Senate Subcommittee Questions Goldman-Sachs

In 1999, under pressure from the Clinton administration, Fannie Mae, the nation's largest home mortgage underwriter, relaxed credit requirements on the loans it would purchase from other banks and lenders, hoping that easing these restrictions would result in increased loan availability for minority and low-income buyers. Putting pressure on the GSE's (Government Sponsored Enterprise) Fannie Mae and Freddie Mac, the Clinton administration looked to increase their sub-prime portfolios, including the Department of Housing and Urban Development expressing its interest in the GSE's maintaining a 50% portion of their portfolios in loans to low and moderate-income borrowers.

As noted, sub-prime mortgages remained a relatively low share of the market during this initial era of loosening of terms, averaging 9 percent from 1996 to 2004. Sub-prime mortgages boomed following the 2004 initiative by the Bush administration to deregulate this market, a policy change spearheaded by an SEC decision to allow the largest brokerage firms to borrow upwards of 30 times their capital. Following these moves, sub-primes ballooned to 21 percent of the market, including the majority of those loans which entered into default after the end of the bubble in 2006. (Subprime Lending)

Senate Permanent Subcommittee Investigations Fourth in a Series of Hearings

Senate Permanent Subcommittee on Investigations held Tuesday, April 27 was the fourth in a series of hearings investigating Wall Street's culpability in the collapse of financial markets. The hearings are the culmination of a year and a half of investigation by the Senate subcommittee. The subcommittee was created by Congress last year to investigate the roots of the financial crisis. The Securities and Exchange Commission on April 16, 2010 charged Goldman, Sachs & Co. and one of its vice presidents for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market faltered

The SEC alleges that Goldman Sachs structured and marketed a synthetic collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS). Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO.

"The product was new and complex but the deception and conflicts are old and simple," said Robert Khuzami, Director of the 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."

Kenneth Lench, Chief of the SEC's Structured and New Products Unit, added, "The SEC continues to investigate the practices of investment banks and others involved in the securitization of complex financial products tied to the U.S. housing market as it was beginning to show signs of distress."

The SEC alleges that one of the world's largest hedge funds, Paulson & Co., paid Goldman Sachs to structure a transaction in which Paulson & Co. could take short positions against mortgage securities chosen by Paulson & Co. based on a belief that the securities would experience credit events.

According to the SEC's complaint, filed in U.S. District Court for the Southern District of New York, 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. The SEC alleges that undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.

The SEC's complaint alleges that after participating in the portfolio selection, Paulson & Co. effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure. Given that financial short interest, Paulson & Co. had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson & Co.'s short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors.

The SEC alleges that Goldman Sachs Vice President Fabrice Tourre was principally responsible for ABACUS 2007-AC1. Tourre 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. In addition, he misled ACA into believing that Paulson & Co. invested approximately $200 million in the equity of ABACUS, indicating that Paulson & Co.'s interests in the collateral selection process were closely aligned with ACA's interests. In reality, however, their interests were sharply conflicting.

According to the SEC's complaint, the deal closed on April 26, 2007, and Paulson & Co. paid Goldman Sachs approximately $15 million for structuring and marketing ABACUS. By Oct. 24, 2007, 83 percent of the RMBS in the ABACUS portfolio had been downgraded and 17 percent were on negative watch. By Jan. 29, 2008, 99 percent of the portfolio had been downgraded.

Investors in the liabilities of ABACUS are alleged to have lost more than $1 billion.

The SEC's complaint charges Goldman Sachs and Tourre with violations of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Exchange Act Rule 10b-5. The Commission seeks injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties. (SEC Charges Goldman Sachs With Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages)

Investigation of Goldman-Sachs--Questions and Outcomes

Did Goldman-Sachs realize that some of the mortgage-related securities they were putting together and selling to investors would fail?

Once Goldman-Sachs realized this, did they continue selling these securities?

Did Goldman-Sachs begin selling short (betting against) the very securities they were including in their clients' portfolios?

Did they advise their clients of the position they were taking on these securities?

Did they notify clients that the 3^rd party (Paulson & Co.) that selected securities to include in Goldman-Sachs client portfolios was taking the opposite position (betting they would fail)? If Goldman-Sachs knowingly allowed this, they and Paulson & Co. would be in a serious conflict of interest.

A similar issue will be examined in the SEC's civil case against Goldman and one of its bankers.

