The Case Against Goldman Sachs

The SEC charges that once golden Wall Street firm Goldman Sachs misled its investors. How the rise of traders over bankers led the firm to riskier business

By Stephen Gandel Thursday, Apr. 22, 2010
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    With the money came promotions. In 2005, bond salesman John Mack took the reins of Morgan Stanley, promising to boost the firm's profits by allowing its traders to dial up risk. At Lehman Brothers, Dick Fuld, who had climbed that firm's bond-trading ranks, was firmly in place as CEO. And in 2006, when Goldman's CEO, Hank Paulson, a classic investment banker, was tapped by President Bush to be the Treasury Secretary, Blankfein was named as his replacement. The traders had won. "The industry became so heavily weighted toward risk, it just made sense to let the traders run things," says top Wall Street recruiter Gary Goldstein, who heads up the Whitney Group.

    Or so it seemed. Traders got Wall Street firms deeper and deeper into more and more complicated products. Complexity, of course, can beget chicanery. Traders were too often in it to make a killing and an exit and cared little about the hazards they might be creating down the road. The term IBG, YBG became popular on the Street. It stands for "I'll be gone, you'll be gone"; someone else will have to clean up the mess.

    Goldman boss Blankfein is an alpha dog in this pack. He hails from Wall Street's roughest neighborhood, the commodities-trading market, which lacks insider-trading rules and many of the other investor protections of other markets. "In the commodities-trading market, when someone is stupid, that's something to be taken advantage of," says Susan Webber, who under the name Yves Smith is the author of ECONned , a book about the financial crisis. "That's the world Blankfein grew up in."

    Goldman's Alleged Duplicity
    The idea that a 20-something trader with too much power could torpedo the biggest, most profitable firm in finance seems like a plot for a Wall Street parody. But it appears to be exactly what is happening to Goldman, and it is perhaps the logical end of a culture that anointed traders king. In late 2006, Fabrice Tourre, a then 27-year-old Frenchman with an engineering degree from Stanford, got an assignment to help John Paulson place bets against the housing market.

    Tourre, known to refer to himself as the "fabulous Fab," figured out how to structure an investment that was sure to suck the last bit of blood out of the few mortgage investors willing to buy into a market that he believed was due to crater. As Tourre was assembling Paulson's CDO in January 2007, he wrote in an e-mail to a buddy: "The whole building is about to collapse anytime now ... Only potential survivor, the fabulous Fab ... standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities [sic] !!!"

    What Tourre did understand, according to the SEC, was how to trick investors. The SEC case against Tourre and Goldman hinges on the investment bank's omission of the fact that Paulson was selecting most of the assets for Abacus. Tourre got the CDO manager, ACA Management, to claim in the offering statement that it had picked the assets for Abacus. ACA was getting paid to act as independent manager of the deal. The SEC alleges that while ACA understood that Paulson would have sway over asset selection, Tourre maneuvered ACA into thinking that Paulson planned to invest in Abacus, not bet against it. Paulson was never mentioned in the information sent to Abacus investors and Goldman's counterparties, who ended up losing $1 billion on the deal.

    For its part, Goldman vigorously denies the charges, arguing it did not structure the portfolio to lose money — in fact, the firm says it lost more than $90 million through its long position — nor did it misrepresent Paulson's short position. "The SEC's complaint accuses the firm of fraud because it didn't disclose to one party of the transaction who was on the other side of that transaction," Goldman said in a press release. "As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor."

    In a sense, Goldman is relying on the so-called big-boy defense: There are no victims on Wall Street, just fools. "This is no slam dunk for the SEC," says Henning. "We want every transaction to be fair, but these aren't babes in the woods that got taken. These are two banks [that] invested in a very risky area and got very badly burned ... That's how free markets work. You take your chances."

    Making the Case for Regulation
    The Goldman case may be the opening salvo as a suddenly muscular SEC takes a gander at other Abacus-like deals. Like Goldman, Deutsche Bank struck deals with Paulson, according to the Wall Street Journal , that were structured to bet against the housing market. Magnetar and Tricadia are also in the spotlight, but even if the two hedge funds played their deals to fail, the investment banks that set them up at least disclosed the role of the hedge funds and the fact that they could take a short position.

    Beyond any legal issues, the Goldman case has become the battering ram for financial-reform legislation that congressional Democrats have been looking for. Democrats say it underscores the need to reregulate an industry gone wild. Republicans retort that the reforms on the table would have done little to stop the Goldman trade. The latter point is probably right, at least in part. The bill sponsored by Democratic Senator Christopher Dodd would require transactions like Abacus to be traded on an exchange. Such transparency would give the SEC and other regulators more access to monitor these deals and potentially catch material misstatements. The SEC might have noticed earlier the obvious conflicts of interest inherent in the Abacus-like deals. But there still would have been no way for the SEC, without an investigation, to have known that Goldman was omitting any mention of Paulson's involvement.

    Nonetheless, the Goldman case does get the Obama Administration back on its best talking points for financial reform: The lack of regulation has morphed Wall Street into a place that regularly trades against our economy. It's our jobs vs. their bonuses on every trade. And if you think Wall Street is going to protect your interests, then I've got a AAA-rated, subprime-mortgage-based CDO to sell you.

    — With reporting by Alex Altman / Washington

    The original version of this article misstated that Fabrice Tourre graduated from Stanford business school. Tourre actually has a master's degree in engineering from Stanford.

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