Goldman Sachs Abacus Fraud: SEC Case and Wall Street Ethics

Introduction: The Goldman Sachs Fraud Scandal

The recent recession and financial scandal brought to light many unethical, illegal, and quasi-legal practices of the major investment firms. One example was the Goldman Sachs securities fraud case, in which the firm was accused of creating and selling bundled mortgage investments in an instrument that was intended to fail — and against which the company itself bet in order to make a profit (Storey & Morganson 2010).

The Abacus 2007-AC1 Investment Vehicle

The government's case against Goldman Sachs concerned Abacus 2007-AC1, one of 25 investment vehicles specifically created to allow its clients to bet against the housing market (Storey & Morganson 2010). This initially protected Goldman from losses when the mortgage market disintegrated and later yielded profits for the bank. Ironically, one of the initial marvels of the credit crisis was the degree to which Goldman appeared to emerge unscathed, in stark contrast to its rivals.

Goldman told investors that the bonds would be chosen by an independent manager. Instead, however, it allowed John A. Paulson — a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst — to select mortgage bonds, despite his personal interest in seeing them lose value (Storey & Morganson 2010). Goldman then sold the package to investors such as foreign banks, pension funds, and insurance companies, which would profit only if the bonds gained value — which they did not (Storey & Morganson 2010).

Goldman initially claimed it had lost money in the transactions overall and had acted with transparency. The firm stated that the losses resulted from the overall collapse of the mortgage market, not from the way the deal was structured (Storey & Morganson 2010). However, when Goldman sold shares in Abacus to investors, the bank and Fabrice Tourre disclosed only the ratings of those bonds — not Paulson's interest in seeing the creditors default (Storey & Morganson 2010). By the end of 2007, Paulson's credit hedge fund was up 590 percent.

Conflicts of Interest and Engineered Failure

In the official SEC statement detailing the civil suit, the Commission stated: "the product was new and complex but the deception and conflicts are old and simple. 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" (Delaney 2011: 2; SEC Charges Goldman Sachs with Fraud, 2010). Although credit default swaps were a relatively new financial instrument, Paulson's practice of betting against assets he was effectively selecting constituted a clear conflict of interest.

It should be noted that Paulson was not the subject of the lawsuit; rather, Goldman itself was targeted because Goldman Sachs Vice President Fabrice Tourre was principally responsible for creating Abacus 2007-AC1. Tourre structured the transaction, prepared the marketing materials, and communicated directly with investors. Tourre allegedly knew of Paulson & Co.'s undisclosed short-selling interest and role in the collateral selection process, and had a responsibility to inform investors of and remedy those conflicts (SEC Charges Goldman Sachs with Fraud, 2010). In addition, he misled ACA Management LLC — a firm managing 22 CDOs with assets of $15.7 billion — by indicating that Paulson & Co.'s interests in the collateral selection process were closely aligned with ACA's interests. In reality, their interests were sharply conflicting (Delaney 2011: 2). The worse the underlying assets performed, the more Paulson would profit.

Paulson effectively stacked the deck against ACA's success. "Paulson's selection criteria [for Abacus] favored [residential mortgage-backed securities] that included a high percentage of adjustable rate mortgages, relatively low borrower FICO scores, and a high concentration of mortgages in states like Arizona, California, Florida, and Nevada that had recently experienced high rates of home price appreciation" (Delaney 2011: 2). Paulson was not simply lucky in betting against the failure of Abacus 2007-AC1; the security was specifically engineered to fail.

Paulson picked those high-risk underlying assets for the Abacus CDO so that he could bet against them by purchasing credit default swaps — insurance policies that pay out if borrowers default. This uniquely bad instrument would not have existed without the active participation of Goldman Sachs (Delaney 2011: 3). There was no risk management — one of the hallmarks of prudent investment — in the creation of Abacus 2007-AC1. All of the assets within Abacus were of the worst kind, featuring the highest-risk borrowers, with no safe assets to meaningfully protect investors. This was unusual and contrary to standard business practice. Moreover, Abacus was rated by Goldman as a low-risk asset, despite evidence to the contrary that even a layperson who had investigated it could have detected, had Goldman acted with transparency.