Goldman Faces SEC Charges for Defrauding Mortgage Investors

On Friday, ""Goldman, Sachs & Co."":http://www2.goldmansachs.com/ and one of its VPs were charged by the ""Securities and Exchange Commission"":http://www.sec.gov/index.htm (SEC) for defrauding investors by misstating and omitting key facts about a synthetic collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS), just as the U.S. housing market was beginning to falter.

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In particular, the New York-based firm is accused of failing to disclose to investors the role that ""Paulson & Co."":http://www.paulsoninvestment.com/Default.htm, one of the world's largest hedge funds, played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO. As a result, investors are said to have lost more than $1 billion.

In its ""complaint"":http://www.paulsoninvestment.com/Default.htm, filed in U.S. District Court for the Southern District of New York, the SEC says the marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. But undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, allegedly played a significant role in selecting which RMBS should make up the portfolio.

According to the SEC, Paulson & Co. paid Goldman Sachs $15 million to structure a transaction in which the hedge fund could take short positions against mortgage securities

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it chose based on a belief that the securities would experience credit events. And after participating in the portfolio selection, the SEC says Paulson & Co. effectively shortened the RMBS portfolio by entering into credit default swaps with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure. Given that financial short interest, the hedge fund had an economic incentive to select RMBS that it expected to experience credit events in the near future.

""The product was new and complex but the deception and conflicts are old and simple,"" said Robert Khuzami, director of SEC's division of enforcement. ""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.""

Paulson & Co.'s deal with Goldman Sachs purportedly closed on April 26, 2007. By October 24, 2007, 83 percent of the RMBS in the ABACUS portfolio had been downgraded, and 17 percent were on negative watch. By January 29, 2008, 99 percent of the portfolio had been downgraded.

The SEC claims that Goldman Sachs VP Fabrice Tourre was principally responsible for ABACUS, as he structured the transaction, prepared the marketing materials, and communicated directly with investors.

Tourre allegedly knew of Paulson & Co.'s undisclosed short interest and role in the collateral selection process, and the SEC claims he misled ACA into believing that Paulson & Co. invested approximately $200 million in the equity of ABACUS. This, the SEC says, indicated that Paulson & Co.'s interests in the collateral selection process were closely aligned with ACA's interests, when in reality, their interests were sharply conflicting.

Goldman Sachs released a statement shortly after the SEC filed its complaint, saying, ""The SEC's charges are completely unfounded in law and fact, and we will vigorously contest them and defend the firm and its reputation.""