Friday, April 16, 2010

SEC Charges Goldman Sachs With Fraud; Was Matt Taibbi Right About The ‘Giant Vampire Squid’?

Earlier today, the SEC charged Goldman Sachs & Co. with fraud relating to transactions the firm - dubbed the ‘giant vampire squid’ in an article by Matt Taibbi last year - structured, tied to the housing market. According to the SEC’s press release:

The SEC alleges that Goldman Sachs structured and marketed a synthetic collateralized debt obligation (CDO) 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” –disclosed elsewhere in the SEC press release as Paulson & Co. – “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.

SEC Enforcement Director Robert Khuzami added:
"The product was new and complex but the deception and conflicts are old and simple. Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party."

Kenneth Lench, Chief of the SEC's Structured and New Products Unit, SEC Enforcement Division, noted:
“The SEC continues to investigate the practices of investment banks and others involved in the securitization of complex financial products tied to the U.S. housing market as it was beginning to show signs of distress."

Was Taibbi Right?
In light of the above news, I wonder if Rolling Stone writer Matt Taibbi feels vindicated now, having faced substantial criticism of his article published on July 9, 2009, entitled: “The Great American Bubble Machine - From tech stocks to high gas prices, Goldman Sachs has engineered every major market manipulation since the Great Depression - and they're about to do it again.”

My recollection of the discussions in the blogosphere and twitterverse at the time Taibbi's article was first published last year (including commentary by former WSJ reporter Heidi Moore, and articles in the Columbia Journalism Review, among others, come to mind) were that Taibbi seemed to be 'reaching' his conclusions about Goldman, without sufficient 'evidence.' With 20-20 hindsight in light of today's announcement, there will likely still be varying views about Taibbi's article, but there may be a shift overall in how it is now perceived.

Goldman’s Response to the SEC
In response to the SEC charges, Goldman Sachs issued a one sentence press release earlier today (one sentence, not including the introduction and tagline), in which the firm stated:
The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation.

My two cents: Goldman Sachs and Mark-to-Market Accounting
My two cents (I remind you of the disclaimer posted in the right margin of this blog): In covering some of the FASB, SEC and Congressional hearings on mark-to-market (fair value) accounting over the past few years amid questions about the role, if any, of mark-to-market accounting vis-à-vis the subprime and credit crisis, I noticed that Goldman Sachs seemed to be the golden go-to boy on the subject of mark-to-market accounting, and that they consistently backed mark-to-market accounting as defined in FASB Statement No. 157 as appropriate - not so much the concept of mark-to-market or fair value itself, or what should or should not be carried at fair value (since FAS 157 did not define what to fair value, but redefined how to arrive at fair value, i.e., thru an ‘exit value’ notion, for which, history shows (as discussed at FASB Valuation Resource Group panels and other panels), many firms felt more comfortable with ‘independent’ ‘third party’ broker quotes for securities - even highly illiquid securities - vs. using other valuation methods that were previously acceptable for arriving at ‘fair value’ prior to FAS 157.

The testimony of and response during Q&A provided by Goldman Sachs at SEC hearings (and I believe FASB hearings as well, if memory serves me correctly, if I find a link I will update this post), advisory groups, or roundtables addressing mark-to-market accounting, generally represented by Matt Shroeder, Managing Director and Global Head of Accounting Policy at Goldman Sachs, often struck me as a little too much of a 'cheerleader' or purist for mark-to-market accounting as it existed under the original FAS 157, particularly with respect to illiquid securities, and my observation is not personal to Schroeder, but just a general observation about the firm's position as expressed at various hearings on this subject. Here are some quotes from Schroeder at an SEC hearing in 2008, from our blog post dated July 17, 2008:
Matt Schroeder, Managing Director and Global Head of Accounting Policy at Goldman Sachs, said, “For us, FV is the oxygen of the firm, we live by it, it’s part of our fabric, we follow daily discipline of marking to market at our firm.” He added that FV accounting “allows us to make economic decisions whether to buy or sell without regard to triggering a gain or loss, [without having to ask] is it going to taint my portfolio, it allows us to be free from those constraints.”...

... Matt Schroeder of Goldman Sachs said, “Is it harder [to measure FV] in illiquid markets, yes, you’ve got to look for more information, it requires you to be proactive.” He said firms need to seek out and put together a body of evidence to support the value they put on their instruments."

Further, although I was not in attendance in person in the observers' gallery at any of these SEC or FASB hearings (but listened via webcast), I always had the impression that many in the group (roundtable, hearing) were in awe of Goldman Sachs' prowess, owing to its leadership and earnings power in the financial markets, including the firm's ability to make money by, in essence, betting against the market.

In fairness to FASB and the SEC, further guidance relating to FAS 157 was released at various points in time, including in response to the SEC's report to Congress on mark-to-market accounting, and in response to the various hearings and roundtables convened by FASB, SEC and Congress.

However, I would suggest that, in light of today's SEC announcement, perhaps some of Goldman Sachs testimony on the particulars of mark-to-market accounting discussed at SEC and FASB hearings or roundtables over the past few years could be looked at from a different perspective - perhaps with less awe about the wonders of a firm that some may have deemed infallable, and perhaps with more skepticism about confidence expressed in market values established by 'the market' when the market is illiquid. (For some expert views on this matter, see our 2.24.09 post: User Views on Fair Value.) Additionally, I would suggest that heavier consideration be given to the firm's role as a market maker, designer of structured securities, trader, etc., vs. what some may have interpreted as a proxy for 'investor' or 'user' views or information that is most useful for investors.

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Darla Sycamore said...

I am mystified as to why the market reaction to this has been a depression of commodity prices and a depreciation of the loonie. May I ask what did Canada do.
I hope the SEC will get to the bottom of this and also look at other financial engineers.

Joseph said...

Goldman gets you coming and going. It is high time for the SEC to prosecute Goldman and we need to support President Obama and Congress to rein in the excesses of Wall Street.

Anonymous said...

Interesting blog insights. Leads one to wonder why Goldman is so keen on "mark to market" accounting and has lobbied FASB and Congress to require MTM for all financial instruments -- even for instruments that aren't traded.

Edith Orenstein said...

More on this topic: Rolling Stone’s reporter Matt Taibbi talks with Bloomberg TV’s Carol Massar Discussing SEC's Lawsuit Against Goldman Sachs:
(hat/tip Heidi Tan of Bloomberg)