Why SEC v. Goldman is far from open and shut

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.

94 comments Add your comment

CrazyInGA

April 19th, 2010
10:43 am

“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?”

Why would the SEC sue Goldman on behalf of Paulson losing? Paulson was in on the entire thing and should have been sued along with Goldman.

I’m hoping Germany follow through on their potential lawsuit. They stand a better chance of putting a real hurt on Goldman.

Also, those guys at WaMu who testified at the financial hearing last week are just as bad. I’m hoping they are the next group to get what should have come to them back in 2006 & 2007.

Kyle Wingfield

April 19th, 2010
10:46 am

Um, because ACA was also “in on the entire thing.” Did you even read the post?

Kyle Wingfield

April 19th, 2010
10:48 am

The whole point, Crazy, is that both sides were in on it…that’s why the lawsuit seems a little weak, barring a whole bunch of additional evidence. As I said, that may well come out. But until and unless it does, this doesn’t strike me as the open-and-shut case that it’s being made out to be.

Jefferson

April 19th, 2010
11:12 am

Greed blinds.

CrazyInGA

April 19th, 2010
11:13 am

Kyle,

I’m betting that Paulson will be used to testify against Goldman. More than likely, some one who is no longer with the company and doesn’t have a conflict. Also, Goldman is the middleman who had all the necessary information and they admitt to not telling buyers and sellers anything about each other.

If the SEC lose this case, we are in a no win situation against Wall Street; because anything goes.

FYI…. we have rules in Georgia for car dealers who don’t disclose information about a vehicle. It doesn’t matter what the product is that is being sold, disclosure is important. That’s why if the SEC can’t prove their case(I believe they will), I think the bank in Germany will not find it as hard to make their case.

CJ

April 19th, 2010
11:22 am

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 usual, the WSJ is misleading it’s readers. By cherry-picking a single deal, readers are led to believe that Goldman lost money on their bets. The $90 million loss on a single deal is a tiny fraction of the hundreds of millions they made by betting against the garbage they were selling.

Of course, this article isn’t really about the Goldman Sachs case. It’s about undermining a legitimate argument for increasing oversight of the large banks and financial institutions which were primarily responsible for great recession.

Hillbilly Deluxe

April 19th, 2010
11:22 am

Wall Street is a lot like Las Vegas. Rule #1-The house always wins in the end. For people like me and most of the other members of the Great Unwashed, it’s best not to play.

jm

April 19th, 2010
11:41 am

We must stop the infidel volcano Eyjafjallajoekull with strict sanctions on Iceland and all those nations contemplating volcanic terrorism.

Jess

April 19th, 2010
12:00 pm

Very good and well researched article. I read an article in the New York Times about three weeks ago about an independent investor who bought securities from Paulson betting on them losing. He did it for the simple reason that things do not always go up, and he thought the fall was due. According to this article, Paulson convinced Goldman to allow him to enter this market simply as a hedge against a fall. This private investor made lots of money for his clients, and $951 million for himself.

In the end I think we will find Goldman is not as dirty as the SEC claims, and not as clean as Goldman claims.

RNC 2010

April 19th, 2010
12:31 pm

“As usual, the WSJ is misleading it’s readers. By cherry-picking”

As opposed to what, CJ? The New York Times? Time Magazine? Got news for ya pal: The WSJ is much more respected than that bastion of liberal OpEd known as the New York Times.

In any event, I do find the timing of the outing of this story suspect as a vote on more banking finance reform comes in the next week. It is no secret that GS was in the tank for the Obama administration all in the name of “fair housing” legislation. Further, it is no secret that just about all of our financial mess can be tied back to sub-prime mortgages, things that liberal Democrats like Dodd and Obama supported. Even further, it is no secret that the Bush administration and Seantors like McCain back in 2004 saw this train wreck coming and wanted to increase regulations on Fannie Mae and Freddie Mac, but liberal Democrats like Barney Frank all but blocked anything being done about it (Frank’s boy lover was a big wheel at Freddie Mac).

So now here we are and the Obama administration is using these failures as an excuse to tighten the leash on banks and inevitably take them over completely, which is what they plan on doing with insurance companies with ObamaCare. Rather ironic that the bottom feeders got mortgages, many of whom fall into that bottom 50% of income earners who pay no income taxes. But that’s what the left wanted, and banks were coerced – some say forced – to loan to people they knew were risky at best.

But we all know how fair liberal Democrats are now, don’t we? Time’s Joe Klein, the definitive foot stool of the left in print media, said yesterday on one of those left wing Sunday morning talk shows that Palin, Beck, and others are guilty of sedition.

Bill Clinton timely makes a comment on the 15th anniversary of the Oklahoma City bombing and said that Tea Party people are domestic terrorists and dangerous.

Now I have a question. Exactly where were these people, and all the other liberals out there for EIGHT YEARS under Bush? Did they all forget about the anti-Iraq war protesters, many of whom carried signs depicting Bush be hanged for treason or depicting Bush as a nazi? Where are all these people of the modern definitive left when G4 comes to town and protesters torch cars and throw bricks into businesses?

When the Right is in power, protesting and speaking out against the government is a good thing. When the Left is in charge, it’s “sedition” and “domestic terrorism.” When the Right is in charge, increasing regulations are bad. When the Left is in charge, it’s good. Do we see a pattern here? And certainly don’t look for the lame stream DNC media to report any double standards, back tracking, and hypocrisies of the Left running this train wreck of economic collapse we’re fast heading towards.

TehranDawg

April 19th, 2010
12:45 pm

The SEC is the best conference in all of college football!!!!!!

Jefferson

April 19th, 2010
1:15 pm

RNC2010 you are full of half truths and talking points. I laugh in your general direction. We see what the R’s did, why do you think they were voted out?

The question is can the D’s handle prosperity?

Kyle Wingfield

April 19th, 2010
1:31 pm

Crazy: These weren’t “buyers and sellers.” They were parties to a series of credit default swaps. But in any case, knowing who is on the other side of the bet seems a lot less important than knowing what the bet was about — i.e., what the underlying securities were. And there’s been no suggestion that this part of the bet wasn’t completely clear to all.

CJ: It’s cherry-picking to talk about the money made or lost in the specific case in which the SEC has filed suit? That’s rich(er than usual).

Linda

April 19th, 2010
1:51 pm

It’s merely a smoke screen during financial reform regulation discussions (moved up) to take away our attention from the real culprits: Fannie Mae & Freddie Mac (& their buddies, Frank & Dodd).

CJ

April 19th, 2010
1:54 pm

No Kyle, ACA Management is not “the specific case in which the SEC has filed suit”. It is, however, the specific case in which this article focused on.

Incidentally, there is a suggestion that the quality of the underlying securities, or lack thereof, was hidden from potential investors–hence the lawsuit.

CJ

April 19th, 2010
1:56 pm

You’re projecting Linda. Republicans have an established record of filing lawsuits for political gain — not Dems.

JF McNamara

April 19th, 2010
2:00 pm

Goldman is about to be in hot water. Not necessarily because of this CDO transaction, but because now they will have to be deposed. If the government asks about their role in the Greek debt crisis, do they have to answer? If the government asks about other CDO transactions, do they have to answer? If the government asks about transactions used to drive hedge funds out of business causing the markets to crash, do they have to answer?

If I’m them, I’d swallow the hubris and settle now. I don’t think they really want to be questioned under oath. I don’t think that we’ll find out that they “are doing the lord’s work”.

Churchill's MOM

April 19th, 2010
2:31 pm

I think some people from Wall Street should go to jail, are these the 1st bunch to go, we’ll find out. The ethics on Wall Street are basically about the same as a used car dealer on Gordon Hwy. in Augusta. In many cases they did the equivalent of selling a car that they knew had been in a flood as a cream puff.

I still don’t understand why you deleted my comments about Saxby last week, please explain.

Bill from Cobb

April 19th, 2010
3:02 pm

The looters will always find a way. I think this book has already been written.

GODAWGS

April 19th, 2010
3:05 pm

AINT NOONE GONNA BEAT THE SEC!!!!!! THE SEC IS BY FAR THE BEST!!!!! WHO GONNA BEAT THE SEC???? THE SEMENOLES?????? THE TROJANS??????? THE BUGS??????? IVE NEVER HEARD OF NO GOLDMAN BUT THEY AINT GOT NO BUSINESS PLAYING THE SEC!!!!!!

GO DAWGS!!!!!!

Bill from Cobb

April 19th, 2010
3:07 pm

Banks, GM, Media, Health Care, and now Wall Street. Wonder who will be next? Is Chavez and Obama brothers from a different mother?

