What happens when the smartest guys in the room are shown to be the dumbest? They sue. Well, not exactly, but that’s kind of what is happening with the $1 billion legal action being brought by Australia’s own collapsed hedge fund Basis Capital against the world’s favourite vampire squid, better known as Goldman Sachs.

In truth, the legal claim is not being brought by the managers of Basis, Steve Howell and Stuart Fowler. They have long been humiliated and are presumably playing little or no part in the claim (Fowler’s LinkedIn page suggests that while he is still a director of Basis, his main role appears to be at debt advisory firm SPAR Capital Partners). Rather, the action is being undertaken by Basis’ liquidator on behalf of the hedge fund’s lenders/investors. Another important point is that the legal claim itself is for a rather sombre $US56 million, Basis’ liquidators are also asking for $US1 billion in punitive damages, a figure they know they won’t get, but makes their claim of $US56 million somewhat more acceptable.

Basis’ claim is that Goldmans sold it a synthetic collateralised debt obligation called Timberwolf, which the bank knew was a poor investment (before the sale, Goldman’s had already started reducing its property exposure). In fact, a Goldman executive described Timberwolf as “one sh-tty deal”, a description that was repeated by US Senator Carl Levin to stunned Goldman executives earlier this year. The description appeared pretty accurate — within a couple of weeks of selling the product to Basis, the hedge fund was subject to a “margin call”. A few weeks after that, it was down about $US30 million (or half of its investment).

While Goldman did not appear to be doing “God’s work” in selling Timberwolf, that doesn’t necessarily mean that the claim has any chance of succeeding, in fact, there are some pretty fundamental problems with it.

Most pertinently, Basis held itself out to be an expert investor (and in fact managed more than a billion dollars worth of CDO investments). One fund manager told Crikey that Basis would tell investors that they were “sophisticated” managers of CDOs. Stephen Bartholomuez wrote last week in Business Spectator that Basis’ disclosure documents claimed that the fund:

“Started with a search for ‘compelling’ opportunities, using ‘detailed models’ maintained by the group to look at each security based on macro and micro factors considered relevant to making an informed investment decision, drawing heavily on the ‘extensive experience’ of the investment team.”

Now that very same fund is alleging that it was misled by Goldman Sachs even though anyone with even the vaguest understanding of how a synthetic CDO worked would have known that either Goldman (or another Goldman client) had taken the exact opposite position to Basis. (A synthetic CDO is a creation of an investment bank and is backed by other instruments, rather than underlying securities such as  mortgages). In that sense, they are more like a contract-for-difference (CFD) than a share in a company. As such, if one investor is “long”, another one must be “short”. In a damning indictment in the hedge fund industry, Basis had been named “Fund of the Year” at the 2005 AsiaHedge awards and was Macquarie Bank “Skilled Manager of the Year” in 2004.

Basis’ claim is, of course, put in a different manner, the Financial Review noted that Basis’ claim alleges the Goldman’s provided incorrect cash flow information and also failed to disclose that it was in discussions about liquidating Bear Stern’s CDO portfolio, which included $US100 million of Timberwolf securities.

That may well be correct, but given Basis most likely charged its clients 2 and 20 (fees of 2% of funds under management and 20% of out-performance), it should have been able to look through Goldman’s sales pitch and make its own assessment of the quality of the Timberwolf product. (In fact, it appears that Basis was so incompetent that if it were still around one would suspect it guilty of misrepresentation in holding itself out to be some sort of expert).

Former non-executive director of Basis (and Swiss-based former Macquarie banker) David Mapley provided a different view to the Financial Review, comparing the collapse of the Basis Yield Alpha Fund to a nervous bather at a beach. According to Mapley, “the weather looks good and the bather’s (supposed) friend tells him to jump in because the water’s nice. But in fact, they know that 400 miles offshore there’s a 50-metre tidal wave coming at you at high speed”.

Mapley’s analogy is, of course, self-serving and absurd. Basis was far from a nervous bather. In fact, Basis held itself out to its own hapless investors as being a veritable coast guard, with its own very long telescope, which allowed it to see any tidal waves. What’s more, it was a coast guard charged bathers a fortune for its supposed expertise.

Giving even less credence to Basis’ claims was the fact that it paid only 80 cents in the dollar for the Timberwolf Securities. If the deal was really as good as Basis claims Goldman was implying, why would Goldman have needed to discount the securities?

All this, of course, doesn’t mean that Goldman’s acted properly throughout — in fact, its actions appeared at best morally questionable (its own executives were boasting of selling a “sh-tty” product). But as Bill Bonner notes, Goldman may be crooks, but at least they’re honest crooks. The role of investment banks is ultimately to determine an efficient allocation of capital. While this has not occurred commonly in recent years, Goldman can at least claim to be expert at separating fools from their money.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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