The Case against ‘Fabulous Fab’

SEC trying to turn financial crisis poster boy into sacrificial lamb

Next week, Fabrice Tourre goes on trial for securities fraud.

Tourre, now 34, is the former Goldman Sachs investment banker who, in 2007, packaged and peddled a synthetic portfolio of sub-prime residential mortgage-backed securities (RMBS) that collapsed within nine months of its issuance.  The two big European banks that invested in ABACUS 2007-AC1 — IKB Deutsche Industriebank and ABN AMRO – lost almost a $1 billion in total.

Based on the difference between what Goldman and Tourre knew about the ABACUS portfolio and what they revealed to its collateral manager and institutional investors, the SEC sued both bank and banker in 2010 for material misrepresentations and omissions.  Goldman settled almost immediately for $550 million in what was at the time the SEC’s largest civil settlement ever (see Material Omissions).  Tourre decided to fight the charges, albeit on Goldman’s nickel.

Abraham Sacrifices IsaacThe ABACUS portfolio was created for hedge fund manager John Paulson.  In 2006, Paulson asked Goldman to compile a reference portfolio of RMBS against which he could buy credit protection through credit default swaps (CDS), effectively betting that the RMBS would default.  To meet investor demand for independent collateral management, Goldman engaged ACA Management, a respected manager of RMBS collateral, to select the reference securities.  Goldman also introduced Paulson to ACA as the equity investor in ABACUS — to the tune of $200 million — who would therefore be recommending RMBS for the portfolio.

Because Paulson’s interest in the portfolio was ostensibly aligned with the interests of other ABACUS investors, ACA accepted the vast majority of RMBS recommended by Paulson for the portfolio.  Tourre, then a VP on Goldman’s structured product desk, quarterbacked all of the ABACUS discussions among Goldman, Paulson and ACA and prepared the marketing materials ultimately given to the two banks that invested in ABACUS.

What ACA didn’t know at the time, and what the two investors in ABACUS were never told, is that Paulson had no intention of acquiring an equity stake in the portfolio and, in fact, proposed reference securities for it specifically on the basis of their likelihood to default.1

What ACA didn’t know at the time, and what the two investors in ABACUS were never told, is that Paulson had no intention of acquiring an equity stake in the portfolio and, in fact, proposed reference securities for it specifically on the basis of their likelihood to default1.  Then, when ABACUS was issued, Paulson shorted the portfolio by buying CDS against it from Goldman and ultimately netted a tidy $1 billion profit for his hedge fund.  For trades like this, Paulson became a billionaire and his fund the darling of the industry.  He was also never charged by the SEC for his involvement in the transaction2.

The SEC complaint against Tourre claims that he knew that Paulson planned to short the RMBS in the portfolio, that he nevertheless led ACA to believe that Paulson was instead acquiring the equity tranche and that he falsely disclosed to the ABACUS investors that ACA had selected the portfolio securities when he knew that the RMBS underlying the portfolio were largely chosen by an investor who intended to bet against it.

Tourre also sensed at the time that the entire RMBS market had become a house of cards.  In a now famous e-mail to his girlfriend, Tourre turned himself into an instant poster boy for the financial crisis: “The whole building is about to collapse anytime now.  Only potential survivor, the fabulous Fab . . . standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities [sic].”

To make its case, the SEC has to prove that Tourre was at least reckless in allowing ACA to believe that Paulson was an equity investor in ABACUS rather than a short-seller and that he deliberately deceived the two European investors in not disclosing Paulson’s significant influence over the RMBS portfolio and his intent to short it.  The SEC will also have to show that, had Tourre been forthright about Paulson’s involvement and intentions, ACA wouldn’t have fronted the deal and the two banks wouldn’t have bought it.3

Tourre’s defense is likely to be that Paulson’s role in the transaction was not material information and that Tourre therefore had no legal obligation to disclose it to investors on the other side of the trade.   He will also probably argue that ACA and the two European banks were sophisticated investors capable of assessing the credit risks in the ABACUS portfolio without knowing Paulson’s involvement in its composition.  If push comes to shove, he might also try to pass the buck to some higher-up at Goldman.

Everyone is waiting for the first banker who promoted sub-prime mortgage-backed securities to pay the piper.  Ralph Cioffi and Matt Tannin, whose Bear Stearns-sponsored RMBS hedge funds imploded at the start of the credit crisis, were acquitted of criminal fraud charges and most every other securities fraud case has involved insider trading.  Tourre is the first high-profile Wall Streeter to be singled out for RMBS retribution, albeit in a civil enforcement action. Usually, the diffusion of authority in a financial institution like Goldman Sachs makes it difficult to hold any one executive accountable for corporate misbehavior.  Wouldn’t it be ironic if the ‘fabulous Fab’ turns out to be the only RMBS investment banker who doesn’t survive?

1Paulson’s proposed RMBS featured dense concentrations of adjustable rate mortgages,  low borrower FICO scores and properties located in states like Arizona, California, Florida and Nevada which had recently experienced high rates of home price appreciation.

2An ACA affiliate, ACA Financial Guaranty, insured the senior tranches of the ABACUS portfolio and, after paying out almost $1 billion itself, sued Goldman in 2011 — and later added Paulson as a co-conspirator – for fraudulently inducing it to sell credit protection to Goldman when they both knew that Paulson had picked the ABACUS bonds specifically to support a future short CDS position against the portfolio. That case, however, was dismissed by the New York Court of Appeals in May of this year on the ground that ACA Guaranty was a “highly sophisticated commercial entity” whose claim of being misled was contradicted by the disclosure in the ABACUS offering document.

3 It is true that John Paulson was a virtual unknown in the hedge fund community in 2007, so it is also possible that neither ACA nor the two European banks would have cared about his role in the transaction.