Why some are scenting blood on Wall Street

PUBLISHED : Wednesday, 21 April, 2010, 12:00am
UPDATED : Wednesday, 21 April, 2010, 12:00am

You might just get your hair styled by a 28-year-old called Fabrice who likes to refer to himself in the third person as 'the fabulous Fab'.

But it boggles the mind that anyone would invest more than US$1 billion in complex derivatives tied to the value of dodgy home loans structured and promoted by such a character.

Nevertheless, that's exactly what happened in early 2007, according to the civil fraud suit filed last week by America's Securities and Exchange Commission against Fabrice Tourre and his employer, Wall Street titan Goldman Sachs.

Both the SEC's complaint and the rebuttal published by Goldman on Monday make fascinating reading. But perhaps the most striking thing about the deal at the heart of the case was just how ordinary it was for Wall Street at the time.

In essence: a big hedge fund wanted to take a position on the market and approached an investment bank to help it implement that view for a fee. The investment bank duly found a couple of investors with the opposite view and arranged the deal by matching buyers and sellers. It's what broker-dealers do all the time.

In this case, the hedge fund manager was John Paulson, who believed the US housing market was running out of steam and that swathes of subprime mortgage-backed securities were likely to default, or at least see their credit ratings downgraded.

As subprime mortgage-backed securities tend to be illiquid, he couldn't simply borrow them to sell short as you would if you had a negative view on blue-chip stocks. So Paulson's fund went to Goldman and proposed that it assemble a virtual portfolio of shaky mortgage-backed securities. Paulson would then take a short exposure to this notional portfolio through a credit default swap, while Goldman would find some property bulls to take on the other, long side of the trade.

Investment banks do their best to make credit default swaps sound brain-scramblingly complex. In reality, they are rather simple. Perhaps the easiest way to think of a credit default swap is as a synthetic bond. An investor who is long a bond will collect a modest income stream in the form of regular coupon payments. A speculator who is short will make a pile of money if the issuer is downgraded and the value of the bond plummets.

After some haggling about the exact composition of the notional reference portfolio, Tourre lined up two investors for the long side of the trade, including Germany's IKB Deutsche Industriebank and US company ACA Capital Management, whose affiliate had vetted the portfolio. The deal was done, and Goldman got a fat US$15 million fee for its services.

Within a year, 99 per cent of the reference securities in the virtual portfolio had been downgraded, inflicting crippling losses of more than US$1 billion on the long investors and earning a cool US$1 billion profit for Paulson.

Fair enough, you might say, caveat emptor, and well done, Mr Paulson. Except that the SEC is now alleging that Tourre and Goldman committed fraud by misleading the long investors about Paulson's role in the deal, making out that the short-seller who had originally proposed the trade was actually taking a long interest in the transaction.

Goldman denies the accusation. And to be fair, although IKB and ACA may not have realised Paulson was on the short side of the trade, they certainly knew that someone was on the other side, betting that the long investors would lose a pile of money.

Still, whatever the legal merits of the SEC's case, Goldman - and by extension the other Wall Street giants who structured similar deals - is now very much on the defensive.

The wording of the SEC's complaint, including the revelation about 'fabulous Fab', seemed intended to generate maximum media interest and public condemnation. Meanwhile, the timing, as the US Congress prepared to debate financial reform, just ahead of next week's Group of 20 meeting in Washington, and with US mid-term elections on the horizon, seemed designed for maximum political impact.

Some observers believe the US administration wants a scapegoat for the subprime crisis, and that it has singled out Goldman as the most prominent - and profitable - candidate.

If so, neither Goldman's size nor its protest on Monday that 'the firm's actions were entirely appropriate' is unlikely to help it much. Some commentators are already comparing the bank to Drexel Burnham Lambert, the powerful investment house which collapsed in 1990 following the conviction of employee Michael Milken for relatively minor stock and tax violations.

That may be stretching the point, but given the political capital to be made from pursuing Goldman, the steep sell-off in the bank's stock on Friday and the sharp rise in the cost of insuring its debt against default (see the charts below) may only be a taste of trials yet to come. The outlook for Goldman and Fabrice Tourre is far from fabulous.