New York – The SEC’s fraud charge against Goldman Sachs showed that the agency can bare its teeth occasionally, a useful trait for a market regulator. It also highlights the sorry state of fixed income research, which the SEC itself is at a loss to remedy.
The SEC chose its case well, centering on a late-stage CDO issued as the subprime market was starting to tank. 100% of the underlying mortgages were downgraded less than a year after Goldman’s CDO was issued, earning over a billion dollars for Paulson & Co. The judge trying the case needs to look no further than Michael Lewis’s new publication, The Big Short, to twig to the game that Goldman & Paulson were playing. (Our theory is that the SEC held off filing the action until the book was released…)
The case would do Spitzer proud. It is has all the earmarks of a Spitzer move: focusing on highly questionable activity that was considered standard practice (wink, wink). And Spitzer was just complaining what a pushover Mary Schapiro was. Like Spitzer, the SEC appears to be going to mat on this case–even though its commissioners where split on whether to bring the action.
The aspect we’ll be focusing on is the research angle, of course. Paulson & Co. made a statement when the SEC case was filed, noting among other things, that all the underlying mortgages in the CDO were rated AAA by Moody’s and S&P. The stocks of both companies fell sharply on Friday.
One of the investors Michael Lewis profiles in The Big Short is Michael Burry, a hedge fund investor with Asperger’s Syndrome. Burry started shorting subprime mortgages in May, 2005, a year before Paulson. His investment technique, according to Lewis, was to cloister himself in his darkened office and read prospectuses. His only tool was a $100 subscription to 10k Wizard (since acquired by Morningstar). No fancy quant models, no monte carlo simulations, no prepayment analysis.
Based on publicly available information, he put together a portfolio of bets against subprime mortgage obligations. According to Lewis: ” He analyzed the relative importance of the loan-to-value ratios of the home loans, of second liens on the homes, of the location of the homes, of the absence of loan documentation and proof of income of the borrower, and a dozen or so other factors to determine the likelihood that a home loan made in America circa 2005 would go bad. Then he went looking for the bonds backed by the worst of the loans.”
The obvious question is if Burry could do this locked in his office in California, why couldn’t rating agency analysts? Or, for that matter, the investors in the CDO’s? The SEC has proposed a variety of fixes for NRSRO’s, but the problem persists. First they tried to stimulate competition, but did nothing to weaken the oligopoly enjoyed by Moody’s, S&P and Fitch. After the credit crisis, the SEC has proposed other solutions including improved disclosure of structured transactions. The problem, however, is an economic one. If investors can get ratings for free, why pay for subscription services? The financial crisis supplied an answer to that question, and now it remains to be seen if investors will take the hint.