Goldman Sachs and the ABACUS Deal

The following is a description of the parties, financial instruments, sequence of events, and transactions in The SEC vs. Goldman Sachs case, which was settled in the summer of 2010.

THE PLAYERS

The central players in the Goldman Sachs ABACUS deal in 2007 include the following:

• Goldman, Sachs & Co. A prominent global investment banking and securities firm founded in 1869 and located in the heart of Wall Street.  Goldman’s credo is they “bring together people, capital and ideas to produce solutions and results for [their] clients by playing a number of roles: financial advisor, lender, investor and asset manager.”  Among other things, Goldman has become known for its advisory services and proprietary trading.

• The Securities and Exchange Commision (SEC). A federal agency that acts as the primary enforcer of federal securities laws and regulates the securities industry, the nation’s stock exchanges, and other electronic securities markets in the United States.  The SEC has the authority to bring civil enforcement actions against individuals or companies alleged to have violated the securities law.

• Paulson & Co. A New York-based hedge fund founded in 1994 by John A. Paulson.  At the time of the case, Paulson was known for his pessimistic outlook of the mortgage industry.  He bet against the ABACUS CDO and netted approximately $1 billion in doing so.

• ACA Management. A former well-known manager of collateralized debt obligations (CDOs) in the financial markets.   ACA was chosen as the Portfolio Selection Agent by Goldman, Sachs & Co. for the 2007 ABACUS deal in an effort to lend credibility for marketing purposes.  It is estimated that ACA lost approximately $900 million due to its position in the ABACUS deal.  Its parent company, ACA Capital, fell under financial distress and eventually failed in late 2007.  The firm is currently operating as a run-off financial guaranty insurance company.

• IKB Deutsche Industriebank AG (IKB). A bank based in Dusseldorf, Germany, that specializes in lending to small and medium-sized companies.  IKB was bailed out in August 2007 because of the massive losses it sustained from the subprime market meltdown.  The SEC asserts that IKB was on the wrong side of the Goldman ABACUS CDO deal, resulting in losses estimated at $150 million.  IKB was a valuable client of Goldman Sachs and had invested in several of Goldman’s CDOs prior to 2007.

THE INSTRUMENTS

The following three highly complex financial instruments were leveraged by Goldman and Paulson & Co. during the 2007 ABACUS CDO deal.  Typically, investors who buy or sell these types of products are considered highly sophisticated.  However, some wonder if the instruments are too complex for such investors to fully understand their potential downside risks.

• Residential Mortgage-Backed Securities (RMBS). Residential mortgage-backed securities are commonly issued bonds that are backed by pools of residential real estate mortgages.  The RMBS related to The SEC vs. Goldman Sachs case were comprised of subprime mortgages.

• Synthetic CDOs. Collateralized debt obligations are a type of security whose value and payments are derived from a portfolio of underlying (fixed-income) assets.  CDO securities are split into different risk classes, or tranches, whereby “senior” tranches are considered the safest.  Interest and principal payments are made in order of seniority.  Thus, junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.  A synthetic CDO is similar to a traditional cash CDO.  The primary difference between the two is that a synthetic CDO does not own the underlying assets.  Alternatively, synthetic CDOs gain credit exposure to a portfolio of fixed-income assets through the use of credit default swaps.  The risk of loss on synthetic CDOs is divided into tranches just like traditional (cash) CDOs.

• Credit Default Swap (CDS). Credit default swaps are a form of insurance policies and function similarly.  CDSs are agreements between buyers who desire some form of debt default protection and sellers that provide a buyer with a nominal payoff in the event of credit default.  Buyers of CDSs pay a series of fee premiums – similar to an insurance policy – for the protection.  CDSs can be used as a way to hedge default risk for those who own bonds, or they can be used as a way to speculate (commonly referred to as naked credit default swaps) on debt issues and the creditworthiness of other entities without having to hold their bonds.

