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by Don Azarias
May 27, 2010
The Wall Street Journal (WSJ) reports that federal prosecutors are conduct ing a criminal probe into whether Goldman Sachs Group, Inc. or its employ ees committed securities fraud in connection with its mortgage trading. The matter was referred to the Manhattan U.S. Attorney’s Office for criminal prosecution by the Securities and Exchange Commission (SEC) which had brought a civil fraud lawsuit against Goldman Sachs charging that it hid vital information from investors about mortgage-related securities it traded.
For the readers’ information, a criminal case is a lawsuit brought by a prosecutor employed by the federal, state, or local government that charges a person or a corporation with the commission of a crime. In a criminal case, the government is always the plaintiff, who is called the prosecution. The prosecution should present sufficient evidence against the defendant that he is guilty beyond reasonable doubt. Failure on the part of the prosecution to do so could lead to the dismissal of the case and a win for the defendant. If convicted, a criminal defendant can face fines, incarceration, and a variety of other penalties. In a civil case, a person, a corporation or, in some cases, the government, can file the lawsuit and be the plaintiff. Unlike in a criminal case, the preponderance of evidence against the defendant is enough for the plaintiff to win the civil case. The plaintiff doesn’t have to prove that the defendant is guilty beyond reasonable doubt. And, if the defendant is found guilty, they are typically required to pay restitution to the aggrieved plaintiff. The monetary judgment is intended to compensate the plaintiff for the damages he has suffered. However, in a civil case, there is no jail time imposed on the defendant.
As most of us know, the SEC has accused Goldman Sachs & Co. of defrauding investors by failing to disclose conflicts of interest in mortgage investments it traded as the housing market was collapsing. The SEC said in a civil complaint that Goldman Sachs failed to reveal that one of its clients helped create——— and then bet against———subprime mortgage securities that Goldman Sachs sold to other investors.
For the readers’ information, Goldman Sachs’ risky trading allowed the firm to weather the financial crisis better than most other big banks. It is also one of those Wall Street firms that received $10 billion bailout funds from the American taxpayers. It earned a record $4.79 billion in the last quarter of 2009 and earned $3.46 billion for the first quarter of 2010. If not for it’s risky trading, it sure makes you wonder how Goldman Sachs was able to amass record-breaking profits.
The Goldman Sachs client implicated in the fraud is one of the world’s largest hedge funds, Paulson & Co. The SEC said Paulson paid Goldman Sachs roughly $15 million in 2007 to devise an investment tied to mortgage-related securities that the hedge fund viewed as likely to decline in value. Separately, Paulson took out a form of insurance that allowed it to make a huge profit when those traded securities became nearly worthless. ABN Amro, a major Dutch bank, was the biggest loser in the securities, having paid Goldman Sachs $841 million, according to the SEC. And IKB Deutsche Industriebank AG, a German commercial bank, lost nearly all its $150 million investment, the agency said. Most of the money they lost went to Paulson in a series of transactions between Goldman Sachs and the hedge fund, the SEC said. Goldman Sachs told investors that a third party, ACA Management LLC, had selected the pools of subprime mortgages it used to create what are known as “collateralized debt obligations” (CDO). But, the SEC alleges, Goldman Sachs misled investors by failing to disclose that Paulson & Co. also played a role in selecting the mortgage pools it traded and stood to profit from their decline in value.
John Paulson was among the first on Wall Street to bet heavily against subprime mortgages. His firm earned more than $15 billion in 2007, and he pocketed $3.7 billion. He has since earned billions more, largely by betting against bank stocks and then buying them back after their shares plunged.
The criminal investigation is centered on different evidence than the SEC’s civil case, according to the WSJ, which added that it could not be determined which Goldman Sachs deals are being scrutinized in the investigation. The SEC lawsuit against Goldman Sachs concerns CDO trading in transactions known as Abacus. The SEC accused Goldman Sachs of failing to tell investors that securities underlying Abacus were chosen by billionaire hedge fund investor John Paulson, who was betting that the securities would lose value.
For the readers’ information, a collateralized debt obligation or CDO is a pool of securities, tied to mortgages or other types of debt, that Wall Street firms packaged and sold in bond markets at the height of the housing boom.
U.S. officials already have taken a close look at one other Goldman Sachs-backed transaction, known as Timberwolf 1, a CDO that Goldman Sachs traded in bond markets in March, 2007 just as the U.S. housing market was beginning to crumble. A team of federal prosecutors in Brooklyn, New York, scrutinized the Timberwolf deal in pursuit of a criminal case against two former Bear Stearns hedge fund managers because the Bear Stearns funds had been a major investor in that CDO.
Federal authorities examined the deal because Goldman Sachs sold a $300 million portion of the CDO to the Bear Stearns funds in March 2007. Prosecutors were particularly perplexed by the fact that Goldman Sachs’ mortgage trading desk began marking down the value of Timberwolf securities within a week of selling that $300 million slug to the Bear Stearns funds and smaller pieces of the deal to other institutional investors, the sources said. In fact, within five months, Timberwolf lost 80 percent of its value and was liquidated in 2008.
The Senate committee hearing into Goldman Sachs’ role in the mortgage mess has thrown a new spotlight on the Timberwolf transaction. The committee, in a report released prior to the hearing, said one reason Goldman Sachs underwrote the Timberwolf trading was so it had a mechanism to “short” the subprime housing market and make money from the collapse of the securities.
The size and scope of the CDO transactions were mind-boggling that CDO investors, composed mostly of banks, pension funds and other big investors, made a lot of money off the investments as the underlying debt was paid off. But as U.S. homeowners started falling behind on their mortgages and defaulted in droves in 2007, CDO buyers lost billions.
For all those losses incurred by CDO investors, someone has to pay the price. In this particular case, Goldman Sachs should be the one held liable, both, civilly and criminally.