SEC: Goldman Sachs May Have Crossed the Line from Conflicted Investment Banker to Fraudulent Communicator

It always disappoints me when the financial media cannot wrap their hands around certain business stories. Here I am today watching the CNBC coverage of the SEC’s fraud charge on Goldman Sachs (GS) and the network has half a dozen reporters and anchors all talking at the same time and confusing what exactly was happening, even though they played the SEC’s conference call live on the air and it was pretty clear what was being alleging.

At any rate, let me review what exactly the SEC claims Goldman Sachs and its Vice President Fabrice Tourre did that was fraudulent in this particular case. The SEC is charging both the firm and the employee in charge at the time with omitting and misstating important disclosures related to the structuring and issuance of a CDO called ABACUS which was backed by sub-prime residential mortgage securities.

One of Goldman Sach’s most prominent hedge fund clients, Paulson and Co, actually helped create the CDO by deciding which mortgage-backed securities were to be included in ABACUS. In addition, Paulson and Co took a short position in ABACUS after it was issued, meaning that it helped structure a CDO that it planned on shorting.

Many on CNBC are incorrectly reporting that this clear conflict of interest is what the SEC is targeting in its complaint. In fact, Paulson and Co. is not being charged at all. Not only that, having a hedge fund help structure a CDO in and of itself does not violate any securities laws. Neither would it be illegal for that same hedge fund to short the CDO after it was created and sold to the public. While this is yet another situation where Goldman Sachs appears to be engaging in transactions that are filled with conflicts of interest with their various sets of customers, these conflicts are not illegal. Rather, they simply beg the question whether Goldman will lose customers due to the perceived conflicts.

All of that said, what exactly is the SEC’s charge related to? It turns out that in the marketing and disclosure materials prepared for potential investors in ABACUS by Goldman Sachs, it was claimed that ACA Management LLC, an independent third party expert in mortgage-backed securities, was hired to select which mortgages were packaged into the CDO. There were no disclosures made to investors that the hedge fund Paulson and Co. was also involved in selecting the securities.

Now you may be wondering why on earth ACA Management would agree to let a hedge fund assist them in structuring ABACUS, given that they are supposed to be an independent third party taking on such a job.  The SEC hints it may have the answer. They are charging that the lead Goldman Sachs employee on this deal told ACA that Paulson and Co. was going to invest $200 million in ABACUS, which would likely calm any fears they had about the interests of ACA and Paulson and Co. being aligned while they collaborated on the creation of ABACUS. Fabrice Tourre, the Goldman VP in charge of the deal, seems to have both omitted disclosures related to Paulson’s involvement, as well as misrepresented to ACA what Paulson’s investment objectives were once ABACUS was issued.

The key point here is that the SEC is charging Goldman Sachs with fraud related to the disclosures made (and not made) relating to the creation and issuance of ABACUS. Therefore, the obvious conflicts of interest here by themselves would not have been illegal had Goldman adequately disclosed to investors the true facts behind the creation of ABACUS.

Now, how does this news alter my opinion of the stock, if at all? Goldman Sachs shares opened today at $185 and are now trading down 15% ($25) to around $160 each. You may recall I wrote a bullish piece on Goldman Sachs back in March explaining why I was accumulating the stock in the 150’s. Until today that investment had proved very timely and given that even with today’s drop, the stock is still above my purchase price, I am not likely going to be doing any heavy bargain hunting at current levels.

If the shares fall back to around the 150 level or even lower as more people react to the SEC’s charges, it is quite possible that I would get more of my clients involved with the stock and/or add to existing positions for those who are already long. While I do not expect there to be much of a negative financial impact on the firm from these charges (Goldman’s fees related to ABACUS were only $15 million), it is reasonable to expect that customers of the firm will have even more questions about conflicts of interest surrounding Goldman’s dealings, including the possibility that other employees are lying about deals they are putting together personally.

Goldman surely has its hands full trying to alleviate these concerns with clients, but they can likely argue that this was an isolated incident involving a rogue employee and minimize the customer fallout from these allegations (as long as this proves to be an isolated incident rather than a pervasive problem at the firm). Given the stock’s valuation based on book value and earnings, I still believe it represents a solid long-term value for investors interested in owning part of the most dominant investment banking firm in the world.

Full Disclosure: Peridot Capital was long Goldman Sachs at the time of writing, but positions may change at any time. And yes, you can be assured that there are no material omissions or misstatements in this disclosure.