A Big Picture Look at the Goldman Sachs Case

A Big Picture Look at the Goldman Sachs Case

As you've no doubt read, the U.S. Securities and Exchange Commission charged Goldman Sachs with fraud last week, a move that caught big headlines around the world.

Although the case has potentially huge impacts on the business world -- and for green buildings -- reading the details about synthetic collateralized debt obligations (CDOs) are enough to make your eyes glaze over.

But the use of these CDOs, in this case one called Abacus 2007-AC1, has significant repercussions for Wall Street, so it's necessary to try to explain Abacus in clear (well, clearer) English. (For background, you can read the SEC complaint here in PDF format.)

Wall Street's use of instruments like Abacus has important impacts on its ability to supply capital to all economic sectors, including the renewable energy and energy efficiency industries. The use of synthetic CDOs has especially profound implications for real estate finance, including green and energy efficient properties, because the lion's share of real estate development and retrofit costs are borrowed, and Wall Street has played an increasingly important role in supplying real estate debt.

At the time of the Abacus deal, roughly one out of every four loan dollars for commercial and multifamily real estate came from Wall Street and the mortgage-backed securities market.

{related_content}My own exposure to mortgage-backed securities and the subprime market began about seven years ago, when I was working for the Mortgage Bankers Association.  My responsibilities included covering the market for commercial mortgage-backed securities on behalf of MBA's members. Other colleagues covered the subprime market and the market for residential mortgage-backed securities.

It was an education. It took me a few months to sufficiently unravel the jargon so that I could follow the industry and communicate with MBA's Wall Street members. (OK, so I was a slow learner.)

My subprime "Aha!" moment -- it was probably in 2004 -- came when a colleague casually mentioned that some subprime mortgages were being written with adjustable interest rates and low or no documentation requirements. In other words, people with bad credit and limited incomes were being put into mortgages whose interest rates could go up, with little or no vetting by lenders. And the one thing that you could bet on in 2004 was that interest rates would go up, as they were then at near-historic lows. I was horrified at the loss potential for both lenders and homebuyers, and repeatedly told real estate industry friends that the subprime market was a train wreck waiting to happen.

I was also a slow learner because it did not occur to me that my subprime insight could be used to make big money in the securities market. (As I mentioned, I quaintly equated mortgage defaults with financial ruin, whether for borrowers or lenders.) But smarter minds on Wall Street had arrived at the same insight, and set about creating ways to bet against the coming subprime debacle. By 2007, Wall Street had even figured out a way to bet against the subprime market without needing to go the trouble of buying or selling subprime mortgages: the synthetic CDO.

Unlike a cash flow CDO, which contains real bonds, loans or mortgages, a synthetic CDO is made up of credit default swaps, essentially financial insurance policies that pay out in the event of default, whether or not the buyer owns the underlying bond, loan, mortgage or other financial asset.

Bluntly put, the synthetic CDO allows big money investors to place bets on a pool of mortgages by, in effect, buying or selling default insurance, whether or not they have an ownership interest in the underlying loans. But unlike the real insurance market, which is heavily regulated, there have been few rules imposed on the use of Wall Street default insurance (credit default swaps).

Which brings us back to Goldman Sachs and Abacus 2007-AC1. In effect, what Goldman did was to assemble a series of insurance policies that would pay off if specific pools of subprime (bad credit) and mid-prime (medium credit) mortgage  loans defaulted. In order to execute the insurance contract, "long" investors (who acted as insurers betting that the loans would perform) and "short" investors (in effect, policy holders who were betting that the loans would crater) were needed.

In fact, the Abacus transaction was initiated by the eventual "short" insurance policy holder, Paulson & Co., a hedge fund that stood to win big if the Abacus mortgages went under. Paulson paid Goldman $15 million to create Abacus, supplied Goldman with a list of mortgage pools on which insurance could be written, and participated in conversations concerning the selection of the mortgage loan pools whose default would trigger a payout.  (The SEC complaint alleges that Paulson suggested mortgage pools for Abacus that were characterized by heavy use of adjustable interest rates, low borrower credit scores, and housing located in markets where prices were escalating, all indicators pointing toward substantial defaults.)

According to the SEC, Paulson's conversations on pool selection took place with Goldman and ACA Management, the firm hired by Goldman to select the Abacus loans. The SEC complaint alleges that (1) ACA was unaware that Paulson would be betting against the pool and (2) ACA was misled by Goldman to believe that Paulson had a financial interest in the sound performance of the Abacus loans. ACA has not been charged with wrongdoing.

