Goldman Sachs and the sub-prime facts

26 April 2010

If ever there was a telltale sign during the housing boom that Goldman Sachs was dubious about the explosion in US house prices it was this - it was the only major Wall Street firm that didn’t own a sub-prime lender.

In the early part of the past decade a handful of Wall Street firms dominated the business of buying Ato D-rated residential loans mostly from non-bank lenders and packaging them into asset-backed securities.

The business had been pioneered by Bear Stearns and Lehman Brothers with assistance from Greenwich Capital which later became the property of the Royal Bank of Scotland, and Citicorp Securities which contained the remnants of the old Salomon Brothers - a pioneer in the trading of mortgage-backed securities back in the 1980s.

Guess how many of these firms are still alive today and draw your own conclusions.

The business model was simple - buy sub-prime mortgages, package them into bonds and market them to institutional clients far and wide.

To ensure a steady flow of mortgages for their bonds Wall Street firms took the model one step further. They began owning the firms that were originating sub-prime loans to consumers.

Lehmans and Bear Stearns had entered the origination space 10 years earlier and Citicorp eventually gobbled up two of the biggest firms in the market - Associates First Capital and Commercial Credit.

RBS didn’t exactly own a sub-prime shop but it was joined at the hip to sub-prime juggernaut Ameriquest Mortgage of California. RBS lent money to Ameriquest and its sister company Argent and then securitised most of their loans.

And then there was Merrill Lynch - late to the sub-prime party. By 2005 Bear Stearns, Lehmans, Citicorp and RBS were the dominant book runners of the sub-prime so-called ABS market. ABS is the phrase generally used to describe sub-prime loans that are securitised whereas MBS applies to A-rated loans sold to government-chartered mortgage giants Fannie Mae and Freddie Mac.

Merrill was jealous of the rest of the Wall Street club and in 2006 eventually bought two sub-prime lenders which helped catapult it to the front of the ABS securitisation ranks.

As for Goldman Sachs (pictured), that white-shoed blue blood of Wall Street, it looked on in amusement as its competitors gobbled up ABS market share.

It’s interesting that there are only two defendants in the case- Goldman and the manager who led the deal

From what I recall of this heady decade Goldman Sachs wasn’t exactly a wallflower. It looked at buying plenty of sub-prime lenders but when its partners kicked the tyres they didn’t like what they saw. On deal after deal they balked, staying on the sidelines and wondering whether they had missed the greatest housing boom in history - or so we thought.

Now we have a messy little civil fraud suit brought against Goldman Sachs by the Securities and Exchange Commission. For well over a week here the media hordes have been reporting on the latest twists and turns in the case, with some reporters - including those at CNBC - seeming to act as apologists for the firm.

In case you missed the details the allegation is that Goldman Sachs put together a synthetic collateralised debt obligation using existing sub-prime ABS and then peddled the thing, which eventually became worthless, to certain clients including German bank IKB Deutsche Industriebank AG.

By now you may be thinking so what, but the catch is that Goldman Sachs created the security with the help of hedge fund manager John Paulson & Co which, unbeknown to IKB and other suckers - I mean buyers - was actually shorting the same CDO. Can you spell ’conflict of interest’?

In other words, in its 22-page complaint the SEC accuses Goldman Sachs of pulling off a Paul Newman/Robert Redford-style sting as featured in the movie of the same name.

But the word the SEC uses is not sting, it’s fraud. According to the government it was Paulson’s idea to short large chunks of the sub-prime market by purchasing credit default swaps. These swaps paid off in spades when the underlying loans went south. The CDO that Goldman peddled to IKB was created in early 2007 just as the sub-prime and US housing markets were beginning to show worrying signs of potential implosion.

The SEC believes that Paulson approached Goldman Sachs in search of something to short. The government believes Goldman Sachs gladly complied and set up IKB and other investors as fall guys. Paulson’s take on the deal was $1bn - about the same amount investors lost.

After the SEC filed its charges Goldman Sachs issued a statement saying the allegations were untrue and that it would vigorously defend the case. A day later the firm told the world it couldn’t have been the puppet master of such a fraud because it lost money on the same CDO - about $75m. It also made $15m in underwriting fees so one might argue that it only lost $60m.

But what’s so interesting about all this is that there are only two defendants in the case - Goldman Sachs and the manager who led the deal, Fabrice Tourre. Although Paulson made $1bn shorting the CDO called Abacus, he is not accused of any wrongdoing.

Then again, the law suit - not exactly a large document when you consider the losses involved - basically absolves Paulson of all sin. After all, John Paulson was merely the guy who built the gun, not the one who found the victim and pulled the trigger.

If you read between the lines you can guess that a former Paulson employee is the SEC’s stoolie.

How the case will play out in court is anyone’s guess. When it comes to white collar fraud the eyes and ears of jurists glaze over, especially when dealing with such complicated matters as CDOs and credit default swaps.

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