UV5683

Oct. 27, 2010

SEC VERSUS GOLDMAN SACHS (A)

The product was new and complex, but the deception and conflicts are old and
simple. Goldman wrongly permitted a client that was betting against the
mortgage market to heavily influence which mortgage securities to include in an
investment portfolio, while telling other investors that the securities were selected
by an independent, objective third party.1
—Robert Khuzami, SEC Director of the Division of Enforcement

In other words, the SEC is a dreadful failure in fulfilling its core mission of
protecting individual investors, as the Stanford and Madoff cases show. But the
SEC is very good at nailing politically correct targets like Goldman years after
the fact on charges that have little or nothing to do with the investing public....In
the cases of Stanford and Madoff, thousands of small investors lost their life
savings. In the case of Goldman, some masters of the financial universe lost
money on what they knew was a calculated gamble. Which did more societal
harm?2
—Editorial, Wall Street Journal

On Friday, April 16, 2010, traders at Goldman Sachs stared at their computer screens in
disbelief. The headline news read: “SEC Charges Goldman Sachs with Securities Fraud.” The
normal buzz of traders talking to clients, shouting market information, or exchanging trade
details ceased as the trading room fell into an eerie silence. Heads turned from individual
computer screens to the television sets above. In a company that built its culture and

1
“SEC Charges Goldman Sachs with Fraud in Structuring and Marketing of CDO Tied to Subprime
Mortgages,” U.S. Securities and Exchange Commission, Release 2010-59, April 16, 2010,
http://www.sec.gov/news/press /2010/2010-59.htm (accessed September 29, 2010).
2
Review & Outlook (editorial), “The SEC’s Impeccable Timing,” Wall Street Journal, April 20, 2010.

This case was prepared by Research Assistant Rick Green under the supervision of Professor Wei Li. It was written
as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation.
Copyright  2010 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved.
To order copies, send an e-mail to [email protected]. No part of this publication may be
reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—
electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School
Foundation.

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compensation on hiring the best people and being the best at what they do, the surprise
accusation that it had committed securities fraud hit traders like a bombshell.

Management was shell-shocked as well. Depositions of key employees and certain clients
relating to certain credit derivative transactions had begun about a year before the
announcement.3 But it was customary for the SEC to give prior notice to a company’s
management of a pending civil suit so the company could manage reactionary damage control.
Moreover, the SEC typically allowed a company to enter into settlement talks before making the
charges public, particularly in high-profile cases.4 Within minutes, the surprise announcement
had caused Goldman’s stock price to plunge. It had closed the previous day at $184.27 and had
risen above $186 Friday morning on expectations of a strong first-quarter earnings release that
was planned for the following week. Now the stock price had dropped to $170 and was clearly
heading toward the $160s (Exhibit 1).

The SEC had accused Goldman Sachs and its employee, Vice President Fabrice Tourre,
of misleading investors in 2007 while marketing and selling a synthetic collateralized debt
obligation (CDO) called “Abacus 2007-AC1.” The commission claimed that the hedge fund
manager, John Paulson & Co., heavily influenced the selection of the underlying securities that
made up the CDO, while planning to take the short position in Abacus. GS hired ACA
Management, LLC, (ACA), an independent credit analyst, to be the collateral manager,
responsible for approving the underlying components of the transaction. The SEC’s complaint
was that Goldman Sachs intentionally failed to disclose Paulson’s role and misled ACA into
believing that Paulson was to hold a long interest with CDO investors—in fact, the equity
tranche of the capital structure. The agency’s investigation had been under way for 18 months,
culminating in a 22-page document issued on April 16 explaining its charges against the
company. The document, SEC filing 2010-59, was filed in the U.S. District Court for the
Southern District of New York.

Goldman Sachs

Goldman Sachs (GS) started out as a small commercial paper dealer, founded in 1869 by
Marcus Goldman. In the early 1900s, the company became involved in the beginnings of the IPO
(initial public offering) business, although that term did not exist at the time. But they handled
the 1906 initial sale of stock for retail giant Sears, Roebuck & Co., among others. The
investment unit, Goldman Sachs Trading Corporation, suffered huge losses in the stock market
crash of 1929, but survived.

3
Carrick Mollenkamp, Serena Ng, and Gregory Zuckerman, “SEC Chief Bets Big by Going After Goldman,”
Wall Street Journal, May 15–16, 2010.
4
Patrick Jenkins and Francesco Guerrera, “Goldman Versus the Regulators,” Financial Times, April 18, 2010.

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GS, structured as a partnership, built an investment bank and equity and bond trading
capabilities over the next 60 years. In 1990, Robert Rubin (later U.S. Treasury Secretary) and
Steven Friedman took over as co-senior partners and focused on merger and acquisition (M&A)
activity and on expanding its global presence. John Corzine assumed leadership in 1994,
followed by Henry Paulson (later U.S. Treasury Secretary) in January 1999. In May 1999, GS
itself went public, valued at $33 billion. In conjunction with its IPO, Henry Paulson became
chairman and CEO. The company’s monthly stock price since the IPO is illustrated in Exhibit 2.

Goldman Sachs had three main segments responsible for revenue generation: Investment
Banking, Trading and Principal Investments, and Asset Management. Clients included public
corporations, other financial institutions, state and national governments, and individuals (see
financial statements in Exhibits 3 and 4).5

 The Investment Banking segment consisted of financial advisory services and

underwriting. Advisory assignments were taken with respect to mergers and acquisitions,
corporate defense initiatives, divestitures, restructurings, and spinoffs. Underwriting
included the arranging of public offerings as well as private placements of debt and
equity securities. In 2009, this segment contributed $4.8 billion to gross revenues (before
expenses).
 The Trading and Principal Investments segment had experienced spectacular growth
since 2004. It included FICC (fixed income, commodities, and currencies), equities, and
principal investments divisions. Except for 2008, FICC had generated an increasing share
of revenues between 2001 and 2009 (Exhibit 5). The division’s most profitable year ever
was 2009, when it earned gross revenues of $23.3 billion The division made markets
(quoting both bid and offer sides of a market) in fixed income, commodities, and
currencies, adding credit derivatives over the previous 10 years. It structured and traded
derivatives and engaged in proprietary trading and arbitrage. The equities division
performed similar activities in the equities markets. Principal investments concentrated
on merchant banking activities.
 The Asset Management segment earned management fees by providing investment
advisory services through mutual funds and private investment funds. Asset management
fees were based on the value of clients’ portfolios; therefore, fees could be reduced due to
declines in asset values, fund redemptions, or investor shifts to products that generated
less fee income. Securities service performed prime brokerage and securities lending to
institutional clients.

Lloyd Blankfein, 55, was chairman and CEO of Goldman Sachs in 2010. He was born
during the baby boom and grew up in Brooklyn, New York. His father was a U.S. postal worker
and his mother a receptionist. He had spent virtually his entire career at Goldman Sachs.
Blankfein had been working as a gold bar and gold coin dealer for J. Aron & Co., a commodities

5
Goldman Sachs annual reports, 2001–2009.

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trading company, when GS acquired it in 1981. He continued trading commodities, ran J. Aron
under the GS banner, and then merged the commodities arm into the FICC segment of GS’s
trading business.6 He rose up the ranks of FICC, was promoted to vice chairman in 2002, and
then succeeded Henry Paulson as chairman and CEO when Paulson was picked by President
Bush to be U.S. Treasury Secretary in 2006.