The Abacus deal closed on April 26, 2007. The denouement was swift. By late October, 83 percent of the loans in the Abacus pool had defaulted or been downgraded. By the close of January 2008, defaults and downgrades had risen to 99 percent of the pool. Paulson reportedly earned $1 billion on Abacus, with IKB and ABN AMRO together losing the same amount.

The SEC complaint charges Goldman Sachs with securities fraud for "materially misleading" investors by failing to disclose that Paulson & Co. played a role in selecting the Abacus securities. (Paulson, as a customer in the transaction -- not an offeror or securities -- did not have a duty to disclose its role and has not been charged with wrongdoing.)

Did Goldman commit securities fraud? I'd say that the legal outcome is uncertain.

On the one hand, if the SEC's version of events is correct, Paulson -- which was betting on the Abacus mortgages to default -- was given a voice in choosing the Abacus pool without the knowledge of investors who were betting that the loans would remain sound.

On the other hand, the offering documents for Abacus were meticulously lawyered (as such documents inevitably are). Read the Abacus "flip book," an overview prepared for marketing purposes, here. Among numerous disclaimers, investors were warned that neither Goldman nor ACA made express representations or warranties concerning the performance of Abacus, and that the "flip book" did not necessarily include all relevant information about the subprime mortgage pools on which Abacus was based. Investors were advised to make their own investigations about the condition of the underlying mortgage pools.

In its defense, Goldman will likely argue that the Abacus pools were selected by a highly qualified, independent expert (ACA); that the largest investor in the pool (ACA Capital) selected the pool through its ACA Management subsidiary; that the underlying securities were rated independently as investment grade (the mortgages have been reported to have been given the lowest investment grade rating of Baa); and that Goldman itself lost $90 million on the transaction, far more than the $15 million that Paulson paid it to create Abacus. (It should also be noted that Goldman, at the same time, was heavily "shorting" [betting against] the mortgage market in other transactions, for a substantial profit.) Goldman has already presented most of these arguments in detailed statements, here and here. Goldman contends that the SEC's complaint is "unfounded in law and in fact," and that Goldman "did not structure a portfolio that was designed to lose money."

The courts will decide whether or not Goldman Sachs defrauded investors in its management of Abacus. It's a question worth deciding, but there is a larger and more important question to be asked.

What troubles me is that purely speculative synthetic CDOs are perfectly legal, and were widely used in the run-up to the 2007-2008 economic crisis. ProPublica reports that transactions similar to Abacus were arranged by numerous major Wall Street houses, not just Goldman Sachs. These transactions, side bets on the subprime mortgage market, increased the subprime fallout well beyond the volume of subprime loans actually issued. Why was this so? Because the volume of bets on the subprime mortgage market (which could, of course, be made without going to the trouble of making even a single mortgage loan to a single subprime borrower) was far greater than the number of subprime mortgages actually in circulation. Because of the ability to bet easily and comparatively inexpensively on synthetic CDOs, far more capital was riding on the performance of the subprime mortgage market than otherwise might have been the case, making the 2007-2008 financial collapse substantially more severe.

While I concur that credit default swaps are useful vehicles to offset actual investment risk (such as that created by buying and holding mortgage loan portfolios with high levels of risk), I can't see while they should be available for pure speculation.  Deals like Abacus -- unproductive side bets on capital market activity -- turn the securities markets into poorly regulated casinos.

Some fixes to consider: Ban or severely restrict the use of purely speculative CDOs, such as the Abacus transaction. Regulate the credit default swap industry by imposing more rigorous collateral, audit and reporting requirements on swap participants. Require the establishment of a central clearing house to provide for orderly derivatives trades, as is done in the stock and commodities markets.

When all is said and done, we deserve better than Abacus for the securities markets and ourselves. The losses sustained by IKB and ABN AMRO weren't just funny money. The billion dollars lost could have been used for business loans, consumer loans, equity investments in real companies and, yes, renewable energy, energy efficiency or green real estate projects. Gaming is available in Vegas, in Monte Carlo, at Aqueduct and in numerous other venues. The capital markets should be reserved to create genuine economic value, in the sustainable real estate sector, the renewable energy sectors and elsewhere.

Leanne Tobias is founder and managing principal of Malachite LLC, an advisory firm that specializes in the development, leasing, management, financing and certification of sustainable or green real estate on a global basis. Write to Leanne about your thoughts on trends for 2010 or ways to jumpstart the economy at [email protected]. She'll share the best ideas in future posts.

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