Money and Power Read Online Free
Author: William D. Cohan
out the mortgages continued to pay them off, the security would keep its value. If, on the other hand, home owners started defaulting on their mortgages, the security would lose value since investors would not get their contracted cash payments on the securities they bought.
Investors who bought the CDO were betting, in late April 2007, that home owners would keep making their mortgage payments. But in an added twist of Wall Street hubris, which also serves as a testament to the evolution of financial technology, the existence of the CDO itself meant that other investors could make the opposite bet—that home owners would not make their mortgage payments. In theory, it was not much different from a roulette gambler betting a billion dollars on red while someone else at the table bets another billion on black. Obviously, someone will win and someone will lose. That’s gambling. That’s also investing in the early twenty-first century. For every buyer, there’s a seller, and vice versa. Not surprisingly, plenty of other Wall Street firms were manufacturing and selling these exact kinds of securities.
But in its lawsuit, the SEC essentially contended that Goldman rigged the game by weighting the roulette wheel in such a way that the bouncing ball would have a very difficult time ending up on red and a much easier time ending up on black. What’s more, the SEC argued, the croupier conspired with the gambler betting on black to rig the game against the fellow betting on red. If true, that would not be very sporting, now would it?
Specifically, the SEC alleged that Goldman and Fabrice Tourre, the Goldman vice president who spent around six months putting theCDO together, made “materially misleading statements and omissions” to institutional investors in arranging the deal by failing to disclose that Goldman’s client—hedge-fund manager John Paulson, who paid Goldman a $15 million fee to set up the security—was not only betting home owners would default, but also had a heavy hand in selecting the mortgage-related securities that the CDO referenced specifically because he hoped the mortgages
would
default. The SEC further alleged that Goldman had represented to ACA Management, LLC, a third-party agent responsible for choosing the mortgage securities referenced by the CDO, that Paulson was
actually
betting the CDO would perform well, when in fact he was betting the opposite.
Adding credibility to the SEC’s argument of fraud was the fact that some six months after the completion of the deal—known as ABACUS 2007-AC1—83 percent of the mortgage securities referenced in ABACUS had been downgraded by the rating agencies—meaning the risks were increasing so rapidly that they would default. By mid-January 2008, 99 percent of the underlying mortgage securities had been downgraded. In short, John Paulson’s bet had paid off extravagantly—to the tune of about $1 billion in profit in nine months.
On the losing side of the trade were two big European commercial banks: the Düsseldorf-based IKB Deutsche Industriebank AG, which lost $150 million, and ABN AMRO, a large Dutch bank that had in the interim been purchased by a consortium of banks led by the Royal Bank of Scotland, which then hit trouble and is now 84 percent owned by the British government. ABN AMRO got involved in the deal when it agreed—for a fee of around $1.5 million a year—to insure 96 percent of the risk ACA Capital Holdings, Inc., an affiliate of ACA Management, assumed by investing $951 million on the long side of the deal. In other words, ABN AMRO had insured that ACA Capital would make good on the insurance it was providing that ABACUS would not lose value. When ACA Capital went bust in early 2008, ABN AMRO—and then Royal Bank of Scotland—had to cover most of ACA’s obligation regarding ABACUS. On August 7, 2008, RBS paid Goldman $840.9 million, much of which Goldman paid over to Paulson.
Goldman itself lost $100 million on the
Investors who bought the CDO were betting, in late April 2007, that home owners would keep making their mortgage payments. But in an added twist of Wall Street hubris, which also serves as a testament to the evolution of financial technology, the existence of the CDO itself meant that other investors could make the opposite bet—that home owners would not make their mortgage payments. In theory, it was not much different from a roulette gambler betting a billion dollars on red while someone else at the table bets another billion on black. Obviously, someone will win and someone will lose. That’s gambling. That’s also investing in the early twenty-first century. For every buyer, there’s a seller, and vice versa. Not surprisingly, plenty of other Wall Street firms were manufacturing and selling these exact kinds of securities.
But in its lawsuit, the SEC essentially contended that Goldman rigged the game by weighting the roulette wheel in such a way that the bouncing ball would have a very difficult time ending up on red and a much easier time ending up on black. What’s more, the SEC argued, the croupier conspired with the gambler betting on black to rig the game against the fellow betting on red. If true, that would not be very sporting, now would it?
Specifically, the SEC alleged that Goldman and Fabrice Tourre, the Goldman vice president who spent around six months putting theCDO together, made “materially misleading statements and omissions” to institutional investors in arranging the deal by failing to disclose that Goldman’s client—hedge-fund manager John Paulson, who paid Goldman a $15 million fee to set up the security—was not only betting home owners would default, but also had a heavy hand in selecting the mortgage-related securities that the CDO referenced specifically because he hoped the mortgages
would
default. The SEC further alleged that Goldman had represented to ACA Management, LLC, a third-party agent responsible for choosing the mortgage securities referenced by the CDO, that Paulson was
actually
betting the CDO would perform well, when in fact he was betting the opposite.
Adding credibility to the SEC’s argument of fraud was the fact that some six months after the completion of the deal—known as ABACUS 2007-AC1—83 percent of the mortgage securities referenced in ABACUS had been downgraded by the rating agencies—meaning the risks were increasing so rapidly that they would default. By mid-January 2008, 99 percent of the underlying mortgage securities had been downgraded. In short, John Paulson’s bet had paid off extravagantly—to the tune of about $1 billion in profit in nine months.
On the losing side of the trade were two big European commercial banks: the Düsseldorf-based IKB Deutsche Industriebank AG, which lost $150 million, and ABN AMRO, a large Dutch bank that had in the interim been purchased by a consortium of banks led by the Royal Bank of Scotland, which then hit trouble and is now 84 percent owned by the British government. ABN AMRO got involved in the deal when it agreed—for a fee of around $1.5 million a year—to insure 96 percent of the risk ACA Capital Holdings, Inc., an affiliate of ACA Management, assumed by investing $951 million on the long side of the deal. In other words, ABN AMRO had insured that ACA Capital would make good on the insurance it was providing that ABACUS would not lose value. When ACA Capital went bust in early 2008, ABN AMRO—and then Royal Bank of Scotland—had to cover most of ACA’s obligation regarding ABACUS. On August 7, 2008, RBS paid Goldman $840.9 million, much of which Goldman paid over to Paulson.
Goldman itself lost $100 million on the
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