On the SEC’s Too Little, Too Late “Fabulous Fab” CDO Victory

Narrowly speaking, it’s good that the SEC won its case against ex-Goldman staffer Fabrice Tourre for his role in marketing a toxic CDO to bond insurer ACA. The SEC has been depicted, heretofore correctly, as the gang that couldn’t shoot straight when it comes to litigating anything much beyond its comfort zone of insider trading cases. The Tourre victory provides a badly needed boost to moral and may embolden the agency in future cases, particularly now that star litigator Mary Jo White heads the agency.

But let’s not kid ourselves as to what this verdict amounts to. We had a meteor-hitting-the-planet-and-nearly-killing-the-dinousars level financial crisis, with the special part the meteor hitting the planet wasn’t an accident. As pundits, some candid current and ex regulators, deeply frustrated members of the public, and various interest groups, ranging from wonky (Better Markets) to broad-based (Occupy Wall Street) have said, individuals need to be held accountable to prevent this sort of disaster from happening again. CEOs doing the perp walk was what the public wanted to see. Instead, six years later, we have one young guy at Goldman who will disgorge some income and be barred from working in the industry (for how long yet to be determined). This is so far short of what needed to happen that it’s pathetic to see the SEC high-fiving over its win.

There were paths to getting individuals in jail or at least seriously denting their reputations and balance sheets had there had there been political will. Eliot Spitzer set forth one in the movie Inside Job, which was to prosecute individuals on clear criminal abuses, which was hiring hookers and paying for drugs on the company nickel, typically done via “research” paid to improbable vendors, like madams (aside from the information provided by one such recipient of Wall Street “research” money in Inside Job, read another ex-Goldman CDO salesman Testsuya Ishikawa, who’s thinly disguised autobiography, “How I Caused the Credit Crisis” gives some long-form examples of how important prostitutes and drugs were in getting clients to agree to buy dreck). Spitzer argued you needed to treat Wall Street like the mob, bust the foot soldiers on the not-too-hard-to-prove criminal charges, and press to get them to turn state’s evidence on juicier stuff (and one has to wonder how many of the lower rate tranches of CDOs would have been sold absent the suborning of the decision-makers at the employees. Choking off the supply of bribes in the form of hookers and drugs to clients might in and of itself produce meaningful changes in buy-side behavior).

Charles Ferguson, the Oscar-winning producer of Inside Job set forth a second path in his book Predator Nation, that of prosecuting the institutions, with a lengthy discussion of how evidence in the public domain was sufficient to indict several specific players (Ferguson also made clear that he’d merely chosen them as examples, that this was a target-rich environment). The problem with that is that prosecuting a company is a nuclear option. Some counterparties like government investors are prohibited from doing business with a business that has been indicted, others will increase haircuts and reduce exposures in light of the risk that the prosecution might prevail.

So in many cases, threatening a criminal suit will allow the government to get whatever it wants. That might seem perfectly reasonable if you are dealing with a serial recidivist. But look at the hue and cry when Spitzer used the threat of a criminal suit to get Hank Greenberg of AIG to resign (I’m convinced it was Greenberg, who cultivated a reputation as the toughest SOB around, who was responsible for Spitzer’s demise. He’s be the sort to have Spitzer tailed). Imagine the backlash if (in an alternative universe) the DoJ or New York AG had filed criminal charges against Bank of America over its mortgage servicing? Oh, can’t risk blowing up the system to defend the rule of law, now can we?

As we discussed at length on this blog, there was a third route, which was to use Sarbanes Oxley. Sarbanes Oxley was designed to halt the “I’m the CEO and I know nothing” defense. But since no one has bothered to try (we think the SEC was unduly deterred by one ruling), that sort of intelligence-insulting blather continues to be effective.

And the SEC, way too late in the game, has shown that there was a fourth route: going after the middle level guys on securities law charges. It’s not clear even if the SEC had begun this process earlier that it could have used it to daisy chain its way to bigger fish. One has to infer that that was its hope with the Fabulous Fabrice Tourre, but Tourre illustrated that the threat of civil charges aren’t enough to induce highly paid young professionals to rat out their employers.

Now the SEC is apparently over the moon over this victory. Admittedly, the media had been predicting an SEC loss. And if you had been following the case, one of the SEC’s witnesses, Paulson & Company’s Paolo Pelligrini, clearly perjured himself in saying he didn’t know what a CDO was (various accounts of the crisis, such at Greg Zuckerberg’s book The Greatest Trade Ever, describe in some detail how Pellegrini was the architect of Paulson’s strategy of creating synthetic CDOs to take large short bets on the mortgage market).

It may be more accurate to say that Tourre’s lawyers lost the case than that the SEC won (Tourre’s side didn’t call any witnesses, an unusual step that was seen as indicating their confidence in victory). However, a reading of juror interviews says the SEC did surmount a key obstacle in a case involving complex instruments (particularly when the judge instructed the SEC not to do into the weeds).

