22 April 2010

A Quick and Dirty Guide to the Goldman Sachs Case

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As is well known, last week the Securities and Exchange Commission charged Goldman Sachs with fraud. Since then both Republicans and Democrats have been using the case to promote their respective. For Democrats, Goldman Sachs demonstrates the need for more financial regulation. For Republicans the case raises questions about the involvement of some members of His Beatitude's Administration. Some wonder if His Grace will return nearly one million in Goldman Sachs campaign contributions.

What really happened? What, precisely, is the fraud which Goldman Sachs has allegedly perpetrated?Goldman Sachs sells securities, or investments. Some of the investments Goldman Sachs sells are for ordinary investors, people like you and me, who don't really have much knowledge or experience when it comes to investing. We might buy stock in a company for the same reason my little girl buys a particular pair of shoes (and usually not the pair I would have purchased for her): They're pretty.

It doesn't take a lot of investment knowledge to buy stock in Ford, or Microsoft. In the other hand, some investments really are for sophisticated investors. The fact is, some investments are so complicated and difficult to understand that the person who sells those investments has a legal obligation to determine whether you actually know what you're doing.The fact of this legal obligation is critical to understanding the case because the particular type of investment at issue here is called a collateralized debt obligation (CDO). In this case, the CDOs are investment instruments backed by mortgages. If you have no idea what it means to say that an instrument is backed by mortgages, then you probably have no such instruments in your portfolio, if you manage your portfolio yourself. But even so, if you understand a mortgage at all, you can begin to see the trouble. An instrument backed by a mortgage isn't backed by much if one or more of the mortgages is defaulted. Hence, as one might guess, mortgage-backed securities haven't been viewed as reliable investments the last couple of years. But Goldman Sachs is in the business of creating CDOs to sell to investors, among other instruments.

But creating a CDO is easier said than done. One must determine which mortgages to include. To do this, Goldman Sachs engaged the services of John Paulson of Paulson & Company, who managed to do something few others have done: While most have been losing money in the market, Paulson has been making money because he bet against real estate.

This fact about Paulson is critical. Goldman Sachs was selecting contents for an investment fund they called Abacus 2007-AC1. Paulson's firm was hired to help with this selection. But Paulson had decided that securities backed by mortgages were a bad investment, to say the least. Nevertheless, he helped Goldman Sachs select the mortgage bonds and instruments to include in Abacus. It is possible (isn't it?) that Paulson, having determined to bet against mortgage-backed securities might design a CDO for Goldman Sachs which will fail in the market?

Apparently he did precisely that. Abacus was a dismal failure. Now, try to figure out what, if anything is wrong with the picture. On one hand, Paulson was paid $15 million by Goldman Sachs to select the contents of Abacus. On the other hand, he made about one billion dollars in profits by selling Abacus short. Goldman Sachs, which allegedly perpetrated a fraud, bet on Abacus to succeed and lost about $90 billion in the deal.

The SEC lawsuit claims that before Goldman Sachs sold this instrument to investors it was obligated to tell investors every detail about the creation of the CDO, including the involvement of John Paulson. In that regard bear in mind the following. First, a CDO is a very sophisticated investment instrument; those who purchase them know just as much about them as the people at Goldman Sachs who created them in the first place. We're not talking Ma and Pa Kettle, here. Try Gordon Gekko. Second, when Goldman Sachs put together Abacus, John Paulson was as famous as Bud Fox when he met Gekko. He hadn't yet made his name by betting against mortgage-based securities. Disclosure of Paulson's involvement would have meant as much to investors as news that the sun rises in the east. Third, it seems clear, given Goldman Sachs's own stake, that they truly believed they had created a profitable CDO. How else to explain their own bet on Abacus and consequent loss of ninety billion dollars. I say again: NINETY BILLION DOLLARS. Paulson is the one who should be on trial.

The SEC is claiming, to the contrary, that Goldman Sachs was actually betting that Abacus would fail, planning to reap profits through a hedge fund. That would have been a neat trick, given their bet in favor of Abacus. They must have thinking that they'd make more through the hedge fund betting against Abacus than they would lose in their other bet in favor of Abacus. Yes, that must be it exactly.

It's too bad Goldman Sachs can't be prosecuted for stupidity, because that's what it was if they knowingly perpetrated a fraud and, at the same time, bet anything at all on their fraudulent product.

There is something almost eerie about this case, however; it is the manner in which the SEC has handled it. In these types of cases there is an opportunity to reach a settlement, such as, for example, paying fines. Strangely, the SEC refused, or simply failed, to return phone calls from Goldman Sachs in the days preceding the lawsuit. I don't think this has ever happened before. Frankly, the suit is rather unprecedented. But so, they tell us, is the present malaise. Unprecedented times call for unprecedented measures. I think that was Abraham Lincoln's excuse. But I digress.

Golly gee. I wonder what gives? Oh, yes. His Beatitude and his Court. Possessed of the wherewithal to control the nation's health, or put your grandma on a pain pill instead of allowing her to have that really unnecessary hip replacement surgery, he now desires to go after Wall Street. He's got his own health, wealth and prosperity gospel, and it now requires -- one struggles to find the appropriate adjective connoting large size; the un-federal government is so much larger and has so much more power that we just no longer have sufficient adjectives! Anyway -- new regulations on America's financial institutions.

When Sebastian Malleby and I are both taking the same tack on matters of political economy it is time to pay attention.

Curiouser and curiouser.

By the way, the latin proverb above is from Tacitus and translated, "They create a desolation and call it peace."

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About Me

James Frank SolĂ­s
Former soldier (USA). Graduate-level educated. Married 26 years. Texas ex-patriate. Ruling elder in the Presbyterian Church in America.
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