Joe in Decatur, GA

April 19th, 2010
3:19 pm

RNC2010,

People were protesting the war in Iraq because it was, in fact, a fraud. There were no weapons of mass destruction and Iraq never attacked the U.S.A. on 9/11 or at any other time. Do you really believe that protesting a war where tens of thousands of people have died on the basis of fraudulent claims is somehow the same as protesting an attempt to make health care more affordable for all?

HDB`

April 19th, 2010
3:31 pm

RNC2010: Now I have a question. Exactly where were these people, and all the other liberals out there for EIGHT YEARS under Bush? Did they all forget about the anti-Iraq war protesters, many of whom carried signs depicting Bush be hanged for treason or depicting Bush as a nazi? Where are all these people of the modern definitive left when G4 comes to town and protesters torch cars and throw bricks into businesses?

Weren’t the protestors who were against Bush called TRAITORS and UN-AMERICAN?? Weren’t those protestors railing against economic policies? Did those protestors blow up any federal buildings recently?? Look…the vitriol is on both sides…but the LEVEL of then vs. now speaks volumes. It’s NOT just a policy issue with Obama….and many here refuse to acknowledge that fact!!

When the Right is in power, protesting and speaking out against the government is a good thing. When the Left is in charge, it’s “sedition” and “domestic terrorism.” When the Right is in charge, increasing regulations are bad. When the Left is in charge, it’s good. Do we see a pattern here? And certainly don’t look for the lame stream DNC media to report any double standards, back tracking, and hypocrisies of the Left running this train wreck of economic collapse we’re fast heading towards.

It was REAGANOMICS that started the nation down this path…and the nation getting BUSHwhacked exacerbated it!! Do you expect Obama to fix in 2 yrs what it took over 250 years to do?? C’MON, MAN!!

Linda

April 19th, 2010
4:17 pm

Joe@3:19, I’m a Tea Party participant & I can assure you that we are not protesting “an attempt to make health care more affordable for all.”
I can assure you that imaginary thought never entered our minds.

Linda

April 19th, 2010
4:25 pm

HDB@3:31, The subprime mess started under Clinton. Affordable Housing/Social Justice is a Dem/Progressive strategy. It was a great part of Clinton’s history.

Jefferson

April 19th, 2010
4:39 pm

Linda, you are just wrong.

Avery

April 19th, 2010
5:01 pm

Linda, that perfectly explains why the COMMERCIAL real estate losses have been as bad/worse than the residential real estate losses. All those minorities and their affordable commercial property promised to them by Clinton.

Don’t let reality get in the way of your mythological world.

Avery

April 19th, 2010
5:06 pm

Kyle,

Goldman was pimping these CDOs to investors as a safe AAA investment (even retaining the equity tranche for show, I’m guessing these are the “losses” you refer to in your blog), while placing backdoor massive bets in the other direction at the same time.

It actually seems to be a pretty “open and shut” violation of GS’s responsibility to its clients.

Jeffrey

April 19th, 2010
5:15 pm

Kyle,

No way the SEC loses.

Jeffrey

HDB`

April 19th, 2010
5:18 pm

Linda

April 19th, 2010
4:25 pm
HDB@3:31, The subprime mess started under Clinton. Affordable Housing/Social Justice is a Dem/Progressive strategy. It was a great part of Clinton’s history.

The “Ownership Society” was a key tenet of the BUSH campaign. The subprime mortgages exploded when the Bush regulators ignored the markets!! Glass-Stegall WAS repealed under Clinton…but the laissez-faire economic practices were implemented under Bush…..

Lest you forget…..

Peter

April 19th, 2010
5:19 pm

Kyle…….Please tell me why the ratings agency’s are not on the hook ?

All know they said the paper was A+.

Bottom line GS will not get charged with anything in the end…… It is all about buyer beware, and due your homework on the product.

HDB`

April 19th, 2010
5:19 pm

Avery — GOOD POINT!! It was the commercial property crash that accelerated the real estate crash…not the residential market……

Peter

April 19th, 2010
5:33 pm

Hey Kyle…… This vote may have some clues as to whether the SEC can actually win the case…….

By: Bob Pisani
CNBC Reporter

Word that the SEC vote to sue Goldman Sachs was 3-2, right along party lines (first reported by Bloomberg), came out a bit after 2pm ET and helped lift Goldman and the overall market.

Volume in GS immediately picked up and price moved from $159 to $162 in a matter of minutes, putting GS into the green for the first time today.

Why is this important? Because it implies that if the SEC cannot get a unanimous vote, culpability may be less than clear.

Kyle, I would suspect the Dem’s voted 3….. perhaps they are being over anxious with the thought of banking reform, and wanting to “GET SOMEONE” to prove the point.

This may turn out to be a huge back fire.

Kyle Wingfield

April 19th, 2010
5:56 pm

CJ, what are you talking about? The SEC has filed one lawsuit against Goldman Sachs. It concerns one CDO. No one but you is talking about other cases, or other securities involved in this case.

Might the SEC investigate other deals and file other cases? Perhaps, perhaps not. It’s obvious that you and some others on here think Goldman is guilty of all manner of offenses. But if you know of other fraud lawsuits outstanding between the SEC and Goldman Sachs, please reveal them to the rest of us.

Chris Broe

April 19th, 2010
5:58 pm

What does the word “bet” mean as it was used by both Kyle and The WSJ? Bet against? What does that entail?

Kyle Wingfield

April 19th, 2010
6:01 pm

JF, I don’t know the answers to your questions but if Goldman had to answer some of them it could indeed end up in a bad spot. Saying this is a weak case is not the same thing as saying Goldman was run by a bunch of angels…

Peter: Good question about the rating agencies. In fact, the biggest problem I have with the approach that Congress and the SEC seem to be taking is that it may leave us with the undesirable effect of getting even rather than doing justice — not to mention avoiding another calamity down the road.

Linda

April 19th, 2010
6:08 pm

Jefferson@4:39, How am I wrong? Are you accusing Bill Clinton of lying?

Linda

April 19th, 2010
6:16 pm

Avery@5:01, Are you accusing Clinton of lying? Are you denying that the MANDATE under Clinton was not the catalyst that caused the world-wide economic crisis?

Linda

April 19th, 2010
6:21 pm

HDB@5:18, You, too, are accusing Clinton of lying when he ADMITTED that the Bush adm. & the Reps tried over & over again to rein in the GSEs. I’m not saying that Bush was innocent, but blaming Bush for the economic crisis is stupid. It started under Clinton & he BRAGGED about it in his biography.

Mike

April 19th, 2010
6:36 pm

Where were the tea-partiers when Bush was creating the largest government entitlement (Medicare Part D) since the ’40s? Where were the tea-partiers when the Constitution was being completely trampled by warrantless wiretapping and data-mining of American’s communications on a massive scale? Where were the tea-partiers when the deficit was being exploded by two unfunded wars?

Linda, the economic collapse wasn’t caused by subprime mortgages. It was caused by the deregulation of the banking industry and the repeal of the Glass-Steagall Act; if that hadn’t happened, there would have been no financial meltdown. The bill that repealed that Act was introduced by Phil Graham (R-Texas) and Jim Leach (R-Iowa) in 1999. The bills were passed by a Republican majority pretty much along party lines, with most Republicans voting for it and most Democrats against in both the Senate and House.

And did President Bush do ANYTHING to rein in the easy availability of credit to pretty much anyone with a heartbeat? No, he pushed it and pretty much took credit for it!

We’re creating… an ownership society in this country, where more Americans than ever will be able to open up their door where they live and say, welcome to my house, welcome to my piece of property. – President George W. Bush, October 2004.

Linda

April 19th, 2010
6:40 pm

The sub-prime loans were MANDATED by Congress in the ’90’s. They were originated by mortgage companies, used by homeowners & investors, purchased & bundled into securities by Fannie Mae & Freddie Mac (mandated by Congress), rated by Moody’s & Standard & Poor, insured by AIG, resold on Wall St. & all over the world & regulated by thousands of govt. bureaucrats.
Public & private retirement accounts invested in them.
The fed. govt. has bailed out the homeowners who used them (even paying for their moving costs), are paying the real estate agents who benefited from them & who are now negotiating short sales, has bailed out AIG along with almost all of Wall St. & is now stuck with states & cities in the dilemma that there’s no money to fund retirement & health care benefits to govt. workers.
Anyone who wants to join the Tea Party is welcome.

