The Case Against Goldman Sachs: Epilogue

Last April, I outlined the case against Goldman Sachs.  In that discussion, I posed the following questions:
1.  Should rating agencies rate securities on their own merit (not by considering who may or may not be investing in them)?
2.  Since ACA chose the securities in this investment from a list given to them by Goldman (from a Paulson list), was it a misstatement that ACA was "Portfolio Selection Agent?"
3.  Since banks and pension funds are defined as "sophisticated" investors, should they analyze the investments they are considering on their own merit (not by considering who may or may not be investing in them)?
Those questions have been answered by the Security and Exchange Commission in their settlement with Goldman.
In that settlement, the SEC found that Goldman omitted the material fact that Paulson & Co. was on the other side of the trade.  That finding assumes that ACA would have selected securities differently had it known that Paulson was taking a position against, rather than investing in the securities it was analyzing.  Stated slightly differently, that is analogous to saying that I would report findings on the financial health of Johnson and Johnson, the Washington Post, Moody's and Kraft Foods differently if I knew Warren Buffett was selling them than if he was buying them.  That doesn't say much for me as an analyst.  There's always someone selling when another is buying.  When must that be disclosed?  When the person is well respected?  Smart?  Well known?
The SEC additionally noted that material facts need by disclosed whether or not investors are "sophisticated" or not.  Again, that doesn't say much for banks and pension funds, which generally have staff analysts who review the financial health of potential investments.  Does the SEC feel that these analysts will conclude differently if someone they know is selling, rather than buying a security?  I taught Security Analysis and Advanced Security Analysis at UCLA, and focused upon balance sheets, cash flow statements and other fundamental measurements of financial health.  Not once did I recommend researching whether other people were buying or selling a stock when making a determination of its financial viability.
Put into perspective, the fine against Goldman was approximately three days' earnings, so even though it was the highest fine assessed so far by the SEC, it will not materially effect Goldman's earnings.
Further, Goldman admitted no wrongdoing in its acceptance of this agreement.  Consequently, those lining up to recoup losses from their investment will have a much higher burden of proof.
My assessment of this settlement is that of a business decision by Goldman to pay a fine rather than engage in a protracted battle with the SEC.  But the more meaningful message is this:  The SEC has little confidence in either analysts or rating agencies.
Should you?

The Case Against Goldman Sachs

There is no doubt that the sentiment toward big banks is negative.  Many resent that these banks were bailed out during the financial crisis, when the individual citizen who suffered as a result of irresponsible lending practices, misrepresentation of the safety of securities backed by those loans and resulting falling home prices, paid for the bail outs with their tax dollars.  When, added to that, historic profits are earned by those very banks, and enormous bonuses are paid to their employees, while ordinary citizens battle near double-digit unemployment, that anger is understandably exacerbated.
Few news reports give details of this charge, describing it as "complicated, difficult to explain, and hard to understand."  I disagree.  I think that, when explained properly, this is very understandable. 
It's easy to vilify Goldman for bad  behavior.  Let's take a look at this case, and decide for ourselves.
In plain English, Goldman is accused of selling derivative securities to their clients in April, 2007.  Derivative securities are securities that derive their price from another asset. The assets on which the price of these securities was derived, were residential mortgages, which were rated BBB-, the lowest "investment grade" rating available, by ACA Management, LLC, a company with experience rating securities like these. 
A Goldman employee, Fabrice Tourre, allegedly led ACA to believe that a hedge fund, Paulson & Co., Inc., was investing in these securities, when in fact, Paulson was investing in the other side of the transaction, i.e., a "short" position, or an interest in the securities losing value.  The securities that ACA approved as investment grade were chosen from a list that Paulson had chosen to invest against.
The approved securities were described as "Selected by ACA Management" and were marketed, not to individual investors, but to "sophisticated investors,” like banks and pension funds.
When explaining the difference between what must be disclosed to such sophisticated investors, former SEC lawyer Jacob Frenkel, explains,“Materiality is a lot like a continuum.  The amount of information that needs to be disclosed to institutional investors at the highest level, where they’re doing their own research and analysis, is less. Their criteria for the investment decisions tend to be far more sophisticated than the individual investor’s.”
So, the case is this.  A hedge fund wants to bet against sub-prime mortgages, and brings a list of the mortgages it feels will go down to Goldman.  Goldman takes the list to a rating agency, does not tell that rating agency that it received the list from a hedge fund that thinks the securities will go down, and gets an investment grade rating for most of those securities from that rating agency.  It sold those securities to banks and pension funds without telling them that a hedge fund was betting against them.  The banks and pension funds lost money.  So did Goldman, by the way.  They received $15 million for structuring this deal, but they lost $90 million investing in it.
The SEC alleges that Goldman should have told ACA and its investors that Paulson was investing on the other side.
Here are some questions that may help you decide how you feel:
1.  Should rating agencies rate securities on their own merit (not by considering who may or may not be investing in them)?
2.  Since ACA chose the securities in this investment from a list given to them by Goldman (from a Paulson list), was it a misstatement that ACA was "Portfolio Selection Agent?"
3.  Since banks and pension funds are defined as "sophisticated" investors, should they analyze the investments they are considering on their own merit (not by considering who may or may not be investing in them)?
I understand the anger many people feel toward investment bankers.  That said, I also feel that the analysis of securities, particularly by those who buy them on behalf of institutions or pension fund participants, should be based on analytical evaluation, not by "who else is buying this?"
I believe this to be a fundamentally weak case, and cannot help but notice that it was made public during the Financial Regulatory Reform debate.
For the record, I am in favor of Financial Regulatory Reform.  While this case may increase the likelihood of the passage of such reform, I find it largely without merit.
I welcome your comments.