Summary of Senate Subcommittee's Questions and Goldman-Sachs Answers

Goldman-Sachs people continued to insist that they did nothing wrong. They were selling short and selling long on investments. (Selling short is not illegal). They insisted that they always insure their investments by taking both positions.

Senators continued to insist that it is obvious from internal emails turned over to the SEC by Goldman-Sachs, that they knew securities were going to fail and begin to sell short (betting against the very product they were selling). Senators also tried to get present and former employees of Goldman-Sachs to admit to knowing the securities were going to fail, and to admit that what they did was highly unethical.

Is Goldman-Sachs hedging against their own company? Their stock rose, while other financials fell on Tuesday. (Economy Watch: Blankfein speaks Martian, Levin speaks Venutian)

What to Expect in the Coming Days

Senators will continue to try and get Goldman-Sachs to admit fault in the collapse of banks and other financial institutions based on employee emails in which Goldman-Sachs own sales force referred to the investments as "cr*p, and lemons."

The Goldman-Sachs people, advised by lawyers, will continue to insist they did nothing wrong. And, in their eyes, they didn't. The SEC is bringing a civil suit, not a criminal suit, against Goldman-Sachs. Listening to or reading about the hearings was, as one reporter noted, like watching people from two different planets communicating. (Blankfein speaks Martian, Levin speaks Venutian)

The Subcommittee will no doubt make recommendations for financial reform as an outcome of these hearings.

Sen. Carl Levin's opening statement:

Sen. Carl Levin, D-Mich., opened the hearing by describing what he thought the function of Wall Street should be. "Today we will explore the role of investment banks in the development of the crisis. We focus on the activities during 2007 of Goldman Sachs, one of the oldest and most successful firms on Wall Street. Those activities contributed to the economic collapse that came full-blown the following year.

Goldman Sachs and other investment banks, when acting properly, play an important role in our economy. They help channel the nation's wealth into productive activities that create jobs and make economic growth possible, bringing together investors and businesses and helping Americans save for retirement or a child's education.

That's when investment banks act properly. But in looking at this crisis, it's hard not to echo the conclusion of another congressional committee, which found, "The results of the unregulated activities of the investment bankers ... were disastrous." That conclusion came in 1934, as the Senate looked into the reasons for the Great Depression. The parallels today are unmistakable.

In summary, Sen. Levin proclaimed that Wall Street should be selling financial instruments that it believes in to its customers. He stated that the firm's own documents show that while it was marketing risky mortgage-related securities, it was placing large bets against the U.S. mortgage market. The firm has repeatedly denied making those large bets, despite overwhelming evidence.

"Why does this matter? Surely there is no law, ethical guideline or moral injunction against profit." But Goldman Sachs didn't just make money. It profited by taking advantage of its clients' reasonable expectation that it would not sell products that it didn't want to succeed, and that there was no conflict of economic interest between the firm and the customers it had pledged to serve. Goldman's actions demonstrate that it often saw its clients not as valuable customers, but as objects for its own profit. This matters because instead of doing well when its clients did well, Goldman Sachs did well when its clients lost money. Its conduct brings into question the whole function of Wall Street, which traditionally has been seen as an engine of growth, betting on America's successes and not its failures." (Senate Turns up Heat on Goldman Sachs Executives)

CEO Lloyd Blankfein Testifies

CEO of Goldman-Sachs, Lloyd Blankfein, the last witness called for the day, responded to Sen. Levin's charges by saying that he "can't endorse" Levin's characterization of Goldman Sachs problematically selling the same securities it's betting against. Blankfein says that the company always buys to seller and sells to buyers and that he's not troubled by it. (CBS News Live Blogging)

Ethics Questioned

Sen. John McCain, R-Ariz, reminded Blankfein of the 10 billion in TARP money loaned from the government. McCain also asked Blankfein how much he received in bonuses for 2009. Blankfein responded, "about $9 million."

Sen. Coburn asked Viniar if the company's compensation system compromised the ethical behavior of employees: "What is the ethical creed of Goldman Sachs? ... Do they have an ethics department?"

Viniar's reply: "We care very much about ethics at Goldman Sachs. ... We don't believe in any way shape or form that our compensation is not consistent with people having good ethical standards."

Evidence Found in Emails That Goldman-Sachs Knew Investments Would Fail

Senator Levin in questioning CEO Blankfein stated "You're going short against the very security (you're selling) ... many of which are described as cr*p by your own sales force internally."