Linda

April 19th, 2010
6:56 pm

Mike@6:36, I can’t speak for the entire Tea Party & I do not endorse all the actions of Bush. I beg to differ with the root cause of the economic collapse. It was caused by the ideology of Dems/Progressives of Affordable Housing in the name of Social Justice, the number one agenda of our president in the ’90’s as well as our current president. Clinton negotiated for his agenda by signing the Glass-Steagall Act.
Clinton ADMITTED that the Dems denied all efforts by Bush & the Rep’s efforts to rein in the GSEs.

Mike

April 19th, 2010
6:57 pm

Linda, you’re either seriously misinformed about the Community Reinvestment Act, or just practicing typical right-wing revisionism. The actual wording of the act… “help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods, consistent with safe and sound operations.” I’ll repeat that last part for emphasis – CONSISTENT WITH SAFE AND SOUND OPERATIONS! It was NOT a mandate… no percentages were required, and it gave the banks a huge amount of discretion on who they approved and denied.

The other points you bring up don’t conflict at all with what I was saying was the result of banking deregulation and the repeal of the Glass-Stegall Act. And we all know what party worships at the feet of deregulation and unregulated capitalism!

Peter

April 19th, 2010
6:59 pm

Kyle, at this point if the ratings agency’s can say anything and not be considered negligent when they totally blow it, as they did in this case……it kind of makes me worry about this thought…….

Are also in the back pockets of these wall street big guys ?

Jay

April 19th, 2010
7:15 pm

Sir:
A jurty will determine whether the SEC v. Goldman Sachs case is a slam dunk or not and NOT the editorial pages of the WSJ. For any American who lost or had his/her 401 wiped out due to Wall Street chicanery, the lawsuit is welcome news. I commend Obama and the SEC for having the guts to bring action against Goldman. I hope similar cases are brought against other players in the mortgage mess and pray for criminal charges as well.
The foundation of our capital markets is the free flow of information. Goldman is a publicly traded entity and subject to public disclosure requirements. Certainly, the information that was withheld from the public would have mattered to any investor. If such information was not disclosed, then they broke the law and would have their day in court.
I dont think Goldman Sachs needs another choir master to sing its tunes. They already have attorneys and PR folks.

CJ

April 19th, 2010
7:20 pm

I’m wrong Kyle. You’re right. Very sorry. My neurons are misfiring today.

Yes, Goldman Sachs did make billions betting against the housing market but did lose millions on the CDO specific to this lawsuit (Abacus).

Essentially, Goldman Sachs appears not to have properly disclosed John Paulson’s role in developing this product, and such lack of transparency is, evidently, illegal.

Linda

April 19th, 2010
7:59 pm

Mike@6:57, Fannie Mae & Freddie Mac were given QUOTAS by the fed. govt. for subprime loans. Let me give you a website:

http://www.nytimes.com/1999/09/30/business/fannie-mae-eases-credit-to-aid-mortgages-lending.html/

In case this doesn’t work, the New York Times says:
“…to individuals whose credit is generally not good enough to qualify for conventional loans…Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under pressure from the Clinton adm. to expand mortgage loans among low- & moderate-income people…loans to so-called subprime borrowers…whose incomes, credit ratings & savings are not good…Fannie Mae has expanded home ownership for millions of families in the 1990’s by reducing down payment requirements…Fannie Mae is taking on significantly more risk…but the government-subsidized corporations may run into trouble in an economic downturn, prompting a govt. rescue…by the year 2001, 50% of Fannie’s & Freddie’s portfolios be made up of loan to low- & moderate-income borrowers. Last year (1998) 44% of the loans Fannie Mae purchased were from this group.”

Linda

April 19th, 2010
8:02 pm

Mike, My source did not work, but you can find the article based on my link. Get back to me after you do. I look forward to hearing from you.

Michael H. Smith

April 19th, 2010
8:08 pm

You are right, Linda.

Michael H. Smtih

April 19th, 2010
8:28 pm

Isn’t the timing of this Goldman thing “REALLY GOOD”, Kyle? Wonder how long the SEC sat on this deal all shush, shush? Now that Comrade Pelosi has no need of her broom anymore – I mean, with Air Pelosi and all at her service to fly around on – her broom could be put to better use over at the SEC – cleaning house!

One other thing Kyle, what do you know of this Kotlikoff “limited purpose banking” idea?

http://www.kotlikoff.net/