The Securities and Exchange Commission (SEC) has charged Goldman Sachs and one of its vice presidents for defrauding investors by misstating and omitting key facts about a synthetic CDO backed by subprime mortgages.

The SEC alleges that Goldman Sachs structured and marketed the synthetic CDO, the performance of which was based on subprime RMBS. The bank failed to disclose to investors vital information regarding the said CDO, specifically the role that a major hedge fund played in the portfolio selection process as well as the fact that the hedge fund had taken a short position against the CDO.

Goldman Sachs responded to the charges on Friday with a press release where it said the SEC's charges are "completely unfounded in law and fact" and the bank said it would "vigorously contest them and defend the firm and its reputation."

"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."   

"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," said Kenneth Lench, chief of the SEC's structured and new products unit.

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

According to the SEC's complaint, filed in the U.S. District Court for the Southern District of New York, the marketing materials for the CDO known as ABACUS 2007-AC1 all represented that the RMBS portfolio underlying the CDO was selected by ACA Management (ACA), which is a third party that is an expert in analyzing RMBS credit risk. 

The SEC alleged that undisclosed in the marketing materials and without investors' knowledge, Paulson & Co., 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 given to investors.   

The SEC alleged that Goldman Sachs Vice President Fabrice Tourre was mostly responsible for ABACUS 2007-AC1. Tourre structured the transaction, prepared the marketing materials, as well as communicated directly with investors. 

Tourre allegedly knew of Paulson & Co.'s undisclosed short interest and role in the collateral selection process.  Additionally, he supposedly misled ACA into believing that Paulson invested roughly $200 million in ABACUS' equity, indicating that Paulson's interests in the collateral selection process were closely aligned with ACA's interests. However, their interests were actually  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% of the RMBS in the ABACUS portfolio had been downgraded and 17% were on negative watch.  By Jan. 29, 2008, 99% 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 charged 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 has sought injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties. 

Tourre, age 31, is currently based in London works for Goldman as an executive director. When the Abacus CDO was created, he was based in New York City and was a vice president on the firm's structured product correlation trading desk.

In an email sent out in January 2007, Tourre wrote to a friend "more and more leverage in the system, the whole building is about to collapse anytime now ... only potential survivor, the fabulous Fab[rice Tourre] ... standing in the middle of all of these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!"

In 2007, Goldman was the sixth ranked underwriter of CDOs in the U.S. and it was also sixth ranked worldwide, according to Thomson Reuters.

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