Securities Law

SEC Accuses Goldman Sachs of Selling Mortgage Investment Designed to Fail

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The Securities and Exchanges Commission has accused Goldman Sachs of securities fraud in a civil complaint that alleges the investment bank created a mortgage investment that was designed to fail.

Goldman sold the mortgage investment, called an Abacus 2007-AC1, and then essentially bet against its success, the New York Times reports. “As the Abacus deals plunged in value, Goldman and certain hedge funds made money on their negative bets, while the Goldman clients who bought the $10.9 billion in investments lost billions of dollars,” the Times says.

The complaint says Goldman created the Abacus investment at the request of hedge fund manager John Paulson, packaging together mortgage bonds that were most likely to decline in value. Paulson favored mortgage-backed securities with a high percentage of adjustable rate mortgages, relatively low borrower FICO scores, and a high concentration of mortgages in states like Arizona, California, Florida and Nevada, according to the SEC complaint (PDF).

The Abacus investments were sold to hedge funds, insurers, pensions and foreign banks, the Times says.

The complaint says Goldman Sachs should have disclosed Paulson’s role in the selection process and his hedge fund’s positions that bet against the investment vehicle, the Wall Street Journal reports.

Paulson’s hedge fund effectively shorted the Abacus investments by entering into credit default swaps with Goldman Sachs to buy protection on specific layers of the Abacus structure, the SEC says in a press release.

Paulson was not named in the SEC complaint. The SEC alleges Goldman Sachs vice president Fabrice Tourre was principally responsible for the Abacus investment, and names him as a defendant.

The complaint cites portions of an e-mail Tourre sent to a friend in January 2007. “More and more leverage in the system, The whole building is about to collapse anytime now,” he wrote. “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!!!”

The Abacus was a a synthetic collateralized debt obligation that hinged on the performance of subprime residential mortgage-backed securities, the SEC press release says.

“The product was new and complex but the deception and conflicts are old and simple,” Robert Khuzami, director of the Division of Enforcement, said in the press release. “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.”

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