THE EVENTS

Considered by many economists to be the worst financial crisis since the Great Depression, the financial crisis of 2007 was primarily the consequence of a liquidity shortfall in the U.S. banking system.  One early indicator that a financial crisis was imminent was the collapse of the subprime mortgage market.

Subprime, by definition, means “less than prime,” and in the mortgage industry, subprime loans are considered to be one of the riskiest classes of credit.  Subprime borrowers are those who typically do not qualify for conventional financing and are characterized by undesirable financial metrics such as low credit scores, high debt-to-income ratios, and limited net worth.  During the early-to-mid 2000’s, subprime borrowers were able to obtain financing rather easily due to the abundance of credit available at historically low costs and lax mortgage underwriting standards.  Borrowers gorged on the seemingly infinite stream of easy, cheap debt.  Many borrowers then used the loans to buy houses.  As demand for homes skyrocketed, housing prices began to (artificially) inflate and deviate from their true underlying values, effectively creating a bubble.

Approximately 80% of U.S. mortgages issued to subprime borrowers during this time were adjustable-rate mortgages (ARMs).  In mid-2006, home prices in the U.S. peaked and subsequently began a rapid decline.  Increasing interest rates were a significant contributing factor to the house price decline.  In addition, “teaser” rates on subprime ARMs were beginning to reset at prevailing higher interest rates.   As the economy contracted, subprime borrowers were unable to refinance their freshly adjusted high-rate mortgages into conventional fixed-rate mortgages.  The result was an increase in delinquencies, defaults, and eventually foreclosures.  The effects of the subprime market meltdown were devastating and far-reaching.  As many of the subprime mortgages were pooled together after origination and re-sold as packaged securities, numerous economic sectors – regardless of size – were adversely impacted by the subprime fallout.

THE TRANSACTIONS

While other elements of The SEC vs. Goldman Sachs case (such as the parties involved, the financial instruments leveraged, and the events that took place) are fairly clear, the actual information (or lack thereof) communicated between parties involved is in dispute.  Facts of the case that all parties have agreed upon include:

• Goldman was approached by John Paulson of Paulson & Co. to assemble a synthetic CDO, dubbed ABACUS 2007-AC1, in exchange for a $15 million fee.

• Goldman brought in an outside asset manager (ACA Capital) to aid in the selection of collateral that was to comprise ABACUS.  In the end, it consisted primarily of subprime mortgage securities.

• Goldman sold ABACUS to German-based bank IKB.

• Paulson effectively shorted ABACUS by entering into credit default swaps to buy protection on specific layers of the CDO (the senior tranches).

• The CDO ultimately failed as a result of the subprime market meltdown.  In the end, John Paulson netted approximately $1 billion, IKB lost approximately $150 million, ACA Capital lost approximately $900 million, and Goldman lost approximately $100 million (which was partially offset by the $15 million fee it received from Paulson & Co.).

The disagreements between the parties center on the information Goldman provided to the parties on the “other” side of the transaction and on the sales strategies Goldman employed to close the deal.

In short, the SEC alleged that Goldman made materially misleading statements and omissions in connection with the ABACUS CDO placement.  The SEC charged that Goldman’s marketing materials for ABACUS conveyed that ACA Management, an independent third party with experience analyzing RMBS credit risk, selected the reference portfolio of the RMBS underlying the CDO.  In fact John Paulson (who, unbeknownst to IKB, had a direct adverse economic interest in the instrument) played a significant role in the portfolio selection.  Additionally, the SEC alleged that Goldman’s salesman for ABACUS, Fabrice Tourre, misled ACA into believing that Paulson had invested hundreds of millions of dollars in the equity of ABACUS.  Tourre further said that Paulson’s interests in the collateral selection process were aligned with ACA’s when in reality their interests sharply conflicted.

