The government’s lawsuit against Goldman Sachs, announced Friday by the Securities and Exchange Commission, is a doozy. It alleges that the Wall Street firm defrauded investors in a synthetic — remember that word “synthetic,” because it’s important — collateralized debt obligation, or CDO. The charge is that Goldman let an investor named John Paulson help put together the CDO without telling other parties that Paulson was betting against it, thereby dooming them to lose money.
So far, so scandalous. But that’s not the end of the story.
First, about that word “synthetic.” The Wall Street Journal explains that
the investment at issue did not hold mortgages, or even mortgage-backed securities. This is why it is called a “synthetic” CDO, which means it is a financial instrument that lets investors bet on the future value of certain mortgage-backed securities without actually owning them.
Yet much of the SEC complaint is written as if the offering included actual pools of mortgages, rather than a collection of bets against them. Why would the SEC not offer a clearer description? Perhaps the SEC’s enforcement division doesn’t understand the difference between a cash CDO—which contains slices of mortgage-backed securities—and a synthetic CDO containing bets against these securities.
More likely, the SEC knows the distinction but muddied up the complaint language to confuse journalists and the public about what investors clearly would have known: That by definition such a CDO transaction is a bet for and against securities backed by subprime mortgages. The existence of a short bet wasn’t Goldman’s dark secret. It was the very premise of the transaction.
Now, it should go without saying that any investment is a gamble, that the only investments that forever go up, up, up usually result in someone like Bernie Madoff going to jail. The only honest gamble is one in which one side wins money and the other side loses.
And in this case, we are talking about a particular kind of CDO, one which is even more explicitly designed as a betting proposition. There is no consideration here of, say, income from the mortgages upon which the bet was based. It is purely a matter of up-or-down. No sophisticated investor — and the majority of the losses from this bet were sustained by big international banks — would make this bet thinking that everyone was betting on the upside. Yet that’s one of the things the SEC alleges against Goldman: that it didn’t tell some investors that other investors were betting on the downside, when that should have been plain to everyone.
The more serious allegation is that Goldman let Paulson build the CDO with mortgage-backed securities that were especially likely to fail. Actually, the complaint says that Paulson “played a significant role in the portfolio-selection process.” Who else played a significant role? ACA Management LLC, which the SEC describes as “a third-party.”
Undermining the narrative, however, is this revelation from Goldman Sachs on Friday: ACA was the largest “long investor” (meaning ACA was betting that the CDO would rise in value, not fall) in the deal, with $951 million.
So, ACA was not some disinterested “third-party.” It put together a CDO in which it then invested nearly $1 billion. It clearly was building a CDO on which it thought it could make some money. Borrowing the language of the lawsuit, you might even say its “interests were sharply conflicting” with those of short-side investors.
What’s more, Goldman itself lost $90 million on the deal, more than erasing the $15 million in fees it earned for arranging the deal. As the WSJ editorial puts it, “the SEC is suing Goldman for deceiving long-side investors in a transaction in which Goldman also took the long side. So Goldman conspired to defraud…itself?”
Can we assume the SEC would also sue Goldman if the bet had turned out the other way, and Paulson had lost money on the CDO he helped build, rather than ACA losing money on the CDO it helped build?
It’s always tricky commenting on a just-filed lawsuit, because more information invariably comes out as the process unfolds. There may be some truly damning information about Goldman’s role in this deal yet to come out. There may be other cases that are truly egregious — although, if that’s true, one has to wonder why they wouldn’t be the first ones out of the gate. But no such information has been unveiled yet, and based on the available evidence it’s easy to imagine the SEC losing this case, despite all the bluster about this supposed breakthrough in revealing how Wall Street makes the sausage.