In 2008, the U.S. Federal Reserve and Treasury faced the worst financial crisis since the
Great Depression, and they formulated an unprecedented policy response to stabilize the
financial system.7 On September 21, 2008, Goldman Sachs Group, Inc., became a traditional
bank holding company, under the jurisdiction of the Federal Reserve. The Great Panic of 2008
reached a crisis state in October. At that time, GS borrowed $10 billion from the Troubled Asset
Relief Program (TARP) as Series H preferred stock. The company also issued a 10-year warrant
to the U.S. Treasury for the purchase of up to 12.2 million shares of common stock at an exercise
price of $122.90 per share (notional of $1.5 billion). In July 2009, GS repaid $11.42 billion to the
U.S. Treasury, including the return of $10.0 billion in TARP funds, interest on the preferred
stock, and $1.1 billion for the repurchase of the warrant.

GS recovered from the crisis better than most. Although earnings dropped substantially in
2008, the firm succeeded in earning $13.4 billion in 2009, while also paying bonuses of $20
billion to employees. GS had a self-perpetuating status as the best-connected trader.8 Its
combination of supreme market knowledge and a strong client network enabled it to gain
information from clients on their plans in exchange for GS’s ideas on what everyone else was
doing. The company put itself in the direct flow of market information. One observer wrote:

Goldman is the smartest, toughest, most aggressive, most powerful player in the
world. Period. They have the most powerful political connections. They get the
smartest people to work for them. They have the most competitive culture. They
make the most money. They win. Not all the time, but most of the time. The way
they play the game makes them the biggest dog in the world. In other words, you
could think about Goldman the way most of the world thinks of the United
States.9

Banking Regulation

A bank in the United States could be granted a charter by one of three authorities: Its
home state banking commission could grant a state charter, the Office of the Comptroller of the

6
Emily Thornton and Stanley Reed, “The Man Goldman is Banking On,” BusinessWeek, January 26, 2004.
7
Details of the financial crisis are outside the scope of this case study, but can be reviewed in David Wessel’s
book, among others: In Fed We Trust: Ben Bernanke’s War on the Great Panic (NY: Random House, 2009).
8
Jenkins and Guerrera.
9
Alan Webber, “Is This the Face of Capitalism?,” On Leadership (forum), Washington Post, May 2, 2010.

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Currency could grant a federal charter, and the Office of Thrift Supervision could grant a charter
to a savings and loan institution. The chartering authority of a bank acted as its primary regulator
and retained authority to close a bank or thrift that had failed. The following is a brief synopsis
of those regulatory agencies:

 The Office of the Comptroller of the Currency (OCC) under the U.S. Treasury
Department was formed in 1863 under Salmon P. Chase to issue charters to national
banks and to regulate and examine their lending and investment activities.
 The U.S. Federal Reserve Bank (FRB) was created in 1914 as the country’s central bank.
Its primary functions were to conduct the nation’s monetary policy, maintain the stability
of the financial system, and provide financial services to the U.S. government (including
the country’s payment system) and to foreign official institutions. Although the FRB
conducted supervisory examinations of banks that were part of the Federal Reserve
system, its focus was not on individual banks but on the banking system as a whole. As
part of the Financial Services Modernization Act (Gramm-Leach-Bliley) of 1999, the
FRB was established as the umbrella supervisory body over all bank holding companies.
 The Federal Deposit Insurance Corporation (FDIC), an independent agency, was created
in 1934 in response to the numerous bank failures that occurred during the Great
Depression. The FDIC insured depositor’s savings accounts, checking accounts, and
certificates of deposit via insurance fees charged to banks and thrift institutions.
 The U.S. Commodity Futures Trading Commission (CFTC) was created by Congress in
1974 and regulated trading in commodity and financial futures and options.
 The Office of Thrift Supervision (OTS) was created in 1989 as a division of the U.S.
Treasury to charter, supervise, and regulate the savings and loan industry.

The primary regulators of Goldman Sachs are listed in Exhibit 6. While the FRB was
now the umbrella regulator of the Goldman Sachs Group, Inc., the SEC was still the primary
regulator of its broker–dealer activities. During the time that GS was an investment bank,
including the period of the marketing and sale of Abacus, its primary regulator was the SEC.10

U.S. Securities and Exchange Commission

In the 11 years following the end of World War I, millions of investors sought their
fortune in the ever-rising stock market of the Roaring Twenties. Many of those investments
became worthless during the Great Depression that followed the stock market crash of 1929.
Without rules on disclosure and fair dealing, many of those investments had been made with
very little reliable information on the underlying securities.

10
For more details, see Darden technical note by Wei Li and Rick Green, “The Financial Regulatory
Environment,” UVA-GEM-0103 (Charlottesville, VA: Darden Business Publishing, 2010).

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In order to restore investor confidence, which was considered necessary for the economy
to recover, two related acts were passed by Congress. The Securities Act of 1933 established the
main concepts: (1) that people or companies that trade securities, including brokers, dealers, and
exchanges, must treat investors fairly and honestly and (2) that companies offering securities for
sale must tell the truth about themselves, the securities they are selling, and the risks of investing.
In the following year, the Securities Exchange Act of 1934 was passed, which created the SEC.
The mandate of the SEC was to enforce the provisions of the Securities Act by protecting
investors, maintaining market integrity (fair, orderly, and efficient markets), and facilitating
capital formation.

The SEC was headed by five presidentially appointed commissioners and consisted of
five main divisions and numerous offices. The five divisions were Corporation Finance, Trading
and Markets, Investment Management, Enforcement, and the Division of Risk, Strategy and
Financial Innovation. The commissioners were appointed for five-year terms, which were
staggered so that each year the term of one of the commissioners ended and the president
appointed a new person to fill that vacancy. To preserve independence from the government, the
law stated that no more than three of the commissioners could belong to the same political party.
In 2010, two of the commissioners were Democrats and two were Republicans. The fifth
commissioner, Mary Schapiro, who was appointed chairman of the SEC by President Barack
Obama in 2009, was registered as unaffiliated.

The chairman of the SEC served as a member of the President’s Working Group on
Financial Markets, along with the chairman of the Federal Reserve, the secretary of the Treasury,
and the chairman of the CFTC. Typically, a newly elected president would appoint a commission
chairman from his own party, while a balance was maintained in the other four seats. Therefore,
under a two-party system, vacancies (other than the chairman) due to an expired term were
typically filled with individuals of the same party as the departing commissioner. So for
example, the expiring term of a Republican commissioner needed to be filled with a Republican
appointee to maintain that balance, regardless of the president’s political affiliation.