The critical bit was how was ACA so dumb as to take the long position in a drecky CDO. ACA had not understood that this CDOs was being designed to satisfy the keen demand of short investors, and apparently didn’t know there were lots of parties like Paulson that were eager to take the short side.

Paulson (actually Pellegrini) had been the originator of the Trojan horse strategy that was later improved upon by the hedge fund Magnetar: a hedge fund would take a long position in the equity tranche of a CDO. That was the riskiest piece and (when this sort of trade was first being done) necessary to get the deal done. The investors in the other long tranches took comfort from the presence of the equity tranche investor, who’d take the first losses.

But hedge funds like Paulson and later Magnetar and its imitators would take the equity tranche (typically 5% of the deal) and a MUCH larger short position (Paulson wanted to take down the entire short side of his CDOs, leaving him 95% short; for reasons not germane to this post, Magnetar would wind up substantially net short but not take down the entire short side).

There is another piece lost in the dustbins of history: the Wall Street types love to say the folks who were CDI longs were just stupidniks who got what they deserved: “Everyone knew there was a short side to the CDO”. But someone taking down a short position (technically, the credit default swaps that provided the cash flows for the synthetic long position) was not necessarily someone taking a short bet. The existence of subprime shorts was not well known in 2006-2007. By contrast, you had a lot of players, such as major banks and securities firms that had subprime exposures who might want to and actually did use CDS to hedge their long exposures. One of our sources for ECONNED who worked on a CDO desk said that hedgers accounted for roughly 25% of the CDS demand. The problem with folks like ACA is they had no idea the percentage was that low. With an exploding RMBS business and little information about subprime shorts (Paulson was just small fry back then but did get picked up in Bloomberg a couple of times), someone like ACA wouldn’t be in a position to know what the level of hedging v. speculative shorting was in its CDOs. And the tight CDS spreads in on the subprime indexes would suggest that there wasn’t a lot of speculative shorting (in fact, that was the point of using CDOs, to keep from blowing out index spreads).

So here was the tricky bit for the SEC (from what I infer from reading the initial filings and later media accounts, anyone who attended the trial or read transcripts is encouraged to correct or refine this discussion): Goldman and Tourre apparently never told ACA that Paulson was taking an equity position. And in the end, Paulson never took part in the deal at all (this was a late-in-cycle deal, and didn’t in the end its equity tranche was never sold, see here for a more technical discussion).

So the hurdle was…if Goldman and Tourre never lied about Paulson, how was there harm done? Well, it turns out the conclusion hinged on what constituted a misrepresentation.

The testimony established that ACA did think Paulson was taking the equity tranche and Tourre never disabused ACA of that idea (jurors discounted a deal document that was presented to ACA when the deal was well advanced showing that there would be no equity tranche as not germane since it misrepresented a different deal point). Now why is that so damning? Well, why would someone like Paulson be involved in the deal design at all (as in they were in meetings, someone like ACA would assume as a prospective investor). The ONLY reason to let someone like ACA know Paulson was (or might be) investing was if they were going to be long. If any CDO long side investor thought a hedge fund had influence on the deal and was going to be on the short side, the long side investor would run for the hills. Introducing Paulson to ACA as a short investor would be guaranteed to kill ACA’s appetite for the deal. Thus it was completely logical for ACA to assume Paulson was a long investor.

The fact that the SEC was able to get the jury to understand that without going overmuch into technical details is a solid accomplishment. A second hurdle was persuading the jury that Tourre should be held responsible as a mere 28 year old mere Goldman staffer (a point the SEC failed to convey adequately in a similar case against Citigroup employee Bruce Stoker). Although the jury had some qualms about finding for Tourre when Goldman was not on trial too, his role in overseeing the deal and his $2 million pay package persuaded them he was plenty responsible.

The SEC made the issue how Wall Street acted as if it could create its own rules central to its argument. From the New York Times:

Mr. Tourre, {SEC attorney] Mr. [Matthew] Martens later declared in his closing remarks, was living in a “Goldman Sachs land of make-believe” where deceiving investors is not fraudulent…

“They portrayed him as a cog, but in the end a machine is made up of cogs and he was a willing part of that,” she [juror Reverend Beth Glover] said.

Felix Salmon looked at the Tourre and the Sergei Aleynikov cases (the ex-Goldman programmer that the government aggressively prosecuted at Goldman’s behest, whose case is the subject of a new Michael Lewis story in Vanity Fair) and concluded:

In any case, I’m increasingly coming to the conclusion that America’s system of jurisprudence simply isn’t up to the task of holding banks and bankers accountable for their actions. The only people who ever get prosecuted are small fry and insider traders, rather than the people who really caused the biggest damage.

Ahem, this is 2013 and Felix is just waking up to this issue and fingering America’s legal system? Let’s at least pin the tail on the right donkey, which is America’s political system.

