$1 Billion Goldman Sachs Synthetic CDO Debacle a Reminder that Even Highly Sophisticated Investors Can Be Defrauded

Although the Senate hearing over Goldman, Sachs, & Co.‘s role in structuring a collateralized loan obligation that caused investors to lose about $1 billion in losses has ended, the case against the investment bank is far from over. The SEC’s securities fraud lawsuit filed earlier this month makes numerous disturbing allegations against Goldman Sachs, and now lawmakers are calling on the Justice Department to begin a criminal probe into the CDO transaction that is a focus of the SEC case.

The SEC says Goldman Sachs and one of its vice presidents defrauded investors by structuring and marketing a synthetic collateralized debt obligation that was dependent on the performance of subprime residential mortgage-backed securities (RMBS), while at the same time failing to tell investors about certain key information, such as the role that a major hedge fund played in portfolio selection or that the hedge fund had taken a short position against the CDO.

The hedge fund, Paulson & Co, is one of the largest in the world. The SEC says that Paulson & Co. paid Goldman to allow it to set up a transaction that let it take these short positions. The SEC contends that Goldman acted wrongfully when it let a client that was betting against the mortgage market heavily influence which securities should be part of an investment portfolio, while at the same time telling other investors that ACA Management LLCS (ACA), an objective, independent third party was choosing the securities. Investors therefore did not know about Paulson & Co’s role in choosing the RMBS or that the hedge fund would benefit if the RMBS defaulted.

SEC alleges that Paulson & Co. shorted the RMBS portfolio it helped choose by taking part in credit default swaps (CDS) with Goldman Sachs to purchase protection on specific layers of the ABACUS capital structure. Because of its financial short interest, Paulson & Co had reason to choose RMBS that it thought would undergo credit events in the near future. In the term sheet offering memorandum, flip book, or marketing materials that it gave investors, Goldman did not reveal Paulson & Co’s short position or the part it played the hedge fund played in the collateral selection process.

The SEC is also accusing Goldman Sachs Vice President Fabrice Tourre of being principally responsible for ABACUS. He structured the transaction, prepared the marketing materials, and dealt directly with investors. The SEC claims that Tourre knew about Paulson & Co’s role and misled ACA into thinking that the hedge fund invested about $200 million in the equity of ABACUS, while indicating that Paulson & Co’s interests in the collateralized selection process were closely in line with ACA’s interests.

Six months after the deal closed on April 26, 2007 and Paulson & Co had paid Goldman Sachs about $15 million for structuring and marketing Abacus, 83% of the RMBS in the ABACUS portfolio was downgraded and 17% was on negative watch. By Jan 29, 2008, 99% of the portfolio had been downgraded.

“Synthetic derivative investments are so highly complex that even highly sophisticated investors can be defrauded,” says Shepherd Smith Edwards & Kantas LTD LLP Founder and Stockbroker Fraud Attorney William Shepherd. ” Any other investor being sold these is simply “fair game” for Wall Street. Our securities fraud law firm represents five school districts that lost over $200 million in what they were told were very low risk investments into bonds. Not only were these not “bonds” but the risk to them was enormous.”

Goldman CEO says has board’s support: report, Reuters, April 27, 2010
Blankfein Says He Was ‘Humbled’ By Senate Hearing, NPR, April 29, 2010
What’s Next for Goldman Sachs?, New York Times, April 29, 2010
SEC Charges Goldman Sachs With Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages, SEC.gov, April 16, 2010
Read the SEC Complaint (PDF)

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