In 2009, Schapiro appointed Robert Khuzami to be head of the Division of Enforcement,

whose role was to execute a law enforcement function by investigating violations,
recommending civil or administrative actions, and prosecuting those violations on behalf of the
commission. Enforcement investigations were conducted privately by interviewing people and

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examining trading data, the results of which were then presented to the commission. The SEC
could then authorize either a civil action in federal court or an administrative action.11

The failure of the commission to detect and investigate frauds by Bernard Madoff and
John Sanford had tarnished the SEC’s reputation. Schapiro wanted to restore its credibility, so
she brought on Khuzami and restructured the Enforcement Division to convey a new toughness.
According to some attendees at a division meeting in April 2009 with top SEC lawyers, Schapiro
said, “If we don’t get serious about this process, we may cease to exist.”12

Mortgage Securitization Market

In order to appreciate the structure of Abacus 2007-AC1, it may be useful to understand

U.S. mortgage loans and the various instruments created by using mortgage loans as collateral.

Residential mortgages

A mortgage was a loan secured by the collateral of specified real estate property.
Residential mortgages were typically written on one- to four-family homes, condominiums,
cooperatives, and apartments, with an original maturity of 15 to 30 years. The borrower
(homeowner) was required to make a series of payments to the lender (the bank) until either the
loan was paid off or the house was sold. Failure to make the required payments for a certain
period of time resulted in default on the loan; the bank would then have the legal right to force
the homeowner out of the house and foreclose on the property. Under foreclosure, the bank
would take possession of the house and place it on the market for sale.

The underlying interest rate on a mortgage could be fixed for the life of the loan, floating
based on a fixed spread over an index (generally set each year), or a “hybrid,” which began with
a fixed rate for a certain number of years and then changed to an adjustable floating rate. Until
the 1980s, residential mortgages were sold primarily by local savings banks, and the interest rate
was usually fixed. Historically, short-term interest rates were lower than long-term rates, so the
savings and loan industry traditionally made money on the yield curve spread. In the 1980s,
short-term interest rates rose to unprecedented heights, and the savings and loan industry
suffered huge losses and was forced to offer floating-rate loans to customers to protect

11
In either case, an administrative law judge would issue an initial decision subject to appeal by the defendent
before final determination. Sanctions against the defendant could include suspension or revocation of broker–dealer
and investment advisor registrations, monetary penalties, or other penalties. In a civil action, the commission filed a
complaint with a U.S. District Court and asked the court for a remedy. The commission frequently asked for an
injunction, a court order that prohibited any further acts that might violate the law or commission rules. The action
could also result in civil monetary penalties or the return of illegal profits (called disgorgement). The court also had
the ability to bar or suspend an individual’s security registrations, or bar an individual from serving as a corporate
officer or director.
12
Mollenkamp, Ng, and Zuckerman.

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themselves. Financial deregulation also promoted competition from commercial banks, which
were not previously allowed to write residential mortgage loans.

The monthly mortgage payment from the homeowner to the issuing bank typically
comprised interest and a partial principal repayment. The holder of a mortgage (homeowner)
could repay part of or the entire mortgage at any time, normally without penalty. This feature
essentially provided a put option to the homeowner. Additional partial prepayments by the
homeowner could happen upon receipt of additional income, such as from a family inheritance
or an employee bonus. Because a home serves as the collateral for its mortgage loan, when the
home is sold, the outstanding balance on the mortgage loan must be repaid in full regardless of
the reason for the sale.

A bank that issues mortgages must manage the interest rate risk associated with any
mortgage payments, so it creates models based on historical patterns and interest rate
expectations to help estimate prepayments. The impact of interest rate changes on the market
was particularly difficult to predict, however, because if interest rates dropped significantly,
homeowners could refinance, in which case the original mortgage would be paid off in full.

During the 1990s, the federal government pressured lenders to finance more home
ownership for lower-income families; the higher interest rates lenders charged led to increased
profits, home prices rose constantly, and a market emerged for mortgage-backed securities, so
subprime lending13—to borrowers with substandard credit characteristics—became popular.

Upon origination of a mortgage loan, a bank could hold onto the mortgage or sell it
outright. But instead of selling individual loans, they would typically package a number of
mortgages in order to diversify both the prepayment risk and the default risk of any individual
mortgage holder; that way, they were also more attractive to investors.

Mortgage-backed securities

An asset-backed security (ABS) was created when one or more financial institutions
formed a collection or pool of assets and sold smaller units of that pool to investors. The assets
could be mortgages, credit cards, trade receivables, auto loans, or high-yield bank loans. The
pool of assets was typically transferred to a special purpose vehicle (SPV), whose purpose was to
collect principal and interest payments and dispense those to the holders of the new securities.

More specifically, a mortgage-backed security (MBS) was created when the underlying
pool of assets consisted of mortgages. An RMBS (residential MBS) had residential mortgages in

13
Lenders typically evaluated various criteria to determine the homeowner’s ability to repay the mortgage loan,
including the borrower’s “FICO” credit score. FICO (named after its founder, the Fair Issac Corporation) scores take
into account several factors to produce a score between 300 and 850; subprime borrowers were defined as those
having scores below 620.

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the pool, whereas a package of commercial loans was known as a CMBS (commercial mortgage-
backed security). The simplest form of an MBS was “pass-through,” where an investor who
purchased a certain percentage of the pool was entitled to receive that percentage of the principal
and interest cash flows received from all the mortgages in the pool, less servicing fees. A
financial institution that had underwritten many mortgages may have wanted to reduce its own
interest rate risk or its exposure to prepayments or defaults by selling some of its portfolio. But
there was no market for individual mortgages to be bought or sold due to the prepayment and
default risk specific to any one homeowner. If similar mortgages were combined into a pool,
however, the prepayments and defaults followed a historic pattern, which could be modeled via
computer programs, normally Monte Carlo simulations. Upon establishment of the pool, the
mortgages became “securitized,” and they could be sold off to investors.

Congress established two government-sponsored entities (GSEs) to operate in the

secondary mortgage market. Their mandates were to keep money flowing into the mortgage
market and to expand opportunities for home ownership and affordable rental housing. The
Federal National Mortgage Association (FNMA or “Fannie Mae”) was converted from a
government agency to a private-shareholder-owned company in 1968. Two years later, Congress
formed the Federal Home Loan Mortgage Corporation (FHLMC or “Freddie Mac”). Both GSEs
created MBSs so long as the underlying collateral met their standards for conformance. The
GSEs then sold the securities with a guarantee that the GSE would make good on the MBS even
if some of the underlying borrowers defaulted. These agencies did not, in fact, enjoy the full faith
and credit of the U.S. government, although it was widely believed that they did.

