Goldman Sachs and Abacus – Something’s Not Adding Up

The news just keep getting worse for Goldman Sachs. Now, Britain’s financial regulator, the Financial Services Authority (FSA), is following the SEC’s lead and has announced it will also launch its own investigation into Goldman’s Abacus project.

Since last Friday when the SEC first issued its communiqué that it was probing Goldman Sach’s use of Collateralized Debt Obligations (CDOs), Abacus has become ground zero as the cause of the global recession. While this may be a bit of an exaggeration, the SEC claims that Goldman Sachs did knowingly sell billions in repackaged debt as investment grade, when they were in fact, backed by poor quality, subprime mortgages that were actually designed to fail. That’s right – designed to fail.

Worse still, Goldman and a handful of hedge funds profited directly by shorting these securities, knowing full well that the CDOs would lose value as the underlying mortgages defaulted. According to the SEC, Abacus worked like this.

Hedge funds including Paulson & Co. – which started life in the early 1970s when “Chet” Paulson founded Paulson Capital Corp. – approached Goldman Sachs to help them structure a series of CDOs. Paulson would select the underlying securities and these were based almost entirely on mortgages expected to suffer from a high default rate. After receiving the Goldman Sachs stamp of approval, Goldman sold slices of the new CDO as investment grade to unsuspecting investors, knowing full well that the CDO was actually far below investment grade. Goldman also knew that Paulson was shorting the CDOs as they fully expected them to lose value once the true nature of the mortgages became known.

The SEC is conducting its investigation on the basis that Goldman Sachs was negligent in both how it represented the CDOs, and also that it failed to provide material information to investors regarding the involvement of the hedge funds. In other words, Goldman failed to disclose that a hedge fund was responsible for selecting the composition of the CDOs, and that the hedge fund was then betting that the CDOs would tank. Given the seriousness of these accusations and the fact that insiders actually went to the SEC with details, it is hard to believe that Goldman will get through this unscathed.

Some damage has already become apparent and has had a negative impact on Goldman’s share price. This past Friday, Goldman stock was trading at just under $185 a share. Once the SEC announced its investigation however, the share price started falling, and by Monday morning, had lost nearly 20% with no support yet in sight. American and European stock markets have also lost ground as investors wait for more news.

For the more cynical amongst us, there are some who feel this is justified payback for Goldman earning $13.4 billion in profit last year, with much of it as we are now learning, stemming from questionable practices. Public opinion is also teetering against Goldman as more details come to light. British PM Gordon Brown, who is in the middle of an election campaign, is clearly framing this as just further evidence that the actions of big business were directly responsible for causing the global recession.

Brown went on record this morning saying that he was “shocked” at the allegations against Goldman Sachs, while at the same time, referring to the paying of huge bonuses to top Goldman executives as “moral bankruptcy”. In the U.S. where the shift towards greater regulation of the financial industry is growing stronger, this will undoubtedly be seen as further justification for tighter restrictions on the investment industry.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.