I’m hardly an expert in securities law, and the Securities and Exchange Commission has yet to prove in a court of law the facts that it laid out in its stunning civil suit filed Friday against Goldman Sachs.
But if the facts prove out as the SEC alleged, the whole culture of Wall Street is even more corrupt and cynical than we have been led to believe.
Which is really saying something.
Let me try to make this as simple as possible. The SEC alleges that in 2005-6 or so, hedge fund manager John Paulson could foresee problems coming with the billions of dollars in securitized mortgages, or collateralized debt obligations, being sold as Triple-A rated. In fact, Paulson was so sure that many of those CDOs would default that he wanted to short them, or bet against them paying off.
So far, so good. That’s what hedge fund managers do — they look for inefficiencies in the market and exploit them. They are also compensated quite handsomely. According to the New York Times, Paulson himself made $3.7 billion in 2007 from his hedge fund, and another $2 billion in 2008. (Thanks to a quirk in tax law, he also probably paid just 15 percent of that in income tax, roughly half the rate he would otherwise pay. So far, congressional Democrats haven’t summoned the courage to try to close that grotesque loophole.)
But according to the SEC, Paulson wasn’t just a passive investor.
As the narrative reads, Paulson goes to Goldman Sachs and asks the investment bank to create mortgage-backed bonds that he could short. Goldman Sachs agrees, taking a $15 million payment from Paulson for doing so. But Goldman goes a step farther by allowing Paulson to pick the mortgages that would be bundled into bonds — the mortgages that Paulson thought would be most likely to fail. Goldman then sold those tainted, Triple A-rated bonds to unwitting Goldman clients, collecting another hefty fee in the process. Like Paulson, it too placed secret bets that the bonds it had sold to trusting clients would fail.
In effect, Paulson and Goldman had inside information that the CDOs they were creating would more than likely fail, because they had designed those instruments to do exactly that (within a year of their creation, 99 percent of bonds in question had indeed been downgraded). But Goldman’s clients that bought those CDOs were not privy to that knowledge.
“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,” according to Robert Khuzami, director of the SEC’s enforcement division. (Paulson has not been charged because, Khuzami told the WSJ, he made no false representations to investors about the riskiness of the bonds. Goldman allegedly did.)
Described another way, Paulson handpicked sick, diseased pigs to be made into sausage, then bet millions that the resulting sausage would make people sick. Goldman, for its part, made the poisoned sausage (and got paid), sold that sausage to its own unwitting customers (and got paid again), and. like Paulson, bet millions that those customers would get sick (and got paid yet again).
And unfortunately, this doesn’t seem to be an isolated incident. ProPublica, the nonprofit investigative reporting outfit, has thoroughly documented similar allegations against Magnetar, a Chicago-based hedge fund that also created mortgage-based bonds and then bet those bonds would fail.
“several people with direct knowledge of the deals … say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure. The hedge fund acknowledges it bet against its own deals but says the majority of its short positions, as they are known on Wall Street, involved similar CDOs that it did not own. Magnetar says it never selected the assets that went into its CDOs….
Key details of the Magnetar Trade remain shrouded in secrecy and the fund declined to respond to most of our questions. Magnetar invested in 30 CDOs from the spring of 2006 to the summer of 2007, though it declined to name them. ProPublica has identified 26.
An independent analysis commissioned by ProPublica shows that these deals defaulted faster and at a higher rate compared to other similar CDOs. According to the analysis, 96 percent of the Magnetar deals were in default by the end of 2008, compared with 68 percent for comparable CDOs….
The issues in the Goldman case go to the heart of the controversy in Washington over Wall Street regulation. President Obama is demanding much greater transparency in the buying and selling of CDOs and their derivatives, called credit-default swaps; congressional Republicans, at the behest of Wall Street, are trying to limit that disclosure.
But had tighter rules and greater transparency been in effect a few years ago, such transparency would have tipped off both investors and regulators about the game being played by Goldman, Paulson, Magnetar and no doubt others, a game that played a large part in driving us into this recession.
For those interested, here’s a simplified explanation of how CDOs were created, and how they failed: