The legal document reads less like a court filing, and more like a twisted story of how actions by Wall Street's most notorious investment bank allegedly caused losses of $1 billion for investors.
Here's what it said:
The opportunity: real estate bubble
In late 2006 and early 2007, when the United States housing market is beginning to show signs of distress, hedge fund Paulson & Co. takes a "bearish view on subprime mortgage loans," according to the SEC complaint.The fund -- run by John Paulson -- identifies more than 100 bonds with the lowest credit ratings, which are likely to experience defaults. Paulson cherry-picks these bonds by favoring adjustable rate mortgages, borrowers with low credit scores, and mortgages in states like Arizona, California, Florida and Nevada, where the real estate bubble hit the hardest.
The strategy: create a product to bet against
In January 2007, Paulson meets with Goldman Sachs vice president Fabrice Tourre, and asks for help betting against these bonds through the use of credit default swaps -- essentially, Paulson is asking to buy insurance on the weakest subprime-mortgage bonds.Paulson and Goldman Sachs discuss creating -- and then betting against -- a package of the low-rated bonds.
Paulson would hand-pick the securities, but Goldman Sachs and Tourre also need other investors. And they know it would be a hard sell if they disclosed that Paulson had selected the securities, given that he wanted the value to go down.
So they seek out a reputable third party to, as internal Goldman memos state, put its "name at risk...on a weak quality portfolio."
In January 2007, Goldman Sachs approaches ACA Management to act as that "portfolio selection agent."
Goldman e-mail, March 12, 2007: "We expect to leverage ACA's credibility and franchise to help distribute this Transaction."
Selecting the portfolio
In February 2007, Tourre, Paulson and ACA meet to discuss the portfolio.While both Goldman Sachs and Tourre are completely aware of Paulson's intent to short the portfolio, ACA is unaware, according to the SEC.
On that same day, ACA e-mails Paulson, Tourre and others at Goldman Sachs a list of 82 real estate bonds on which they already agree, but adds 21 "replacement" bonds to the list and asks for Paulson's approval. Paulson deletes eight of the bonds recommended by ACA, leaves the rest, and states that it agrees that the remaining 92 bonds make a sufficient portfolio.
An internal e-mail at ACA asks, "Did [Paulson] give a reason why they kicked out all the Wells [Fargo] deals?" Wells Fargo was generally perceived as one of the higher-quality subprime loan originators, the SEC said.
On or around February 26, 2007: Paulson and ACA agree on the portfolio to be called ABACUS 2007-AC1.
Selling the portfolio
In trying to sell the new ABACUS portfolio to investors, Goldman Sachs uses false and misleading marketing materials, according to the SEC. The materials, created by Tourre, boldly claim ACA as the "portfolio selection agent," but make no mention of Paulson's role in selecting the bonds.
The "flip book," in particular, contains 28 pages about ACA's expertise, track record and credit selection process, and assures investors that the party selecting the portfolio had an "alignment of economic interest" with investors.
While none of the marketing materials mentioned Paulson's role in the transaction, internal Goldman Sachs communications clearly identified Paulson, its economic interests, and its role in the transaction, according to the SEC.
Investors buy in
Beginning in 2002, IKB Deutsche Industriebank AG, a commercial bank in Germany, had been involved in the purchase of assets backed by U.S. mid-and-subprime mortgages. But in late 2006, IKB informed Goldman Sachs and Tourre that it was no longer comfortable investing in mortgage bonds that were not selected by an independent third-party with knowledge of the U.S. housing market.
In February, March and April 2007, Goldman Sachs sends IKB copies of the ABACUS marketing materials, all of which represented that the portfolio had been selected by ACA, and failed to mention Paulson.
On or about April 26, 2007: IKB buys a total of $150 million worth of ABACUS notes at face value.
Within months, as the U.S. housing market begins to crumble, the investment is nearly worthless. Most of this money was ultimately paid to Paulson in a series of transactions between Goldman Sachs and Paulson, said the SEC.
In total, investors lose $1 billion, the SEC said.
The next steps
The SEC charges Goldman Sachs with fraud for failing to disclose Paulson's conflicting interest and role in selecting the ABACUS portfolio. The civil suit asks for a jury trial, and for Goldman Sachs to be fined and forced to repay illegally-obtained profits.In response to the SEC's complaint, Goldman said Friday that "the SEC's charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation."
Paulson & Co. also issued a statement claiming no responsibility for Goldman's misleading or fraudulent marketing.
"Paulson did not sponsor or initiate Goldman's ABACUS program, which involved at least 20 transactions other than that described in the SEC's complaint," Paulson's statement said.
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