Collateralized debt obligations

In a typical ABS, all investors in the pool received the same total return (interest and
principal) in proportion to their investment. Alternatively, in a collateralized debt obligation
(CDO), three or more tranches were normally established with different levels of seniority. Each
tranche was differentiated in terms of its interest rate as well as its priority in repayments. The
buyers of the different tranches were frequently referred to as “classes” of investors.14

The cash flows of the underlying bonds, mortgage securities, or bank loans were
redirected among the different tranches, but interest cash flows were directed differently than
principal cash flows. Suppose a security was divided into four tranches: A, B, C, and D. All
tranches shared in the distribution of the total interest received on all the underlying assets so that
total interest received equaled total interest paid out. But interest was distributed according to the
terms that applied to that particular tranche; some tranches received a rate lower than the average
rate in the pool, whereas and others received a higher rate. If tranche A had the highest seniority,
it was considered the safest tranche, so investors in tranche A received the lowest interest rate.
But tranche A investors had priority in principal payments, meaning they received all principal
payments until all tranche A investors had been paid in full. Then, principal payments were paid

14
For the sake of consistency, references herein will be to “tranches” for both the securities and the investors.

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to tranche B investors until they had been paid in full, then to tranche C, and finally to tranche D.
The interest rate for each tranche rose as the risk rose. Tranche D provided the highest interest
rate, but because it did not receive principal payments until tranches A, B, and C were
completely paid off, it was the first tranche to absorb losses from any defaults. Almost all CDOs
were arranged as private placements and were priced via proprietary trading models, with little
transparency in the market as to the value of the underlying collateral.

Collateralized mortgage obligations

In a typical pass-through MBS, all investors in the pool received the same total return
(interest and principal) and bore the same prepayment risk. Alternatively, in a collateralized
mortgage obligation (CMO), the cash flows of the underlying mortgages were redirected among
different classes of bondholders, similar to that of CDOs. Again, three or more tranches were
created; each tranche was differentiated in terms of its priority in principal repayments as well as
a different coupon rate.

The primary difference between CDOs and CMOs was that the structure of CMOs also
allowed for prepayment risk on the underlying assets. All repayments of principal, whether
scheduled repayments or unscheduled prepayments, would go the investors in tranche A until
they were paid off in full. Since mortgage loans were more susceptible to prepayments than other
assets, the investors in tranche A bore the risk that their principal would be paid off early, which
would reduce the duration of their investment. Tranche D investors, on the other hand, had little
prepayment risk since they would be the last to receive principal payments, but they had higher
default risk since they would be the first to absorb losses. Losses due to default would be shared
in the opposite direction of principal payments; tranche D absorbed losses first, then tranche C
would absorb losses until it was exhausted, then tranche B, and finally investors in tranche A.
The tranche with the lowest seniority was sometimes called an equity tranche, which would
normally be held by the issuing bank. This structure allowed the tranches to be tailored to
different investors based on their risk-versus-reward preferences, which broadened the appeal of
the CMO as compared with traditional fixed-income securities.

Credit default swaps

A credit default swap (CDS) was a derivative contract between two counterparties that
provided the buyer insurance protection against the risk of a credit event affecting a specific
reference asset of a specific reference entity. The CDS contract defined a specific credit event (or
events) that would trigger the insurance payment. The credit event was typically a failure to pay
principal or interest, bankruptcy of the reference entity, or a restructuring of the specified
obligations of the reference entity. The reference asset could be a corporate or sovereign debt
security (single-name CDS), a credit index, or a synthetic debt obligation such as an MBS. A
CDS could be used by debt holders as short-term insurance on their underlying position or by a
financial institution that wished to reduce exposure to a particular company or sector while
maintaining possession of the underlying assets. Since there was no requirement to hold the

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reference asset, a CDS could also be used to speculate (one could either bet that the credit event
would happen or that it wouldn’t happen).

The buyer of the CDS (the buyer of protection) typically paid a series of premiums to the
seller fixed in amount at the initiation of the contract, based on the credit spread of the
underlying reference asset. These payments continued for the life of the contract or until a credit
event occurred. A credit event triggered the settlement of the contract, either via physical
delivery or in cash; the method and timing of settlement were specified in the contract. If
physical delivery was specified, the CDS buyer delivered the underlying bonds to the seller in
exchange for their par value. In the case of physical delivery, the contract did not have to
reference anything about the calculation of the asset’s price; obtaining it was the responsibility of
the buyer of protection. The seller of protection suffered a loss equal to the difference between
the par value and the market price of the bonds. Alternatively, in the case of cash settlement, an
independent calculation agent determined the market price of the reference security by averaging
dealer quotes obtained a specified number of days after the credit event had occurred.

Since a CDS was created as a synthetic instrument, it was not in any way connected to
the cash flows of the underlying instruments. Moreover, there was no limit to the amount of
money at risk in the market for CDS transactions that referenced an individual company or
financial instrument as the underlying asset. With some investors seeking higher returns, other
participants speculating on side bets, and hedgers and market makers covering their own
positions, the collective amount of money at risk in the marketplace could be many times the
underlying debt or collateral value. In those cases, one would expect the market reaction to large
price changes in the underlying assets to be magnified as all long/short investors attempt to
adjust their exposures.

Synthetic CDO

A synthetic CDO, as compared to a cash CDO, did not contain underlying assets
(receivables or loans), mortgages, or MBS. It was effectively a CDS instrument created to allow
investors to speculate on the direction of a package or pool of CDOs. By definition, a synthetic
CDO needed to have parties on both sides of the transaction, a buyer of protection (short position
in the pool of assets) who paid premiums and a seller of protection (long position in the
underlying asset pool) who received the premiums. It was generally not necessary to set up a
special-purpose vehicle, nor did the synthetic CDO require an equity tranche. The market
utilized the term “synthetic CDO” to describe CDSs on both CMOs and CDOs. The distinction
between the latter two instruments resided in the cash flows of the underlying instruments,
because CMO cash flows could be significantly affected by principal prepayments. Since the
synthetic CDO depended only on the credit performance of the underlying reference assets and
not their cash flows, the distinction between mortgage securities or other debt instruments was
irrelevant.

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The Abacus Deal

By early 2005, Goldman Sachs had created a structured products correlation trading
desk.. Among other strategies, the desk provided the structuring and marketing of synthetic
CDOs called “Abacus” whose performance was tied to residential MBSs. In January 2007, John
Paulson and Company (Paulson & Co.) approached GS requesting that GS structure a deal
whereby Paulson & Co. could purchase credit protection on a pool of CDOs backed by subprime
mortgages. John Paulson was just another hedge-fund trader. He founded the company in 1994
and was known primarily for merger arbitrage. This activity consisted of attempting to earn
returns based on whether anticipated merger transactions would either go ahead or collapse. An
arbitrageur would go long in the securities of one of the parties and would take a short position
on the other. Beginning in 2006, Paulson & Co. was developing a contrarian view that the
housing market would not continue rising forever. It created two funds (under the name Paulson
Credit Opportunity), which bought credit protection through various CDSs on underlying debt
securities.

GS agreed to Paulson & Co.’s request and made one of its young executives, Fabrice
Tourre, principally responsible for structuring and marketing the transaction, a synthetic CDO
named Abacus 2007-AC1 (Abacus). At a ski resort in Jackson Hole, Wyoming, in January 2007,
Tourre brought together representatives from Paulson & Co. and ACA Management, LLC. ACA
was an independent credit risk analyst that would serve as the “collateral manager.” At the time,
ACA had constructed and managed 22 CDO transactions with underlying portfolios consisting of
$15.7 billion in assets. ACA Capital Holdings, Inc., the parent company of ACA, was a small
bond insurer. It had single-A financial strength and approximately $400 million in capital and
resources to pay claims.

