortgage loans to whoever purchases the bundle.  Whoever securitizes the loans must place the notes and mortgages in a vault and track which set of legal instruments goes with which mortgaged property.  When Joe the Debtor defaults and the loan servicer hired to oversee the loans files for foreclosure it must present the original promissory note and mortgage to the court to prove that it owns the loan and is owed debt service payments.  No original promissory note and, usually, no right to foreclose.

It is distressing and depressing, but not surprising, to learn that keeping track of the notes and mortgages was not a Wall Street priority.  Bookkeeping is not sexy or lucrative.  Yet it is often the mundane details, the faulty O-ring, the failed anchor bolt, that brings down complicated machines.  The NY Times reported on Sunday “bankruptcy judges are finding that institutions claiming to hold the notes that back specific mortgages often cannot prove it.”  When this happen the court should hold the lender has no right to foreclose the loan.

Like everything else economic these days, no one knows how big a problem missing loan documentation might be.  The Times reports-

as messes go, this one has, ahem, potential. According to Inside Mortgage Finance, some eight million nonprime mortgages were put into securities pools in 2005 and 2006 and sold to investors. The value of these loans was $797 billion in 2005 and $815 billion in 2006.  If notes underlying even some of these mortgages were improperly assigned or lost, that will surely complicate pending legislation intended to allow bankruptcy judges to modify mortgage terms for troubled borrowers. A so-called cram-down provision in the law would let judges reduce the size of a loan, forcing whoever holds the security interest in it to take a loss. But if the holder of the note is in doubt, how can these loans be modified?

One more thing to watch.