Lloyd Blankfein, CEO of Goldman Sachs, wrote to shareholders explaining that Goldman Sachs didn’t bet against its clients, just differently. Let’s see how that letter stacks up to the SEC’s complaint against Goldman Sachs. The letter is here (large .pdf), and the complaint is here (.pdf).

    The Complaint.

The SEC complaint says that Paulson & Co., Inc. (PCI) did an extensive analysis of existing real estate mortgage backed securities (RMBS). RMBSs are debt securities backed by residential real estate mortgages. PCI decided that the lowest rated debt securities, rated BBB by Standard & Poor’s, would fail. It asked Goldman Sachs to facilitate its bets on that proposition.

The Complaint says that PCI selected a number of recent-vintage BBB RMBSs, and asked Goldman Sachs to “help it buy protection, through the use of CDS…”. Para. 15. The problem was to find counterparties, because there was a lot of concern in the “market” for mortgage related securities.

Goldman Sachs decided to set up a synthetic CDO. Collateralized debt obligations (CDOs) are debt securities issued by special purpose vehicles, like trusts or LLCs. The special purpose vehicle holds debt securities like RMBSs. Goldman Sachs formed ABACUS 2007-ACI as a synthetic CDO. A synthetic CDO doesn’t hold debt securities; it writes protection credit default swaps against a portfolio of RMBSs or other CDOs, called the reference securities. The buyer of those swaps pays a premium to ABACUS 2007-ACI. If the reference securities fail, then the ABACUS 2007-ACI has to pay off on the CDSs. The premiums paid by the purchaser of protection are used to pay interest and principal on the debt securities. Goldman Sachs knew it would be difficult to sell ABACUS 2007-ACI:

… if they disclosed to investors that a short investor, such as Paulson, played a significant role in the collateral selection process. By contrast, they knew that the identification of an experienced and independent third-party collateral manager as having selected the portfolio would facilitate the placement of the CDO liabilities in a market that was beginning to show signs of distress.

Goldman Sachs hired ACA Management LLC, a third party known for its ability to evaluate RMBS. All the offering materials for the ABACUS 2007-ACI securities said that ACA handled the selection of the reference securities. What they didn’t disclose was that PCI was deeply involved in the selection of the reference RMBS. Furthermore, Goldman Sachs led ACA to believe that PCI was buying an equity tranche of securities, which would eat the first losses if the reference securities started failing. That was false. Goldman Sachs had no intention of selling the equity tranche, and PCI only intended only to buy protection CDSs from Goldman Sachs. The Complaint does not say who bought the protections CDSs from ABACUS 2007-ACI.

The Complaint says that one potential purchaser, IKB Deutsche Industriebank AG, told Goldman Sachs that it was worried about the housing market and would not buy anything unless the portfolio was selected by an independent agency. IKB bought $150 million of debt securities of ABACUS 2007-ACI, not knowing of the role of PCI in selection of the reference securities and its adverse interest. Those debt securities are nearly worthless. Most of the IKB money went to PCI.

ACA wrote protection CDSs on the senior tranche of ABACUS 2007-ACI, intermediated by AMRO Bank N.V. In early 2008, ACA failed. ABN also had serious financial difficulties and was bought by other banks. The CDSs were unwound for $841 million, most of which was paid to Goldman Sachs, which in turn paid most of it to PCI.

    The Blankfein Letter

Blankfein’s letter explains that Goldman Sachs didn’t bet against its customers. Goldman Sachs was strictly a market maker.

The markets for residential mortgage-related products, and subprime mortgage securities in particular, were volatile and unpredictable in the first half of 2007. Investors in these markets held very different views of the future direction of the U.S. housing market based on their outlook on factors that were equally available to all market participants, including housing prices, interest rates and personal income and indebtedness data. Some investors developed aggressively negative views on the residential mortgage market. Others believed that any weakness in the residential housing markets would be relatively mild and temporary. Investors with both sets of views came to Goldman Sachs and other financial intermediaries to establish long and short exposures to the residential housing market through RMBS, CDOs, CDS and other types of instruments or transactions.

The SEC complaint says that Goldman Sachs had to work to sell the debt securities of ABACUS 2007-ACI, and that it had to commit fraud to make it close. In the face of the SEC complaint, it doesn’t seem likely that IKB and ACA just showed up at Goldman Sachs’s door to establish a position based on their own research and review of the data on the housing market. Goldman Sachs actively misled both into participating in the deal. Maybe the SEC should take a look at the shareholders letter.