Did "Fabulous Fab" Take A Dive For His Bosses?

Note: Normally, I focus on corruption on the government side of the equation, but this recent verdict I think points out the systemic corruption that is occurring in the United States' financial industry. I felt it was important enough to cover it, even if it seems slightly off topic for this blog.

The US Securities and Exchange Commission gave themselves a big pat on the back over last week’s conviction of “Fabulous Fab” Fabrice Tourre on securities fraud. Tourre was the only individual found guilty in the convoluted, high-dollar ABACUS scandal—a case in which the investors Tourre sold the investment vehicle to were told it was financially sound and intentionally made unaware of the toxic subprime mortgage securities being bundled into its portfolio; all the while the party responsible for the ABACUS 2007 AC-1 creation was betting against it.

Following the verdict, Matthew Martens, the SEC’s overseeing attorney on this case, said, “If this doesn’t convince people we can win these cases, I don’t know what would”. I'm not sure it's that simple though.

Yes, the SEC should be happy that it walked away with this conviction, but it seems much more likely that Fabulous Fab, while certainly guilty, was essentially a sacrificial lamb—a mid-level asset that was jettisoned as soon as it became advantageous for folks higher up the food chain. After all, what happened to the person who gained the most from the ABACUS Scandal, John Paulson; the man who commissioned the creation of ABACUS and who played a significant role in the portfolio’s content selection?

Let’s take a quick look at how the scandal actually broke down:

In the mid-2000's John Paulson approaches Goldman Sachs with $15 million to develop a CDO—an investment product based on collateral assets bundled together, most commonly property mortgages. We now know that Paulson, who was already famously bearish on the housing market at that point, wanted this investment product created specifically to be a failure. So, during the portfolio selection, Paulson loads it to the brim with sub-prime mortgages. In fact, his selections were so bad that less than one year following the introduction of ABACUS, 99% of the residential mortgages in the portfolio had been downgraded.

After Goldman created the CDO and let Paulson fill it with ridiculously bad paper, they sold it to investors without accurately disclosing its actual contents. According to the SEC filing:

Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO.

Goldman made it appear as if they would have an objective third party (ACA Management LLC) in charge of portfolio assignment and management, but that simply wasn’t the case.

GS&Co marketing materials for ABACUS 2007-AC1 – including the term sheet, flip book and offering memorandum for the CDO – all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management LLC (“ACA”), a third-party with experience analyzing credit risk in RMBS. Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc. (“Paulson”), with economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO, played a significant role in the portfolio selection process.

It’s so important to remember: having investors pour their money into the CDO with the intent of it being profitable is the only way that Paulson had the opportunity to make a fortune shorting the fund.

Goldman then sold the fund to IKB Deutsche Industriebank AG and this is where the SEC was able to scoop up its first victory. Goldman eventually had to concede that there had been omissions of fact and that IKB had not been made adequately aware of Paulson’s position in the portfolio selection. Goldman of course argued that, regardless of their inherent fiduciary responsibility, researching the details of the fund purchase ultimately fell on IKB. That argument fell flat and Goldman had to pay a $550 Million penalty.

So IKB gets burned, investors get burned, Goldman gets caught red handed and pays a fine that allowed them to avoid any admission of guilt or criminality (pretty much standard operating procedure in big financial cases), Fabrice Tourre is indicted and found guilty, and John Paulson walks away unscathed with a claim of plausible deniability and a billion—billion with a B—dollars added to his ledger. Something isn’t quite right here.

Look, I don’t think that anyone with any knowledge of the case is going to say that Fabrice Tourre was innocent. He wasn’t. He knowingly misled investors. But my question is this: at the behest of whom?

John Paulson wanted that CDO to fail. He specifically created it and loaded it with toxic mortgages to do just that. But he also knew that he had to have enough investors thinking that it was a wise investment in order to sell it short and reap a windfall. It takes quite a leap of logic to believe that Paulson had no influence in the matter in which it was marketed or, in the very least damning interpretation of events, that he was completely unaware that Goldman was marketing it dishonestly.

Unfortunately, the SEC never attempted to flesh out the obvious assumption: that Paulson and Goldman (via Tourre) were effectively co-conspirators in what amounts to a massive swindle. I don’t know exactly why they didn’t pursue Paulson but I feel comfortable in speculating that he and executives at Goldman, either directly or indirectly (with a calculated level of cooperation with the SEC), offered up Tourre as a sort of sacrifice to a regulatory body that a disgruntled American public has largely deemed a failure in its prosecution of high level financial criminals following the 2008 financial crisis.

What is equally perplexing is the alacrity with which financial booby traps like ABACUS are constructed. Don’t get me wrong, I’m not necessarily against behavior like stock shorting. It makes sense for an investor to be able to look at a failing company and say, “I’m willing to place my money on the fact that this company is failing worse than people realize”, but ABACUS was a completely different animal. ABACUS was a trap for unwitting investors, intentionally created to fail while allowing those in the know to bet on its imminent failure. How the creation of a financial investment product meant to intentionally fail doesn’t fall into the category of fraud is beyond me. It should be and anyone involved should be held accountable.

His name is John Paulson. His name is John Paulson. His name is John Paulson...