By Zachary A. Goldfarb
Washington Post Staff Writer
Saturday, April 24, 2010; A08
Inside the Securities and Exchange Commission, top investigators remained confident this week that a largely overlooked part of the agency's fraud suit against Goldman Sachs would prove pivotal in court, even as potential flaws surfaced with other parts of the case.
SEC officials said the strongest part of its suit involves Goldman's dealings with the Duesseldorf-based commercial bank IKB. In 2007, the German bank turned to Goldman to invest in an instrument that would allow it to bet that housing prices would rise. The SEC alleges that Goldman misled and defrauded IKB.
But it has not been the Goldman-IKB relationship that has drawn the most attention since the SEC filed its case against Goldman eight days ago. Most public discussion has focused on ACA Financial Guaranty Corp., a New York firm that helped Goldman assemble the investment and then bet that it would gain value.
The SEC claims that ACA, too, was defrauded by Goldman. However, legal experts said new developments this week regarding what ACA might have known about the investment could cast doubt on the SEC's allegations.
Goldman and its allies released a fusillade of counterclaims this week attempting to defuse the case, insisting that the bank acted honestly, that its investors knew what they were doing and that it lost money on the deal. The SEC has stood by its allegations but has not commented further.
The crux of the SEC's case against Goldman is that Paulson & Co., a hedge fund, asked the bank to help assemble a financial product that would allow Paulson to bet against the housing market.
Then Paulson helped pick out individual components of the financial product: securities linked to the value of mortgages that it believed would probably fail. But the SEC says Paulson's motivations and role were concealed from the other parties that eventually invested in the product, ACA and IKB.
Much of the criticism of the SEC case -- and a significant part of Goldman's defense -- is that IKB and ACA were sophisticated investors who knew what they were doing. But government officials say that IKB came to Goldman for help explicitly because it wanted objective advice on what to invest in, and that Goldman did not tell the German bank that the product contained mortgages that Paulson believed would fail.
So, SEC officials say, it doesn't matter whether IKB was a sophisticated investor or not because Goldman did not provide the objective investment advice the German bank was seeking.
"The fact that the portfolio had been selected by an independent third-party . . . was important to" IKB, the SEC says in its complaint. "IKB would not have invested in the transaction had it known that Paulson played a significant role in the collateral selection process while intending to take a short position."
While SEC officials expressed confidence in the IKB part of the case, doubts emerged in some circles this week about the case pertaining to ACA.
John Paulson, head of the firm bearing his name, wrote a letter to investors this week that, according to a person close to him, was worded to suggest that the hedge fund had been clear with ACA that it wanted to bet against the mortgage market.
The investment at issue in the Goldman case is known as a synthetic collateralized debt obligation, which describes bets made on a bundle of securities tied to home loans. The parties on one side of the transaction bet that home prices will stay firm and the loans will be safe, and the other parties bet that prices will tumble and the loans will fail.
In the letter, Paulson wrote that "every synthetic CDO by definition has a long and short side. These products are designed specifically so that buyers and sellers can take positions based on their view of the expected performance of a given market. We have always been forthright in expressing our opinions, and we have never misrepresented our positions."
The letter came as two news organizations, CNBC and the Wall Street Journal, reported that a former Paulson deputy named Paolo Pellegrini told ACA that the hedge fund intended to short -- or bet against -- the mortgage investments.
If it is true that ACA was aware of Paulson's position, it could damage the SEC's case, raising serious questions about whether ACA was misled or defrauded.
Meanwhile, in Germany, the alleged defrauding of IKB has angered German officials and threatened Goldman's reputation with the German government.
Several politicians called on Chancellor Angela Merkel to stop the country's dealings with Goldman, which underwrites much of its national debt offerings. The bank also lost business with a major German lender, BayernLB. Merkel's government has said it is examining its relationship with Goldman, but isn't prepared to stop dealing with the bank.