The deal construction was initiated by Paulson & Co., but was finalized by ACA. Paulson
& Co. identified 123 CDOs that could form the pool. ACA then proposed 86 transactions,
keeping 55 from Paulson’s original list (and rejecting 68). After some discussion, they eventually
agreed on 90 securities.15 A list of the securities underlying Abacus was provided to investors in
a marketing pitch-book that was distributed to potential investors. The basic structure of the deal
was that Paulson & Co. entered into a CDS with GS to buy protection against the underlying
credit exposures of the synthetic CDO. GS would need to find counterparties that would take the
other side (i.e., sell protection in return for periodic premiums).

The Abacus deal was essentially a CDS with the underlying reference asset being a
portfolio of 90 existing CDOs. The CDOs themselves were synthetic swaps, duplicating
subprime residential MBSs that already existed (see Exhibits 7 and 8).

If Paulson & Co. had a natural long position in the underlying assets or in similar
investments, this protection would be considered hedging, or credit insurance. Without it,

15
Jamie Heller, “Breaking Down the Case,” Wall Street Journal, April 18, 2010.

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Paulson & Co. was simply betting that a portion of those CDOs would default. A normal CDO
would contain a pool of bonds or loans. Its performance would depend on the strength of the
cash flows of the underlying assets. But the cash flows involved in the Abacus deal would
depend on credit events in the underlying CDOs: In the absence of any default in the underlying
CDOs, the cash flows would consist of premiums paid by Paulson & Co. (and other long
investors who purchased contracts) to the short investors who sold contracts. In the event of any
defaults in the underlying CDOs, the cash flows would consist of insurance payments by the
short investors to Paulson & Co. and other long investors.

The Mortgage Capital Committee at Goldman Sachs signed off on the deal at a routine
meeting.16 The committee was led by GS’s mortgage chief and consisted of a dozen senior
executives (representing mortgage securities products), an advisor from the investment bank, and
representatives of the legal, credit, and compliance departments. Its function was to vet new
products and transactions. A memorandum from the committee indicated that it had full
knowledge of Paulson & Co.’s role in the selection process. The Abacus deal, at a notional
amount of $2 billion, was not large enough to require approval from GS’s overall capital
committee, which was overseen by the CFO and the chief administrative officer of the firm.

Goldman Sachs sold the other side of the deal to two investors. One was a German bank
based in Dusseldorf—IKB Deutsche Industriebank AG (IKB)—which described itself as a
leading investor in CDOs. IKB invested $150 million in Abacus. Founded in 1924, IKB had a
solid history of making loans to the Mittelstand—Germany’s small and midsize businesses. By
the first decade of the 21st century, competition in the Mittelstand sector had intensified,
resulting in increasingly tighter margins. IKB management brought in executives and traders to
expand its credit business; they began by creating short-term cash by selling the company’s own
debt (primarily to various U.S. municipalities). Management then took that pool of cash and
chose to invest billions of euros in complex financial instruments—including MBS backed by
subprime loans and CDOs containing underlying mortgage securities. The Abacus deal was only
one small portion of this new portfolio. After the credit crisis, one observer noted that IKB was
seen by Germans not as an unwitting victim of Wall Street excesses, but as a contributor.17

Because IKB invested only $150 million, GS still needed at least one other investor to
write credit insurance for its remaining exposure in Abacus. ACA Capital Holdings, parent
company of ACA Management, LLC, had apparently participated in similar transactions in the
past and was willing to write the insurance GS was seeking on this deal. ACA, having a less-
than-stellar credit rating itself, was willing to receive above-average yield on an instrument such
as Abacus to offset its higher cost of capital.18 With only $400 million in capital, it had insured

16
Kate Kelly, “SEC vs. Goldman Sachs: What the Committee Knew—Mortgage Deal That Set Off Case Got
Rapid Approval by Goldman Panel,” Wall Street Journal, April 20, 2010.
17
Carrick Mollenkamp and Laura Stevens, “German Bank: Victim or a Contributor,” Wall Street Journal, April
22, 2010.
18
Review & Outlook (editorial), April 20, 2010.

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over $50 billion in financial assets, including a substantial amount of mortgage-related

securities.19 Goldman was apparently anxious to ink the deal with ACA, but did not want to take
on its credit risk.

Goldman Sachs then found that ABN Amro, the largest Dutch bank, was willing to be an
intermediary between the bond insurer and GS (effectively insuring ACA’s credit risk). As an
intermediary, ABN would have one CDS in which it sold credit insurance to GS and a matching
CDS in which it purchased credit insurance from ACA. This put ABN in a dual default situation
in which it would incur losses only if both the underlying securities and ACA defaulted.20

By the time the deal collapsed in mid-2008, ABN had been acquired by Royal Bank of
Scotland (RBS). As part of its 2007 acquisition, RBS inherited the Abacus position. When it
looked to collect on its insurance, ACA was unable to honor its commitment. In August 2008,
RBS unwound the deal by paying GS $840,909,090, most of which was then paid by GS to
Paulson & Co. Due to a significant number of other bad decisions made by RBS, it was rescued
by the British government in 2008 with (British pounds) GBP45 billion in taxpayer money.

April 16: The SEC Announcement

On April 16, 2010, the SEC issued a press release that quickly reached news agencies
worldwide:

“SEC Charges Goldman Sachs with Fraud in Structuring and Marketing of CDO
Tied to Subprime Mortgages”

Washington, D.C., April 16, 2010 — The Securities and Exchange Commission
today charged Goldman, Sachs & Co. and one of its vice presidents for
defrauding investors by misstating and omitting key facts about a financial
product tied to subprime mortgages as the U.S. housing market was beginning to
falter.21

Lloyd Blankfein was in his office when the SEC’s announcement was made at 10:35 a.m.
He issued a statement just before noon that the accusations were “completely unfounded in law
and fact.”22 By the end of the day, Goldman Sachs stock closed at $160.70, a 12.8% drop from its
previous day’s close. Trading volume was 102 million shares, some 10 times normal volume.

19
Serena Ng, “SEC v. Goldman Sachs: Role of Little Bond Insurer ACA in the Government’s Case,” Wall
Street Journal, April 19, 2010.
20
Unfortunately, there was no information publicly available regarding ABN risk management’s thinking on its
role as intermediary (i.e., whether it was relying more on its evaluation of the creditworthiness risk of the underlying
assets, the creditworthiness of ACA, or on the combination of the two).
21
U.S. Securities and Exchange Commission, Release 2010-59, April 16, 2010.
22
Mollenkamp, Ng, and Zuckerman.

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With 515 million shares outstanding, the free fall wiped out approximately $12 billion in market
capitalization.

So what justified the magnitude of the price collapse at Goldman Sachs? If the SEC were
to impose a civil monetary penalty to compensate investors for their losses, it was considered
unlikely that the penalty against GS could exceed the $1 billion that was collectively lost by
those investors. With 2009 earnings of $13.4 billion, GS could certainly afford a billion-dollar
disgorgement. Was there something else worrying investors? Was it possible that the SEC had
additional evidence pertaining to Abacus 2007-AC1 that was not revealed in its release, or was it
aware of other damaging facts on similarly structured deals marketed and sold by Goldman? Or
were the markets concerned that the SEC’s actions could pave the way for further litigation
against GS? Many other banks, insurance companies, and mutual funds lost billions of dollars on
instruments backed by subprime mortgages and could potentially intitiate a wave of new lawsuits
if the SEC’s case was successful.

