Correction to This Article
The article incorrectly said that hedge fund manager John A. Paulson sought to bet through Goldman Sachs against the demise of subprime-mortgage securities. He sought to bet on the securities' demise.

Rivals say Goldman customers are taking a back seat

Analysts think other Wall Street firms could face charges similar to those filed against Goldman Sachs.
Analysts think other Wall Street firms could face charges similar to those filed against Goldman Sachs. (Spencer Platt/getty Images)
By Steven Mufson and Tomoeh Murakami Tse
Washington Post Staff Writer
Tuesday, April 20, 2010

One former hedge fund manager said that when he read the headline about Goldman Sachs being charged with fraud he thought, "It's about time." But when he read the details of the case, he said he thought, "That's it?"

Among many financial executives, there is little love lost for the powerful Goldman Sachs, which has been at the center of controversy over such things as bundling subprime mortgages, trading oil futures, and engineering Greek currency transactions. Although the positions taken by Goldman's own trading desk aren't public, many rival traders and fund managers say Goldman frequently bets against the very securities it is promoting to customers.

That might be perfectly legal -- as well as common in the financial-services business -- given the multi-faceted nature of investment banks, which underwrite and market securities, analyze them and trade on their own accounts. But it makes some money managers uncomfortable, though few of them wanted to be quoted by name given Goldman's powerful position in marketing and trading securities.

"Whether or not it's a criminal case, this underscores the problem with modern investment banks," said one fund manager and frequent short seller. "They have become giant hedge funds, and the interests of their clients are secondary."

That wasn't what happened in the deal that prompted the Securities and Exchange Commission to file civil fraud charges against the firm. In that deal, Goldman acted as an intermediary between big, sophisticated customers who had opposite views of where the housing market was going at a time when it wasn't obvious to many investors. Although Goldman allegedly failed to disclose that the subprime mortgage securities it was selling were weak ones initially hand-picked by hedge fund manager John A. Paulson so that he could bet against their demise, the buyers of those loans might have bought them anyway given their rosy outlook about the housing sector.

In its response to the SEC, Goldman's lawyers said that "all participants in the transaction knew that someone had to take the other side of the portfolio risk," and added that since every subprime mortgage package was "decimated in the market meltdown," therefore "any marginal differences in bond quality . . . would not have resulted in any materially different outcome." In addition, Goldman says "all participants were highly sophisticated institutions that were knowledgeable about subprime securitization products."

Joshua Rosner, managing director of Graham Fisher & Co., an independent research firm, says that investors in the loan package, known as Abacus, "knew what the collateral was. They also had the ability to know all of the details of the collateral and that the collateral was weak and could fail. Is it an ethical lapse if Goldman represented them as something other than they were? Sure, but they are sophisticated investors and should have done their own work." He said the fact that the SEC only voted 3-2 to pursue the case "suggests the government wasn't so sure what their obligation is either."

Goldman wasn't the only financial institution repackaging ill-fated subprime mortgages to sell to some customers. Deutsche Bank, UBS and Merrill Lynch, now owned by Bank of America, also created and sold packages of subprime mortgages that quickly went bad as the housing market collapsed.

As a result, analysts say cases similar to Goldman's could be in the offing. In private lawsuits, the accusations have already been flying.

A Connecticut hedge fund, Pursuit Partners, has sued UBS alleging that the Swiss firm, after deciding it had too much exposure to the subprime mortgage market, "concealed" from investors the value that the securities had lost according to UBS's internal calculations. UBS is fighting the allegations.

A Dutch bank, Rabobank, claims Merrill Lynch engaged in "precisely the same type of fraudulent conduct" as Goldman is accused of in marketing and structuring Abacus, according to a filing Friday in New York State Supreme Court. Rabobank is alleging that Merrill let a hedge fund client, Magnetar Capital, help select assets that went into a $1.5 billion package of debt obligations called Norma, but that Merrill told Rabobank the choices had been made by an objective third party.

"The types of undisclosed conflicts of interest that are identified in the SEC lawsuit against Goldman was [sic] prevalent," said Jonathan Pickhardt, a lawyer who is representing Rabobank and who specializes in litigation related to complex securities. He added that since charges against Goldman were filed Friday, his firm has received a number of inquiries from banks and other institutions that lost money buying securities that went sour.

Merrill Lynch, which has asked for a dismissal of the case, called the lawsuit by Rabobank opportunistic and without merit.

"The two matters are unrelated and the claims being made now are not only unfounded but were not included in the Rabobank lawsuit filed a year ago," Merrill spokesman Bill Halldin said.

Even if the firms that sold packages of subprime mortgages win in court, they could still be tarnished. "Whether they win in court or not is no longer relevant," said a leading European money manager, "because Goldman already lost reputation, tolerance and probably soon clients."

Tse reported from New York.

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