Goldman Sachs for Dummies: How the Alleged Fraud Happened
by Joann M. Weiner Posted: 05/7/10
You might feel that you'll never understand why the Securities and Exchange Commission sued Goldman Sachs last month for fraud -- concerning a security named Abacus and a banker named Fabrice Tourre (a.k.a. "Fabulous Fab") -- unless you have an MBA. But, you can. You just need to follow the principles in the popular "For Dummies" books and cut out the jargon and go straight to the facts.
In just 1,500 words, you'll know how a hedge fund manager made $1 billion on a single trade with Goldman Sachs' help and why you, the taxpayer, are the one paying the bill.
Here's the deal.
In early 2007, the hedge fund manager, John Paulson (no relation to former Treasury Secretary Henry M. Paulson Jr.), was certain the housing market was about to collapse and wanted to wager that it would. As Gregory Zuckerman, author of "The Greatest Trade Ever," reports, the housing market looked "like a casino" to Paulson. However, there's no table at Harrod's or anywhere else where Paulson could bet on the housing market, so he went to the only place where he could do so -- Wall Street. He approached Goldman Sachs to arrange a way to place his bet; that arrangement became the Abacus deal.
All About Abacus
The Abacus deal was essentially a bunch of mortgages packed into a single security with an insurance policy wrapped around it. Such mortgage-backed securities were rated anywhere from the gold-standard AAA to junk by the major ratings agencies: Moody's, Standard & Poor's and Fitch. The insurance pays off if the security defaults.
Goldman Sachs chose ACA Management to handle the portfolio, which Goldman Sachs dubbed Abacus 2007-AC1. It held 90 packages of residential mortgages. If each package contained an average of 5,000 mortgages, then the entire deal included 450,000 mortgages and the performance of Abacus depended on how all those mortgages performed. It was Goldman's failure to disclose Paulson's role in choosing the mortgages -- remember, he wanted the security to fail -- that is the subject of the fraud charges. (The Senate Permanent Subcommittee on Investigations and the Department of Justice are also looking into this, and as of last week, shareholders have filed six additional lawsuits against Goldman.)
While each mortgage was unique, they shared one feature --- the mortgage holders had a relatively high risk of not making their payments. There are many reasons for this risk. For example, the typical borrower might not be using the mortgage to finance a home purchase but to take cash out of an existing home, perhaps to pay for a new swimming pool or to take a vacation in Hawaii; the borrower might have been a NINJA (no income, no job or assets); or the borrower might have gotten a "pick-a-pay" mortgage that allowed him to decide how much to pay each month --- including nothing; finally, the borrower might have received a "liar loan," where he merely stated his income to the lender without providing any proof.
For whatever reason, then, each mortgage was likely to default when the housing market turned down. And, when the Abacus deal was put together in early 2007, the housing bubble had already burst in California, Nevada and Florida, the states where most of Abacus's mortgages were located.
Goldman Sachs' banker Fabrice Tourre was responsible for marketing the Abacus deal. As e-mails from Tourre reveal, he knew the value of the securities was falling. "I have the sensation of coming each day to work and re-living the same agony -- a little like a bad dream that repeats itself," he wrote in an e-mail, adding that "I'm trading a product which a month ago was worth $100 and which today is worth $93 and which on average is losing 25 cents a day."
Looking Overseas
Perhaps because the mortgages were known to carry such high risk, Tourre and ACA found just one investor for the deal, IKB Deutsche Industriebank. IKB mainly lent to small and medium-sized German businesses, but in the early 2000s, it started investing in the U.S. housing market to capture some of the then-high returns and it thought it could continue to do so with Abacus. It purchased $150 million of the security, which it promptly shifted off its books into a special-purpose vehicle named Rhineland, which it had set up in Dublin. ACA and Goldman also held part of the deal.
So far, this deal is rather ordinary. What makes it extraordinary is that in exchange for a $7 million premium, ACA promised to pay nearly $1 billion if Abacus went bad. ACA then arranged with the Dutch bank ABN-Amro to provide coverage. The parties sealed the deal on April 27, 2007, and with that signature, Paulson had his trade in place: If the mortgages defaulted, as he was certain they would do, he would receive his billion-dollar payout. His only risk was the $15 million he paid Goldman for this insurance.
It didn't take long for Abacus to tank. Although the ratings agencies had given a gold-plated assessment to parts of the deal, by January 2008, the portfolio was in ruins. By then, however, Abacus was no longer IKB's and ACA's problem. IKB was long gone, having been rescued by the German government in the summer of 2007. ACA soon followed. After reporting a $1.04 billion loss in the third quarter of 2007, ACA's rating was cut to one step above default and ACA was taken over by state regulators and forced to wind down its $60 billion in insurance contracts, including Abacus.
The company that was actually providing the insurance, ABN-Amro, was also long gone by January 2008. The Royal Bank of Scotland had purchased the Dutch financial institution for a record $100 billion in October 2007. RBS's investment turned out to be a disaster, of course, because it had to cover the insurance policy ABN had written on the Abacus deal, which it did in early 2008.
Thus, within months, the investors in Abacus were completely wiped out and John Paulson had won the bet.
Unfortunately, these players were not the only ones damaged. Given that the U.S. subprime housing market was essentially a house of cards, the whole subprime mortgage securitization market came crashing down and, in September 2008 the entire financial system nearly collapsed due to the housing fiasco.
Now that we understand the deal, we can uncover the real dummies.
Goldman Sachs was no dummy. It lost a few million dollars in the deal, but it more than made up for those losses through its insurance protection. It also confirmed that betting against the U.S. housing market was a good strategy. The only dumb move Goldman seems to have made was not telling ACA about the full extent of Paulson's involvement and not informing investors that the SEC was looking into this omission. (Although, by doing so, Goldman was able to keep this information about the housing market secret.)
Abacus was a dumb investment for ACA, ABN and IKB. But the real dummies in the deal are the taxpayers who have paid billions to cover these disastrous deals. Here's the tally:
U.K. taxpayers -- $70 billion to save RBS.
German taxpayers -- $6.5 billion to keep IKB afloat.
U.S. taxpayers -- $10 billion to keep Goldman Sachs in business, and $700 billion to keep the financial system working.
Because Goldman had offices in both Britain and Germany, those governments can take legal action. The U.K. financial watchdog has opened a formal investigation into the matter, while the German financial regulator is seeking more information from the SEC about the deal.
So, there you have it, Goldman Sachs for Dummies, first edition.
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