Some observers believed that the action was politically motivated. Financial firms were
not in public favor, and Barack Obama’s administration was trying to push a financial reform bill
through Congress. The commission’s vote was 3 to 2, right along the line of the commissioners’
party affiliations: Democrats to charge GS, Republicans not to. Mary Schapiro cast the deciding
vote to proceed with the lawsuit. SEC had normally pursued enforcement actions only if there
was unanimous support of its five commissioners in high-profile cases that were controversial or
that sought large monetary penalties or disgorgement. The April 16 SEC press release contained
this statement: “Synthetic CDOs like Abacus 2007-AC1 contributed to the recent financial crisis
by magnifying losses associated with the downturn in the United States housing market.”23

Perhaps coincidentally, on April 16, 2010, the SEC’s inspector general issued an
exhaustive 151-page report on the agency’s failure to investigate R. Allen Sanford for alleged
fraud. Apparently, SEC examiners suspected Sanford of running a Ponzi scheme as early as 1997
and again in subsequent exams. Yet the enforcement staff failed to act for over 10 years.24
Sanford was eventually indicted in June 2009 for swindling investors out of $8 billion.

What Next?

Eleven days after the SEC announcement, on April 27, Lloyd Blankfein was facing a
televised Senate subcommittee hearing investigating the financial crisis. In his prepared
statement, and in answer to repeated questions on ethics and disclosure, he indicated that GS did
not have a huge short position against the housing market and certainly did not bet against its
clients.25 Viewers could not help noticing that Blankfein appeared confused by the questioners,

23
U.S. Securities and Exchange Commission, Release 2010-59, April 16, 2010.
24
Review & Outlook (editorial), “The SEC’s Impeccable Timing,” Wall Street Journal, April 20, 2010.
25
Testimony from Lloyd C. Blankfein, Permanent Senate Subcommittee on Investigations, April 27, 2010.

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as if they did not understand that there was another side to all transactions—that each and every
trade that Goldman Sachs (or any other bank or trading firm) entered into had both a buyer and a
seller. Evidence of a short bet wasn’t GS’s deep, dark secret; it was the essence of the
transaction.26

Other observers believed the hearings were a great example of the “disconnect” between
Washington and Wall Street. To some, it appeared that Congress was trying to show the world
that GS was running a casino. On the other side, Blankfein was trying to differentiate trading
activities from a consumer electronics store, where a television set or an iPod had a money-back
guarantee. Financial trades could not be undone if they didn’t work out for a customer. SEC
charges and GS’s responses are listed in Exhibit 9.

By definition, a synthetic CDO was bet for and against securities backed by mortgages.
The SEC claims that GS did not reveal Paulson & Co.’s role in the term sheet, flip book, offering
memorandum, or other marketing materials provided to investors.27 GS claimed that ACA
Management had every incentive to select appropriate securities, given its parent company’s role
in selling protection on Abacus to GS. Some found it interesting to note that the subcommittee
did not question anyone from IKB, ACA Management, ACA Holdings, Inc., Paulson & Co., or
ABN Amro.

Both the British and German governments suggested that legal and regulatory action be
taken against GS on behalf of the institutions in their respective countries that were involved in
the Abacus deal. In advance of the UK election, all political parties called for the Financial
Services Authority to investigate GS. The German finance minister indicated that it would seek
information from the SEC before determining what additional steps might be taken.

Blankfein would have a long and tough battle ahead to save GS’s reputation. If the firm
pushed back hard against the SEC, any political motivations that the commission might have had
could drag the suit on for some time—and extend the negative publicity. If the firm looked to
settle quickly with the SEC to minimize headline risk, other unknown litigation could follow,
which could potentially have severe repercussions for the chairman and his company.

26
Review & Outlook (editorial), “The SEC vs. Goldman,” Wall Street Journal, April 19, 2010.
27
Alan Rappeport, “Goldman Accused of Subprime Fraud,” Financial Times, April 16, 2010.

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Exhibit 1
SEC VERSUS GOLDMAN SACHS (A)
Goldman Sachs Daily High-Low-Close

190.00

180.00

170.00

160.00

150.00

140.00

130.00

Source: Created by case writer based on data from Yahoo! Finance.

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Exhibit 2
SEC VERSUS GOLDMAN SACHS (A)
Goldman Sachs Monthly Price History

300

250

200

150

100

50

0
5/4/1999 5/4/2000 5/4/2001 5/4/2002 5/4/2003 5/4/2004 5/4/2005 5/4/2006 5/4/2007 5/4/2008 5/4/2009

Source: Created by case writer based on data from Yahoo! Finance.

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Exhibit 3
SEC VERSUS GOLDMAN SACHS (A)
Balance Sheets (2001–09)
(in millions of U.S. dollars)

2001 2002 2003 2004 2005 2006 2007 2008 2009*

Assets
Cash and cash equivalents $6,909 $4,822 $7,087 $4,365 $10,261 $6,293 $10,282 $15,740 $38,291
Regulatory cash and securities 22,134 20,389 29,715 48,179 51,405 80,990 119,939 106,664 36,663
Receivables: brokers & dealers 5,453 5,779 9,197 14,458 15,150 13,223 19,078 25,899 12,597
Receivables: customers & counterparties 28,010 23,159 27,180 38,087 60,231 79,790 129,105 64,665 55,303
Collateralized agreements 128,815 159,351 155,974 199,343 275,419 301,468 364,730 302,816 334,218
Trading assets 108,885 129,775 160,719 211,804 277,026 334,561 452,595 338,325 342,402
Other assets 12,012 12,299 13,927 15,143 17,312 21,876 24,067 30,438 29,468
Total assets $312,218 $355,574 $403,799 $531,379 $706,804 $838,201 $1,119,796 $884,547 $848,942
Liabilities and Shareholders’ Equity
Deposits $0 $0 $0 $0 $0 $10,697 $15,370 $27,643 $39,418
Short-term borrowings 37,597 40,638 44,202 54,959 47,247 47,904 71,557 52,658 37,516
Payables to brokers and dealers 4,014 1,893 3,515 8,000 10,014 6,293 8,335 8,585 5,242
Payables: customers & counterparties 93,283 93,697 105,513 153,221 178,304 206,884 310,118 245,258 180,392
Collateralized financings 46,231 72,157 60,612 66,967 195,998 220,124 253,512 118,626 167,701
Trading liabilities 74,717 83,473 102,699 132,097 149,071 155,805 215,023 175,972 129,019
Other liabilities 7,129 6,002 8,144 10,360 13,830 31,866 38,907 23,216 33,855
Long-term borrowings 31,016 38,711 57,482 80,696 84,338 122,842 164,174 168,220 185,085
Total liabilities 293,987 336,571 382,167 506,300 678,802 802,415 1,076,996 820,178 778,228
Common and preferred stock, par value 5 5 5 6 1,756 3,106 3,106 16,478 6,965
Restricted stock and stock options 3,322 2,649 2,645 1,896 3,415 6,290 9,302 9,284 6,245
Additional paid-in capital 11,785 12,773 13,562 15,501 17,159 19,731 22,027 31,071 39,770
Retained earnings 5,373 7,259 9,914 13,970 19,085 27,868 38,642 39,913 50,252
Accumulated other comprehensive income (168) (122) 6 11 0 21 (118) (202) (362)
Treasury stock (2,086) (3,561) (4,500) (6,305) (13,413) (21,230) (30,159) (32,175) (32,156)
Total shareholders’ equity 18,231 19,003 21,632 25,079 28,002 35,786 42,800 64,369 70,714
Total liabilities and shareholders’ equity $312,218 $355,574 $403,799 $531,379 $706,804 $838,201 $1,119,796 $884,547 $848,942

* Fiscal years before 2009 ended on the last business day in November. GS’s charter to become a bank holding company required a change in its fiscal year to December 31.

