The Securities and Exchange Commission today charged Goldman, Sachs & Co and one of its vice presidents for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the US housing market was beginning to falter.

... The SEC alleges that Goldman Sachs structured and marketed a synthetic CDOs that hinged on the performance of subprime residential mortgage-backed securities (RMBS). Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO.

... The SEC alleges that one of the world's largest hedge funds, Paulson & Co, paid Goldman Sachs to structure a transaction in which Paulson & Co could take short positions against mortgage securities chosen by Paulson & Co based on a belief that the securities would experience credit events. [1]

The SEC's complaint alleges that after participating in the portfolio selection, Paulson & Co effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure. Given that financial short interest, Paulson & Co had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson & Co's short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors.

The SEC alleges that Goldman Sachs vice president Fabrice Tourre was principally responsible for ABACUS 2007-AC1. Tourre structured the transaction, prepared the marketing materials, and communicated directly with investors. Tourre allegedly knew of Paulson & Co's undisclosed short interest and role in the collateral selection process. In addition, he misled ACA Capital Holdings, the now defunct bond insurer at the center of the case against Goldman Sachs, into believing that Paulson & Co invested approximately US$200 million in the equity of ABACUS, indicating that Paulson & Co's interests in the collateral selection process were closely aligned with ACA's interests. In reality, however, their interests were sharply conflicting.

According to the SEC's complaint, the deal closed on April 26, 2007, and Paulson & Co paid Goldman Sachs approximately $15 million for structuring and marketing ABACUS. By October 24, 2007, 83% of the RMBS in the ABACUS portfolio had been downgraded and 17% were on negative watch. By January 29, 2008, 99% of the portfolio had been downgraded. Investors in the liabilities of ABACUS are alleged to have lost more than $1 billion.

Royal Bank of Scotland executives were on Friday night examining whether the bank had any grounds for legal action against Goldman Sachs, after it emerged that it lost more than $800m (520 million pounds sterling) as part of an allegedly fraudulent transaction.

As part of the Securities & Exchange Commission's charges against Goldman, the regulator said that RBS had paid Goldman $841m to unwind a position in Abacus 2007-AC1, the Goldman-structured collateralized debt obligation at the center of the SEC investigation.

The part-nationalized British bank had inherited the position as part of its 2007 acquisition of ABN Amro, the Dutch bank. The sum involved is small compared with the ฃ45bn the government later pumped into RBS to keep it alive. But the notion that the alleged fraud may have contributed to an eventual taxpayer-backed rescue of RBS is likely to be politically sensitive.

“On or about August 7 2008, RBS unwound ABN's super senior position in Abacus 2007-AC1 by paying [Goldman] $840,909,090,” the complaint said. Most of this money was subsequently paid by Goldman to Paulson, the hedge fund, the SEC said.

... the Magnetar Trade worked this way: The hedge fund bought the riskiest portion of a kind of securities known as collateralized debt obligations - CDOs. If housing prices kept rising, this would provide a solid return for many years. But that's not what hedge funds are after. They want outsized gains, the sooner the better, and Magnetar set itself up for a huge win: It placed bets that portions of its own deals would fail.

Along the way, it did something to enhance the chances of that happening, according to several people with direct knowledge of the deals. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure. The hedge fund acknowledges it bet against its own deals but says the majority of its short positions, as they are known on Wall Street, involved similar CDOs that it did not own.

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