In late 2008, when five top hedge-fund managers testified before Congress at the height of the financial crisis, the result was, by the standards of receptions Wall Streeters and auto executives were getting in Washington at the time, a lovefest. At the hearing, Representative Henry Waxman, a Democrat from California, who had spent the few weeks before grilling other business executives, said, "Our four previous hearings have looked at failure. Today's hearing has a different focus. The five hedge-fund managers who will testify today have had unimaginable success."
A year and half later it appears the root of at least some of that success may not be as lovable. On Friday, the Securities and Exchange Commission (SEC) filed civil securities-fraud charges against Goldman Sachs, alleging the investment bank and its partners created mortgage bonds that were set up to go bust. Goldman then sold these bonds, which are called collateralized debt obligations (CDOs), to unsuspecting investors, who then lost $1 billion on the deal. At the heart of the case is John Paulson, one of the hedge-fund managers that testified in front of Waxman and other Congressmen back in November 2008. Paulson made billions in 2007 and 2008 betting against the housing market. He also allegedly paid Goldman to create the securities and had a hand in picking out the mortgage-related assets that would go into ultimately doomed CDOs. Paulson then shorted the bonds and made billions on this and other deals as the housing market collapsed.
"We shouldn't be limiting our investigation of what went wrong during the financial crisis to the investment banks," says Gene Phillips, a principal at PF2 Securities Evaluations, which specializes in researching CDOs. "There were also a lot of negative pressure and influences coming from outside the banks that were part of the problem."
Goldman Sachs has denied it did anything wrong, and says it will defend itself against the SEC's charges. A statement from Paulson & Co. said that the firm was "not involved in the marketing of any ABACUS products to any third parties," and that the deal's CDO manager and not Paulson "had sole authority over the selection of all collateral in the CDO, securities of which were subsequently rated AAA by both S&P and Moody's."
So far, hedge funds have been able to avoid scrutiny in the wake of the financial crisis. The financial-reform bill does require hedge funds that have $100 million or more in assets to register with the Securities and Exchange Commission. That's better than the current system where hedge funds can volunteer to register with the SEC but are under no requirement to do so. But hedge funds are not required to report their holdings on a regular basis in the same way that mutual funds or pension funds are. And registration alone doesn't seem to be enough to keep an eye on hedge-fund activity. Paulson's fund registered with the SEC starting in 2004.
Treasury Secretary Timothy Geithner, too, has fought for stricter regulation of hedge funds. Early this month, Geithner sent a letter to European regulators requesting they table plans to impose rules that would limit the amount of leverage hedge funds are allowed to use, force the funds to register with European regulators and limit the pay of managers.
Nonetheless, the SEC's case against Goldman is shining new light on the perhaps troubling role hedge funds played in the deals that led up to the financial crisis. According to the SEC complaint and public accounts of the housing bubble and those that bet against it, starting in 2006 Paulson began to think the high housing prices in the U.S. were unsustainable and would soon fall. He began looking for ways to bet against the housing market. Eventually he decided to start buying so-called credit-default swaps (CDSs), or bond insurance, against mortgage bonds. If the people in the home loans that backed the mortgage bonds couldn't pay, then the bonds would default and the insurance contracts kick in. Usually the CDS contracts would ensure that the holder of the bonds didn't lose any money. But because Paulson didn't own the actual mortgage bonds, when the CDS contracts would pay out it would be pure profit.
But there was a hitch. Mortgage bonds are usually diversified, made up of hundreds of borrowers with varying credit scores. Some were likely to default, but many others would probably be able to make their house payments even in a downturn. That's not what Paulson wanted. He wanted to bet against mortgage bonds made up of the worst of the worst just those people who were likely to not be able to make their bills and land in foreclosure. In January 2007 Paulson approached a banker from Goldman named Fabrice Tourre asking the then 20-something banker if his firm would be interested in building low-quality mortgage bonds for Paulson to bet against. Tourre agreed that Paulson would pick the home loans that would go into the mortgage bonds and then Goldman would sell the bonds to other investors. A third firm, ACA Capital, was selected to manage the deal named Abacus 2007-AC1. Paulson was becoming known as a big housing-market and mortgage-bond bear. So Goldman told investors that ACA was responsible for picking the bonds. But according to the SEC complaint, Paulson had the final say in what went into the securities. Goldman sold the bonds during the next few months. But by late 2007, the housing market was collapsing and the Abacus deal was nearly worthless. Investors lost $1 billion. Paulson pocketed at least that much in profits on the Abacus deal alone.
But Paulson had plenty of company among hedge funds that pushed Wall Street firms to help them stack their bets against the housing market. According to a recent report from nonprofit investigative reporting outfit ProPublica, a number of Wall Street firms, including Merrill Lynch, Citigroup and JPMorgan Chase, helped Chicago hedge fund Magnetar do deals similar to the ones Paulson struck with Goldman. Magnetar denies it had any special relationships with the investment banks that allowed it to select the mortgage bonds that went into the CDOs it bet against. George Soros' hedge fund Soros Asset Management also profited from the collapse of the housing market by betting against CDOs. But there is no suggestion as yet that Soros worked with Wall Street firms to create specific CDOs to bet against.
The revelation of the role hedge funds played in helping to create the most poisonous of the toxic assets leading up the financial crisis is sure to spur calls for increased regulation of hedge funds. If hedge funds had regularly reported their holdings and trades to the SEC, or had just been made public, it is possible that regulators would have caught on to the incredible risk and, at least in the Paulson case, alleged fraud in these deals. Though some wonder whether that is really the case.
"The SEC will surely make the case that had it had more information about what these hedge funds were doing it could have caught these traders earlier on," says Scott Meyers, a securities lawyer at Chicago-based firm Ulmer & Berne. "But the reality is that these are vastly complicated investment vehicles. Even if they had seen the trades, it's not clear the SEC would necessarily have been able to figure them out."
One thing is clear, though: the next time a group of hedge-fund managers is summoned to Washington, praise will not be on the agenda.