Data source: Goldman Sachs annual reports 2001–2009.

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Exhibit 4
SEC VERSUS GOLDMAN SACHS (A)
Income Statements (2001–09)
(in millions of U.S. dollars)

2001 2002 2003 2004 2005 2006 2007 2008 2009*

Financial advisory $2,070 $1,499 $1,202 $1,737 $1,905 $2,580 $4,222 $2,656 $1,893
Underwriting 1,766 1,331 1,509 1,637 1,766 3,049 3,333 2,529 2,904
Investment banking 3,836 2,830 2,711 3,374 3,671 5,629 7,555 5,185 4,797
FICC 4,272 4,680 5,596 7,322 8,940 14,262 16,165 3,713 23,316
Equities 5,526 4,002 4,281 4,673 5,650 8,483 11,304 9,206 9,886
Principal investments (228) (35) 566 1,332 2,228 2,817 3,757 (3,856) 1,171
Trading & principal investments 9,570 8,647 10,443 13,327 16,818 25,562 31,226 9,063 34,373
Asset management 1,473 1,653 1,853 2,553 2,956 4,294 4,490 4,552 3,970
Securities services 932 856 1,005 1,296 1,793 2,180 2,716 3,422 2,033
Asset management 2,405 2,509 2,858 3,849 4,749 6,474 7,206 7,974 6,003
Net revenues 15,811 13,986 16,012 20,550 25,238 37,665 45,987 22,222 45,173
Operating expenses 12,115 10,733 11,567 13,874 16,965 23,105 28,383 19,886 25,344
Income before taxes $3,696 $3,253 $4,445 $6,676 $8,273 $14,560 $17,604 $2,336 $19,829

* Fiscal years before 2009 ended on the last business day in November. GS’s charter to become a bank holding company required a change in its fiscal year to December 31.

Data source: Goldman Sachs annual reports 2001–2009.

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Exhibit 5
SEC VERSUS GOLDMAN SACHS (A)
Segment Income as a Percentage of Total Revenues

2001 2002 2003 2004 2005 2006 2007 2008 2009*

Financial advisory 13.1% 10.7% 7.5% 8.5% 7.5% 6.8% 9.2% 12.0% 4.2%
Underwriting 11.2% 9.5% 9.4% 8.0% 7.0% 8.1% 7.2% 11.4% 6.4%
Investment banking 24.3% 20.2% 16.9% 16.4% 14.5% 14.9% 16.4% 23.3% 10.6%
FICC 27.0% 33.5% 34.9% 35.6% 35.4% 37.9% 35.2% 16.7% 51.6%
Equities 35.0% 28.6% 26.7% 22.7% 22.4% 22.5% 24.6% 41.4% 21.9%
Principal investments –1.4% –0.3% 3.5% 6.5% 8.8% 7.5% 8.2% –17.4% 2.6%
Trading & principal investments 60.5% 61.8% 65.2% 64.9% 66.6% 67.9% 67.9% 40.8% 76.1%
Asset management 9.3% 11.8% 11.6% 12.4% 11.7% 11.4% 9.8% 20.5% 8.8%
Securities services 5.9% 6.1% 6.3% 6.3% 7.1% 5.8% 5.9% 15.4% 4.5%
Asset management 15.2% 17.9% 17.8% 18.7% 18.8% 17.2% 15.7% 35.9% 13.3%
Net revenues 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Operating expenses as a % of net revenues 76.6% 76.7% 72.2% 67.5% 67.2% 61.3% 61.7% 89.5% 56.1%

Fiscal years before 2009 ended on the last business day in November. GS’s charter to become a bank holding company required a change in its fiscal year to December 31.

Source: Case writer calculations based on Goldman Sachs annual reports 2001–2009.

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Exhibit 6
SEC VERSUS GOLDMAN SACHS (A)
Primary Regulators of Goldman Sachs as of December 31, 2009
GS Entity Regulator Activities
Group Inc. (1) Federal Reserve Bank (FRB) Primary regulator of consolidated entity under the Bank Holding Company (BHC) Act,
effective as of September 21, 2008.
Goldman Sachs & Company(2) Securities & Exchange Commission SEC is primary regulator of broker-dealer activities.
(SEC)

Financial Industry Regulatory Authority FINRA and NYSE are self-regulatory organizations that adopt rules concerning these broker-
(FINRA) dealer activities
New York Stock Exchange

U.S. Commodities Futures Trading Futures-related activities

Commission (CFTC)
GS Bank USA (3) New York State Banking Department GS Bank USA is a New York State chartered bank and a member of the Federal Reserve
System. Activities included: bank loan trading and origination; interest rate, credit, currency
and other derivatives; leveraged finance; commercial and residential mortgage origination,
FRB trading and servicing; structured finance; and agency lending, custody and hedge fund
administrative services.

Federal Deposit Insurance Corporation Insured deposits

(FDIC)
Goldman Sachs Trust Company, N.A. Office of the Comptroller of the Fiduciary activities—maintains collective investment funds for eligible pension and profit
Currency (OCC) sharing plan clients. GSTC does not accept deposits.
Goldman Sachs Trust Company of Office of the Delaware State Bank Limited-purpose trust company
Delaware Commissioner
Insurance company subsidiaries State insurance authorities Insurance activities

(1)
Prior to becoming a bank holding company on September 21, 2008, the Group, Inc. was considered a Consolidated Supervised Entity (CSE), and its primary regulator was
the Securities and Exchange Commission. On September 26, 2008, the SEC announced that it was ending the CSE program.
(2)
On May 7, 1999, Goldman Sachs converted ownership from a partnership to a corporation and completed their initial public offering by issuing 51 million shares of
common stock.
(3)
GS Bank USA was originally incorporated in Utah, and was supervised by the State of Utah Department of Financial Institutions. In November, 2008, the bank was merged
into Goldman’s limited purpose trust company which was incorporated in New York. The merged entity took the name of GS Bank USA.

Source: Company’s 2009 Form 10-K.

