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United States Regulator sues Goldman Sachs for fraud

Narayan Lakshman

Washington DC: The United States Securities and Exchange Commission on Friday announced that it has charged investment bank Goldman Sachs and one of its vice presidents, Fabrice Tourre, for “defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages,” even as the U.S. housing market began to collapse.

According to the SEC filing in a U.S. court in the Southern District of New York, the cost of Goldman's fraudulent activities to investors was more than $1 billion.

In a statement, the SEC alleged that when Goldman Sachs structured and marketed a synthetic collateralised debt obligation (CDO) whose value was based on the performance of subprime residential mortgage-backed securities (RMBS), it failed to disclose to investors the fact that Paulson and Company — a major hedge fund that had bet against CDO — played a key role in the decision to include that CDO in investors' portfolios.

The SEC further alleged that Mr. Tourre had “devised the transaction, prepared the marketing materials and communicated directly with investors,” knowing fully of Paulson and Company's short interest in the instruments and its role in the collateral selection process.

Mr. Tourre also misled a third-party fund marketing firm into believing that Paulson and Company invested approximately $200 million in a long position on the instrument and, accordingly, that Paulson and Company's interests in the collateral section process were aligned with that of the fund marketer. In reality, Paulson and company's interests were sharply conflicting.

“The product was new and complex but the deception and conflicts are old and simple,” according to Robert Khuzami, Director of the Division of Enforcement at the SEC.

Kenneth Lench, Chief of the SEC's Structured and New Products Unit, added that the SEC continued to investigate the practices of investment banks and others involved in the securitisation of complex financial products tied to the then floundering U.S. housing market.

In a move that heralds a first major prosecution in the aftermath of the financial markets collapse of 2008, the SEC alleged that Paulson and Company paid Goldman Sachs to structure the transaction in which Paulson and Company could “take short positions against mortgage securities chosen by Paulson and Company based on a belief that the securities would experience credit events.”

In other words, Paulson and Company bet that the instrument would lose value and in a bid to maximise its profit from that event it paid Goldman Sachs to get its clients to bet that it would gain in value.

As per the SEC's charges, the marketing materials for the CDO all “represented that the residential mortgage-backed securities portfolio underlying the CDO was selected by ACA Management LLC, a third party with expertise in analyzing credit risk in RMBS.

The SEC alleged that Paulson and Company, undisclosed in the marketing materials and unbeknownst to investors, played a significant role in selecting which RMBS should make up the portfolio.

According to the SEC's complaint, the deal, closed on April 26, 2007, and Paulson and Company paid Goldman Sachs approximately $15 million for structuring and marketing the instruments. The SEC went on to note that by October 24, 2007, 83 per cent of the portfolio had been downgraded and 17 per cent were on “negative watch”; by January 29, 2008, “99 per cent of the portfolio had been downgraded,” the SEC said.

In the filing, the SEC sought “injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.”

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