SEC-Goldman Sachs Settlement Proves Warren Buffett Wrong

I don’t have a problem with Abacus at all, and I think I understand it better than most.”

Warren Buffett (May 2, 2010)

“Goldman acknowledges that the marketing materials for the ABACUS 2007-AC1 transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was “selected by” ACA 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 Sachs (July 15, 2010)

How did Goldman Sachs (NYSE: GS) do it? How did it finagle a “Get out of Jail Free Card” from the Securities and Exchange Commission (SEC)?

Last Thursday (July 15th), the SEC agreed to a settlement that let Goldman off the hook for its fraudulent ABACUS deal in exchange for a paltry $550 million. As I discussed in Gotcha! The SEC sues Goldman Sachs, the SEC had ”smoking gun” evidence that Goldman committed fraud in the ABACUS residential mortgage-backed securities (RMBS) deal. Specifically, Goldman fraudulently represented to investors (i.e., its clients) that the mortgages underlying the ABACUS RMBS were selected by an “independent” third-party manager.

In reality, the mortgages were selected in large part by John Paulson, a hedge fund manager that was betting that ABACUS would default. Furthermore, Goldman fraudulently represented to ACA, the third-party manager, that Paulson was bullish on the RMBS market and wanted to invest $200 million in the “equity” tranche of ABACUS. It was all a complete lie. As Robert Khuzami, head of the SEC’s enforcement division, said in announcing the settlement:

This settlement is a stark lesson to Wall Street firms that no product is too complex, and no investor too sophisticated, to avoid a heavy price if a firm violates the fundamental principles of honest treatment and fair dealing

Goldman Sachs Got Away With Murder

Did I hear Khuzami say the settlement was “a heavy price?” Investors and insurers collectively lost more than $1 billion on the ABACUS deal, yet Goldman escaped responsibility, Houdini-style, for almost half of that figure! Granted, $550 million is the largest settlement amount in SEC history, but it pales next to the losses caused by the fraud. It pales even more next to Goldman’s net profit over the past 12 months of $13.8 billion. In exchange for only 4% of its annual profit and 1% of its revenue, Goldman gets a clean slate without having to admit it committed fraud. What a travesty. Goldman CEO Lloyd Blankfein probably saved his job by pulling off this master stroke. 

My only solace is that Goldman is still vulnerable to private lawsuits. For example, U.K. bailout recipient Royal Bank of Scotland (NYSE: RBS) is reportedly going to sue Goldman for the $840 million it lost (via its horrible acquisition of ABN Amro) insuring the deal. Other lawsuits will surely follow now that Goldman has publicly admitted that it made a mistake by providing incomplete information to investors in its marketing materials.

Reasons Why the SEC Settled

The question remains why the SEC let Goldman off the hook for such a paltry settlement? A few reasons come to mind:

  • Conspiracy theorists note that the SEC announced the settlement just hours after Congress passed the financial reform bill. Perhaps the SEC wasn’t really interested in cleaning up Wall Street but filed the suit at the behest of President Obama and Congressional Democrats in order to help justify and push through the financial reform legislation. Once the legislation passed, the SEC quickly settled for a song. (I hate being so cynical).
  • The SEC feared it would lose in court. Hard to imagine, given the smoking-gun evidence, but courts have been known to make bad decisions. Goldman is rich enough to hire the best lawyers in the country, all of whom could be expected to twist facts and obfuscate. Goldman’s lawyers would have argued that ACA had the power to reject any of the toxic subprime mortgages that Paulson had selected, so it didn’t matter that ACA was unaware that Paulson had selected them. Completely unpersuasive, but a stupid judge might have bought that argument. Anyone remember O.J. Simpson’s murder acquittal despite police having found his blood at the crime scene and Nicole Brown Simpson’s blood on his socks?
  • The U.S. economy remains in a shambles and President Obama realizes that we need the best financial minds in the country to help get us out of this mess. Without a doubt, and regardless of what anyone thinks of their fraudulent behavior, Goldman remains the pinnacle of financial expertise in the country. How else can you explain Goldman’s perfect string of 63 days without a single trading loss? A time-consuming trial would have distracted Goldman at a time when their expertise was needed most.
  • The SEC’s fraud charges against Fabrice Tourre, the arrogant French (redundant?) managing director of Goldman Sachs at the heart of the ABACUS deal, have not been settled, so the SEC expects to uncover all of the facts of Goldman’s fraud through discovery at Tourre’s trial. You can be sure that Tourre will seek the testimony of many Goldman Sachs employees at his trial, which is a good thing.

Warren Buffett Disappoints Me Again

Mr. Tourre is not the only big loser in this settlement. Another loser is Warren Buffett, who spent virtually the entire annual meeting of Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) this past May defending Goldman and telling anyone who would listen that the investment bank did nothing wrong. Buffet arrogantly claimed that critics didn’t understand the deal and that the press was misreporting the facts. It turns out that Buffett was misreporting the facts: Goldman has now admitted that it mistakenly misled investors. This just confirms my earlier conclusion that Warren Buffett is a Huge Disappointment.

Goldman Sachs Earnings Still Positive

I’ve got to mention Goldman’s second-quarter earnings report. Earnings were down 82% on the $550 million SEC settlement, a one-time $600 million U.K. tax on executive bonuses, a decline in trading profits, and a slowdown in the investment banking business. But despite all of that, Goldman still beat analyst estimates and earned $613 million! If, in addition to the $550 million, the SEC had required Goldman to disgorge all of its $613 million in second-quarter profits, investors in ABACUS could have been made whole. That wouldn’t have been too much to ask.

Is Goldman Sachs a Buy?

With the settlement behind it, is Goldman finally a buy? I don’t think so. Its reputation remains shattered by its admission of mistakes, the continuing Fabrice Tourre case promises more explosive revelations, and the U.S. will hopefully follow the U.K.’s lead and finally decide to tax Wall Street’s outrageous bonus packages.

Even if the U.S. doesn’t do the right thing and tax Goldman’s bonuses, at least we can take some satisfaction in the fact that Goldman is suffering from a bedbug infestation! Bad karma always exacts its revenge.


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