"How do you expect to deserve the trust of your clients, and is there not an inherent conflict here?"

Levin asked Viniar if it the e-mail evidence of this was unfortunate and Viniar raised a murmur by saying, "I think that's very unfortunate to have on e-mail."

He then corrected his statement, saying, "I think it's very unfortunate for anyone to have said that," referring to Senator Levin's calling it cr*p.

Fabrice Tourre, Charged with Fraud by SEC Responds to Susan Collins-R

Thirty-one year old French-born Fabrice Tourre, charged by the SEC with fraud for his part in dreaming up the CDO investment vehicle, was asked by acting ranking minority member Susan Collins (R-Maine) "if Goldman has a duty to act in the best interest of its clients." He said: "I do not believe we were acting as investment advisers to our clients."

Big investment firms like Goldman Sachs are market-makers, rather than investment advisors. That's the difference between Goldman Sachs and an investment adviser at a local bank.

Goldman-Sachs Selling CDOs Contributed to Financial Meltdown

Much of the crisis in the subprime meltdown involving collapse of financial institutions is blamed on Collateral Debt Obligations or CDOs. In 2006-2007, subprime companies began to run out of risky borrowers to loan money to. So, financial institutions invented synthetic CDOs. Unlike a normal CDO, which contained the bonds themselves, the synthetic version contained derivatives that "referenced" a particular group of mortgage bonds. Now, Wall Street no longer had to originate new subprime loans. It could simply make unlimited number of bets on the bonds that already existed, as long as investors agreed to take the other side of the bet. Synthetic CDOs enabled investors to bet against (take a "short" position) in mortgage bonds and housing prices. Goldman-Sachs then sold these derivatives to investors (other banks and financial institutions). Investors would either bet that these CDOs would fail, or bet that they would not fail. Goldman-Sachs began betting against the very thing they were selling-in other words, they took a "short" position. When the music stopped, insurance companies, such as AIG who had insured these securities with credit default swaps, found themselves unable to pay, thus necessitating a federal bailout. Banks, credit institutions, and Wall street firms who had paid top dollar for the CDOs could not sell them because of the downward spiraling market. This led to the financial collapse of many financial institutions as they were left holding worthless investments. The New York Times reported that from 2005 through 2007, at least $108 billion of synthetic CDOs were issued, according to Dealogic, a financial data firm. The actual volume was much higher because synthetic CDOs and other customized trades are unregulated and often not reported to any financial exchange or market. (Synthetic CDO)

Need For Financial Reform

Goldman-Sachs selling short position is not illegal and is done by many other financial institutions and investors.

However, if they were betting against the very investments that they were selling to investors, with inside information as to their demise, this is highly unethical.

The Subcommittee's charges have done much harm to Goldman-Sachs' public image.

The Subcommittee, by holding them partly responsible for the financial collapse of many banks and credit institutions, has set the stage for passing a financial reform bill.

Although financial reform bills have been submitted by Sen. Chris Dodd (D) and others, so far, none have been approved by Congress.

Sources

Agence France-Presse, "US Republicans Again Thwart Wall Street Overhaul" News XIN MSN.Com

David S. Morgan, Ken Millstone, "Live Blogging: Senate Hearing on Goldman Sachs" CBS News Econo Watch.

CBS News Correspondent Anthony Mason, "Senate Turns Up Heat on Goldman-Sachs Executives"

Frank Ahrens, "Blankfein speaks Martian, Levin speaks Venutian" Economy Watch, Washington Post

House Committee on Financial Services, H.R. 4173, Wall Street Reform and Consumer Protection Act of 2009, Financial Regulatory Reform

Security Exchange Commission, "SEC Charges Goldman Sachs With Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages," 2010-59, Washington, D.C., April 16, 2010

Senate Committee on Homeland Security and Governmental Affairs: Wall Street And The Financial Crisis: The Role Of Investment Banks Permanent Subcommittee on Investigations

Steve Eder and Dan Margolies, India Reuters, "Goldman CEO Faces Withering Attack Over Ethics" (Additional reporting by Dan Wilchins in Washington, Jonathan Stempel and Christian Plumb in New York, and Kei Okamura in Tokyo, editing by Tim Dobbyn)

Wikipedia, AIG: Chronology of September 2008 liquidity crisis

Wikipedia, Impact on the Subprime Mortage Crisis, Synthetic CDO

Wikipedia, Subprime Lending