Last Friday, the Securities and Exchange Commission filed a civil suit against mortgage investment giant Goldman Sachs. The suit alleges that Goldman Sachs created a mortgage instrument for the purpose of having it fail, sold the instrument to its customers, and then profited by betting against the instrument. The instrument, called Abacus 2007-AC1, was a deal created by Goldman Sachs to give the bank and certain of its customers the chance to make money by betting against the failing housing market. Goldman's clients bought a total of $10.9 billion in Abacus investments, and then lost billions of dollars. Meanwhile, though, one of Goldman's hedge fund managers, John Paulson, saw his hedge fund's value rise 590 percent as he bet against the Abacus mortgages -- mortgages Paulson had personally handpicked for Goldman to include in its Abacus deals.
According to the SEC's complaint, Goldman let Paulson select the mortgage bonds that he believed were most likely to fail. Goldman then packaged those failing bonds into Abacus 2007-AC1, and sold the deal to several institutional investors, including foreign banks, pension funds, insurance companies, and other hedge funds. According to the SEC's complaint, Goldman told the investors that the bonds that were part of Abacus would be chosen by an independent fund manager. Goldman did not disclose that it had any conflicts of interest in the deal.
"The product was new and complex, but the deception and conflicts are old and simple," Robert Khuzami, the SEC's director of enforcement, said in a statement released to the press. "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."
Goldman released its own statement, commenting, "We certainly did not know the future of the residential housing market in the first half of 2007 any more than we can predict the future of markets today....We also did not know whether the value of the instruments we sold would increase or decrease....We did not structure a portfolio that was designed to lose money."
However, Goldman's statement was somewhat at odds with what its CEO, Lloyd Blankfein, told the federal Financial Crisis Inquiry Commission in January, when he remarked that the bank does both package complex debt for investors while also betting against that debt. "We are not a fiduciary," a Reuters story quoted Blankfein as saying.
Knowing that the bank was betting on both sides of the equation, some clients were beginning to shy away from Goldman Sachs even before formal charges were filed. "I don't trust Goldie on this," wrote Washington Mutual CEO Kerry Killinger in an email made public by Senator Carl Levin of Michigan. "They are smart, but this is swimming with the sharks. They were shorting mortgages big-time while they were giving advice."
The Goldman Sachs charges are probably just the tip of a bigger iceberg. The SEC's charges against Goldman came after the governments of the United Kingdom and Germany pushed the United States to investigate the investment banker. But many investment banking firms, not just Goldman Sachs, created complex mortgage securities, which are called synthetic collateralized debt obligations, as the housing market was heating up. At the same time, many traders were expecting the housing market to collapse and were preparing to bet against the market. The SEC is investigating whether other Wall Street firms may have crossed the line into misleading investors about the portfolios they were investing in.
Investors interested in self storage should keep a watchful eye on the Goldman Sachs crisis, for two reasons. First of all, self storage businesses historically have been included in some real estate deals structured by Goldman Sachs and other investment bankers who are starting to be accused to mortgage fraud. As long ago as 2001, Bruce Taub, the then senior vice president of acquisitions for Storage USA commented that some equity deals structured by large firms such as Goldman Sachs and Prudential Real Estate were looking unrealistic: "A number of joint ventures purchased or developed assets in the last few years with an exit strategy that proved unrealistic," he noted in Commercial Investment Real Estate, in words that now seem prescient.
Secondly, at the end of 2009, almost seven percent of Goldman Sach's Real Estate Securities Fund was dedicated to self storage investments. If Goldman Sachs and other major investment bankers lose a lot of money or go out of business, capital for self storage acquisitions and development may have to come from other sources. Developments in one aspect of the market are likely to affect other aspects of the market.
Sources used:
"Goldman Sachs defrauded investors, SEC charges." CBS News. April 16, 2010.
Goldman Sachs Real Estate Securities Fund. Dec. 31, 2009.
Gordon, Marcy. "SEC accuses Goldman Sachs of defrauding investors." Associated Press. April 16, 2010.
Haugh, Michael. "Sizing up self-storage: new trends broaden the appeal of this popular investment property." Commercial Investment Real Estate. Sept./Oct. 2001.
Reuters. "Goldman Sachs charged with fraud by SEC." April 16, 2010.
Story, Louise, and Morgenson, Gretchen. "S.E.C. accuses Goldman of fraud in housing deal." The New York Times. April 16, 2010.