Goldman has defended itself, telling the SEC its allegations were based on “the benefit of perfect hindsight.”  Short-sellers, Goldman contended, were a routine part of synthetic CDO structures such as ABACUS.  It was common practice not to disclose the identity of the short side to the long side.  Regarding the selection process of the CDO collateral, Goldman argued that the portfolio ACA selected with Paulson’s input “had the same characteristics…and experienced virtually the same poor performance” as other similarly structured CDOs.  Goldman further tried to justify its position as an unbiased intermediary by noting that it kept a portion of the CDO on its books and ended up losing approximately $85 million (net of a $15 million structure fee).  Critics maintain Goldman was simply unable (not due to a lack of trying) to shed its position in time to avoid incurring any losses.

THE OUTCOME

Goldman was fined $550 million and eventually conceded saying that,

The marketing materials for the ABACUS 2007-ACI transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was ‘selected by’ CA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson’s economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure.

Was the monetary fine and reputational harm sustained enough to deter Goldman as well as other financial intermediaries from engaging in similar acts in the future?

ANALYSIS OF ETHICAL ISSUES

1. Conflicts of Interest

(a) Serving two clients on the opposite sides of the same deal

A financial institution has an ethical obligation i.e. duty to act in the best interest of its client.  This obligation is one that an agent owes its principal (the client).  An agency relationship is based on trust and confidence.

In the ABACUS CDO case, a pertinent question is: how many masters can a financial institution honestly serve at one time?  It is a biblical observation that no one can serve two masters (Matthew 6:24).  Yet, in the ABACUS case, Goldman Sachs believed it could serve the best interest of at least two masters:

– Paulson & Co.

– IKB Deutsche Industriebank AG (IKB)

Was it arrogance, greed, or an ethically relaxed organizational culture that led Goldman Sachs to believe it could be an honest broker when acting for two clients in the same deal?  In essence, Paulson & Co. was the seller and IKB was the buyer of the ABACUS CDO.  Goldman served both.  Goldman should have known better.

When serving two masters at the same time on the same deal, a financial institution is unlikely to act honestly and transparently for both parties, giving each party equal treatment.  First, the financial gain from one of the parties is always more than the other.  The sums of money involved are usually inordinately large.  Second, the financial institution usually prizes one client relationship more than another because of past returns and expected future returns from that client.  Thus, big income generating and regular clients will be favored over smaller, irregular clients.

It appears in the ABACUS case Goldman favored Paulson & Co. over IKB, because Goldman followed the instructions of Paulson & Co. closely but seemed to be less concerned about fulfilling its fiduciary duty to IKB.  Goldman did not fully disclose material information to IKB about Paulson’s involvement in picking the securities in the ABACUS CDO.  We cannot know for certain the reasons for the unequal treatment, but it is not unreasonable to assume that one of the reasons given in the paragraph above played a role in determining the lopsided treatment of Goldman’s two masters.

In an attempt to be a good fiduciary, Goldman hired ACA, ostensibly to select the underlying subprime mortgage securities of the ABACUS CDO.  This gave Goldman an image of distance from and objectivity on the deal.  This act is itself ethically questionable depending on Goldman’s motives which, admittedly, we cannot determine with full certainty.  If the motive for hiring ACA was ultimately to deceive through giving a false impression of Goldman’s objectivity, and false reassurance to IKB, then the act was unethical, because the motive was unethical.  We can only make an educated inference of Goldman’s motives for hiring ACA by examining the facts.  The most salient fact pointing to the unethical motive is that Goldman withheld the information from IBK about Paulson’s significant involvement in selecting the securities in the ABACUS CDO.  Paulson’s intention was effectively to short the CDO.  It was therefore, economically beneficial for Paulson to choose the worst subprime mortgages with the highest probability of failure.  On the other hand, this strategy and outcome would have been adverse for IKB whose best interest would have been served if subprime mortgages with low probabilities of failure were selected.   Hence, hiring a disinterested third party specialist would give some reassurance to IKB that Goldman had its best fiduciary interests in mind.

This kind of move is necessary if one serves two masters.