If you go back to the Great Depression, we could have wound up with almost exactly the same account were it not for Ferdinand Pecora being appointed the fourth (yes, the fourth) counsel to the Senate committee that was investigating the causes of the crisis. The hearings were being wound up and Pecora was simply supposed to tidy up lose ends left by the third counsel quitting. Pecora used what was envisaged as a one-month task to effectively reopen the hearings and brought to light many destructive practices that had produced investor losses. While the hearings did not produce any prosecutions, they unquestionably stoked the appetite for reform and provided something that had heretfore been missing, evidence, as opposed to suspicion, that there had been widespread bad behavior prior to the crash.

Felix would again likely be singing a different tune had New York state attorney general Eric Scheiderman not been bought off by the shiny toy of the appointment to a state-Federal mortgage task force that was evidently presented to him as a platform for greatness when it was clearly intended to stymie him and like-minded state attorneys-general who were pushing for a tougher state-Federal mortgage settlement (and truth be told, I’m not certain the dissidents’ objectives were to broker a separate deal so much as being sure that the banks didn’t get a “get out of liability almost free” card. Either derailing the state-Federal deal underway or taking a lot of the liability waivers out of the state-Federal deal underway would have suited their aims. Either outcome would have allowed the more aggressive state AGs to continue filing cases). So the failure here hinged on the Obama Administration successfully flipping a key member of the opposition, not any defect of the “judicial system” per se.

And if you wind the clock back, where we wound up was also path-dependent. The SEC, which has spent decades doing pretty much only insider trading cases, decided to enlist the DoJ in going after two Bear Stearns hedge fund executives. They picked a bad target and we’ve paid dearly for that decision.

The problem was that first, the hedge fund was more victim than perp, and second, the DoJ and SEC did inadequate trial preparation (too much reliance on e-mails they thought were damning, not enough examination of other material or deposing of the executives themselves to see what else might have explained their actions). This was an embarrassing loss that cowed the SEC and pretty much took the DoJ out of the business of pursuing anyone other than penny ante crooks they were sure they could beat. This does not reflect deference to Wall Street as much as having unreasonable goals (as in expecting a high win rate in prosecutions, when if you are pursuing new cases, you expect to lose in the beginning. Plus your overall goal should not be to win virtually every case but to make potential abusers afraid of being dragged to court and having a tough battle and decent odds of losing). As one former law official wrote:

There were cases to be made. Part of what held the DoJ back was a lack of willingness to risk significant high profile losses. If DoJ won the Bear Stearns hedge fund case, they would’ve been emboldened. Instead they became terribly frightened. Another and related part was the decision not to allocate necessary resources. It is remarkably important in these cases to flush out cooperators, which is not in the SEC’s wheelhouse. You need the threat of prison time to get these guys to come forward. By outsourcing the cases to the SEC they gave up one their strongest investigative tools: fear.

No doubt the incentives (including some of the cozy relationships between DoJ and the lawyers for the banks, which led DoJ to give undue credence to their arguments) baked into the system helped drive the poor results, but I think the existing system could have worked (and can work).

As for Aleynikov, it’s a mistake to see it as a Goldman case, as much as Goldman was the driver. Remember, the Obama administration targeted Goldman for its first major post crisis case, the Abacus CDO case that produced a $550 million settlement. The Aleynikov is not a finance case, it’s an intellectual property case. Political scientist Tom Ferguson is in the process of finishing his analysis of 2012 donations and though he is not done, it’s clear Silicon Valley was a huge donor to the Obama campaign. The Administration has been insanely aggressive in pursuing software and IP cases, starting with Aaron Swartz (or look at the vastly less sympathetic Kim Dotcom. The Administration’s gotten him tons of fans overseas via getting New Zealand officials, at least initially, to engage the sort of prosecutorial overreach that has become common here). There’s a reason that “hackers” (and Swartz has been maligned by inaccurately calling him a hacker) are becoming the new public enemies number two (“terrorists” are unlikely to be displaced in the top slot), and it’s not just because Hollywood and Silicon Valley want to strengthen their intellectual property rights.

As Edward Snowden has dramatically shown, it is highly skilled IT professionals, and not gun enthusiasts, who now represent the greatest threat to the government. And it’s not just through politically destabilizing disclosures. It’s also through attacking infrastructure and specific assets. Look at Stuxnet and imagine what IT based infrastructure sabotage in the US might look like. Threaten to open the gates on a major dam remotely and flood businesses, cities, and factories downstream? Hack into the systems of a car and engineer a crash of an important executive of official, as some think happened to journalist Michael Hastings? The government was probably delighted to have any big powerful corporation finger a former senior IT professional as running off with supposedly important code. Even better if would spend lots of legal horsepower helping the government make a case. The fact that it was a big Wall Street player (when the Administration has been looking to make nicer to Big Finance) was likely gravy.

As much as it is disheartening to see the SEC tout such a small success, it is also important to calibrate what this event signifies. Dismissing the legal system as hopeless, as Salmon does, lets the SEC and the DoJ off the hook. Just as Tourre was correctly held accountable for his actions, we also need to hold the incumbents of various enforcement offices responsible for their dereliction of duty.