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Exhibit 7
SEC VERSUS GOLDMAN SACHS (A)
Structure of the Abacus Deal

Insurer ABN Amro

ACA Capital
John Paulson & Co. Buyer (a) Abacus 2007-AC1 * Holdings, Inc.
Goldman Sachs SPV Sellers(b)
ACA Management, LLC Collateral IKB Deutsche Industriebank
Manager

CDO CDO CDO CDO CDO CDO CDO CDO CDO

CDO CDO CDO CDO CDO CDO CDO CDO CDO
55 Picked CDO CDO CDO CDO CDO CDO CDO CDO CDO
by Paulson CDO CDO CDO CDO CDO CDO CDO CDO CDO
CDO CDO CDO CDO CDO CDO CDO CDO CDO
CDO CDO CDO CDO CDO CDO CDO CDO CDO
CDO CDO CDO CDO CDO CDO CDO CDO CDO
CDO CDO CDO CDO CDO CDO CDO CDO CDO
CDO CDO CDO CDO CDO CDO CDO CDO CDO
CDO CDO CDO CDO CDO CDO CDO CDO CDO

Each CDO 31 Picked

by ACA
MBS MBS MBS MBS
Each MBS

Mortgage Mortgage Mortgage

Mortgage Mortgage * Abacus 2007-AC1 was a far distance from any homeowner’s mortgage.

(a)
The buyer (Paulson & Co.) was a buyer of credit protection, or insurance, and therefore paid premiums.
(b)
The sellers sold credit protection, and received premiums.

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Exhibit 8
SEC VERSUS GOLDMAN SACHS (A)
Timeline of Abacus 2007-AC1

2006
December Paulson & Co identified over 100 bonds it expected to experience credit events in the near
future.
2007
January GS approached ACA proposing that it be selection agent for synthetic CDO sponsored by
Paulson & Co.
Tourre met with representatives from Paulson & Co and ACA Management at Paulson &
Co’s offices in New York to discuss the proposed transaction.
GS sent Paulson & Co’s list of 123 RMBSs rated Baa2. ACA Management determined that
it had previously purchased 62 of the 123 bonds on Paulson & Co’s list.
ACA Management sent worksheet back to GS with 86 mortgage positions to be included in
the synthetic CDO, including 55 of those proposed by Paulson & Co.
ACA Management met with a Paulson & Co representative in Jackson Hole, Wyoming, to
continue discussions on the reference portfolio.
February Through a series of meetings and exchanges of e-mails and attachments, Paulson & Co and
ACA Management came to final agreement on a reference portfolio of 90 RMBSs for
Abacus 2007-AC1.
GS forwarded marketing materials to IKB.
April Abacus 2007-AC1 closed. IKB purchased $50 million of class A-1 notes yielding LIBOR
plus 85 basis points and $100 million of Class A-2 notes yielding LIBOR plus 110 basis
points.
May ACA Capital sold credit protection on $909 million of the super senior tranche for 50 basis
points per year. ABN Amro subsequently intermediated ACA’s investment with GS
through a series of CDSs between ACA Capital and GS. These back-to-back transactions
netted ABN 17 basis points per year ($1.5 million) for assuming the credit risk of ACA
Capital.
October ABN was acquired by a consortium of banks, including Royal Bank of Scotland (RBS).
2008
August ACA Capital entered into a global settlement with counterparties to unwind approximately
$69 billion of CDSs (38% of which were subprime RMBSs).
October The British government took control of RBS to avoid its collapse.
RBS unwound ABN Amro’s super senior tranche by paying GS $841 million.

This document is authorized for use only in Prof. Shubhasis Dey's Business and Government' at Indian Institute of Management - Kozhikode from Oct 2024 to Apr 2025.
 -25- UVA-GEM-0101

Exhibit 9
SEC VERSUS GOLDMAN SACHS (A)
The SEC Charges and GS Responses

SEC:1 “Goldman’s marketing materials for Abacus 2007-AC1 were false and misleading because they
represented that ACA selected the reference portfolio while omitting any mention that Paulson, a party
with economic interests adverse to CDO investors, played a significant role in the selection of the
reference portfolio.” (#36)

GS: “Goldman Sachs would never condone one of its employees misleading anyone, certainly not
investors, counterparties, or clients. We take our responsibilities as a financial intermediary very
seriously and believe that integrity is at the heart of everything that we do.”2

SEC: “GS & Co. also misled ACA into believing that Paulson was investing in the equity of Abacus
2007-AC1 and therefore shared a long interest with CDO investors.” (#44)

GS: “The SEC’s complaint accuses the firm of fraud because it didn’t disclose to one party of the
transaction who was on the other side of that transaction. As normal business practice, market makers do
not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA
that Paulson was going to be a long investor.”3

SEC: “Had ACA been aware that Paulson was taking a short position against the CDO, ACA would have
been reluctant to allow Paulson to occupy an influential role in the selection of the reference portfolio
because it would present serious reputational risk to ACA, which was in effect endorsing the reference
portfolio.” (#45)

GS: “In the process of selecting the reference portfolio, ACA Capital Management, who was both the
portfolio selection agent and the overwhelmingly largest investor in the transaction, evaluated every
security in the reference portfolio using its own proprietary models and methods of analysis. ACA
rejected numerous securities suggested by Paulson & Co., including more than half of its initial
suggestions, and was paid a fee for its role as portfolio selection agent in analyzing and approving the
underlying reference portfolio. ACA had an obligation and, as by far the largest investor, every incentive
to select appropriate securities.”4

1
The source for all the SEC charges listed are in “Securities and Exchange Commission v. Goldman Sachs &
Co. and Fabrice Tourre,” complaint #2010-59 filed in U.S. District Court, Southern District of New York, April 16,
2010. Numbers in parentheses refer to the item number listed in the complaint.
2
Goldman Sachs: “SEC Complaint Against Goldman Sachs,” press release, April 18, 2010.
3
Goldman Sachs, “Goldman Sachs Makes Further Comments on SEC Complaint,” press release, April 16,
2010, http://www2.goldmansachs.com/our-firm/press/press-releases/current/sec-response.html.
4
“SEC Complaint Against Goldman Sachs,” April 18, 2010.

This document is authorized for use only in Prof. Shubhasis Dey's Business and Government' at Indian Institute of Management - Kozhikode from Oct 2024 to Apr 2025.
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Exhbit 9 (continued)

SEC: “GS & Co. sent the investors (IKB, ACA Capital) copies of the term sheet, flip book and offering
memorandum, all of which represented that the RMBS portfolio had been selected by ACA and omitted
any role in the collateral selection process and its adverse economic interest. These representations and
omissions were materially false and misleading, because unbeknownst to the investors, Paulson played a
significant role in the collateral selection process and had a financial interest in the transaction that was
adverse to IKB and ACA Capital.” (#54)

GS: “The transaction at issue involved a static portfolio of securities, and was marketed solely to
sophisticated institutions.”5 “IKB, a large German Bank and CDO market participant, and ACA Capital
Management, the two investors, were provided extensive information about those securities and know the
associated risks. Among the most sophisticated mortgage investors in the world, they understood that a
synthetic CDO transaction requires a short interest for every corresponding long position.”6

5
“SEC Complaint Against Goldman Sachs,” April 18, 2010.
6
“SEC Complaint Against Goldman Sachs,” April 18, 2010.

This document is authorized for use only in Prof. Shubhasis Dey's Business and Government' at Indian Institute of Management - Kozhikode from Oct 2024 to Apr 2025.