(b) Serving two clients and the institution itself in the same deal

In addition to the conflict of interest that exists when serving two clients on one deal at the same time, there is also the conflict of interest of serving two clients and the financial institution’s own interest on the same deal.  According to modern finance theory, as an economic entity, Goldman’s ultimate goal is to maximize profits.  Yet, maximizing profits may require not serving the best interest of one’s client.  On the other hand, if Goldman is acting as an agent for a client, it has an agency duty to act in the best interest of a client.  These two primary goals are often in conflict.  This conundrum is called the “Agency Problem”.

Goldman was the agent for both Paulson & Co. and IKB.  Goldman was also acting as a principal on its own behalf when it bought the ABACUS CDO and put the deal into its own books.

These are the goals for each principal towards which Goldman must aim:

Paulson & Co:

1. Structure a CDO that is filled with the worst possible subprime mortgages to increase the instrument’s chances of failure.

2. Sell the deal to investors so that Paulson & Co. has a financial instrument in the market against which it can bet.

IKB:

3. Help IKB make money on its investments by selling it financial instruments that Goldman thinks are good buys.

4. If Goldman thinks the instrument is not a good buy then give all relevant information about the deal so that IKB will be buying the deal with full knowledge of what it is buying.

Goldman Sachs:

5. Sell as much as possible to clients in order to make as much commissions and fees as possible

6. Buy good deals for Goldman’s trading book

7. If Goldman thinks the deal will lose money, then sell as much of the deal as possible so that Goldman does not have to take the deal on its books

Clearly, the goals for any one principal conflict with those of the others.  For instance, goal (1) conflicts with goal (3).  Goal (4) leads to an outcome that conflicts with goals (2) and (7).  Hence, we see a possible reason for not disclosing full information to IKB.  Goldman put itself into a position of prioritizing goals for the clients it serves and for itself.  In theory, as an agent its duty is to serve the best interest of all clients.

2. Truth Telling and Transparency

Is honesty the lost virtue in finance?  Most of us teach our sons and daughters to be honest.  If a child takes a dollar out of mom’s purse without informing her, he is chastened and told the act is dishonest.  If a job applicant withholds a material fact in her resume, she is accused of being dishonest and therefore, unethical.  If the untold fact is adverse, the applicant will likely not get the job.

Yet, when Goldman withholds a material fact in its marketing brochure and does not inform its client verbally of the same fact, supporters of free market values (or their red in tooth and claw version of the free market), argue that Goldman was not dishonest.  (The material fact withheld was that Paulson, who was on the short side of the deal and would benefit from a decline in price of the ABACUS CDO, was involved in selecting the underlying securities of the CDO.)  Why does high finance seem to exempt itself from being honest?

Goldman and its enablers argue that in the ABACUS case, IBK was a sophisticated investor, a “big boy”.  Therefore, IBK did not need any handholding and could do its own analysis and derive its own investment conclusions.  IBK should have known the risks.  The bank should have known that there could be an investor on the short side of the deal.  IBK should have taken its lumps and walked away.

The refutation of this argument is that honesty is demanded of an individual and institution at all times.  According to Kant’s Ethical Theory, which is the theoretical foundation supporting the concept of the duties of fiduciaries and agents, one is obligated to be honest.  It does not matter if the other party to whom one must be honest is sophisticated or unsophisticated.  Honesty is a moral obligation.

Thus, even if IBK is a sophisticated investor, Goldman is still obligated to be honest to its client.  That means all material information should be given.  Full transparency is required.  Indeed, full transparency is best both ethically and pragmatically.  For reputational reasons, Goldman would not want to end up on the front page of the Wall Street Journal facing the accusation of deceptive practices.  In the end, of course, it did.

Bottom line, based on the information in this case study of the Goldman Sachs ABACUS case, Goldman Sachs acted unethically because:

(1) The institution failed in its fiduciary duty to act in the best interest of its client.  It failed in this duty because it chose to be in a position where it was subject to conflicts of interest.

(2) The institution was not honest.  It failed to disclose material information to its client, IBK and to its service provider, ACA.

Case Written by Philip Whalen

Ethical Analysis by Dr. Kara Tan Bhala