Goldman vs. SEC

Everyone "knows" Goldman Sachs is the root of all evil and that this SEC complaint is just more proof of that fact. While I'm not going to defend the morality or ethics of GS in any way, shape or form, I will say this is a pretty weak complaint on the surface. In fact, I think it might have ulterior motive.

The complaint is relatively short at 22 double-spaced pages. (Why do government documents always look like they were typed in 1952? Haven't they heard of Microsoft Word?) You can read it for yourself here. Anyway, the crux of the issue is a "synthetic CDO" called ABACUS 2007-AC1. Let's start with what a "synthetic CDO" is. It is a derivative whose value is based on a collection of "real" investments. To form this ABACUS derivative, some 90 underlying subprime mortgage bonds were ultimately selected. The buyer of this derivative would profit if the value of those bonds rose, the seller would profit if the value fell.

Paulson wanted to bet against the subprime loans. He asked Goldman to create a synthetic CDO for this purpose. Obviously, if you are "going short" as the "seller" betting the bonds will lose, you want to short a "shitty" group of bonds. Goldman's job was to create this SCDO to fit Paulson's investment needs and that's what they got paid to do. Goldman hired an expert in this area, a company called ACA, to actually select the portfolio of bonds. With Paulson's help, ACA chose the 90 underlying bonds, many of which were Paulson's suggestions. Then Goldman marketed ABACUS primarily to two banks, IKB and ABN Amro while ACA actually guaranteed (insured from default) one tranche of SCDO it created.

ABACUS proceeds to lose all value and we find ourselves looking at the SEC complaint. The SEC says Goldman made "materially misleading statements and omissions" which is the source of the fraud. Just what were those statements? According to the complaint, GS omitted Paulson's involvement in selecting the portfolio.

What I find weak, is that not disclosing the other side of a transaction happens all the time, legally. (One feature of a good market is anonymity.) Say for example I owned a sizable block of GM about two years ago. One morning I decide GM is terrible- no, outright "shitty"-  and I want to sell all my stock. I'd call up a broker like GS and tell them to get me out. Goldman would work the order and unload my shitty stock on a willing buyer. Would that buyer know who was selling? Of course not. Would it make a difference? They can and do decide what they want to buy and at what price all the time. Who cares who the seller is? Every transaction on Wall St. has both a buyer and a seller and they both can't win.

IKB and ABN were offered to buy ABACUS with full disclosure of every bond in it. They were experts in mortgage bonds and decided to buy of their own free will. No one magically put it in their portfolio based on trust- they agreed to buy it just like every other burned buyer of subprime bonds. The claim is NOT that GS lied about the merchandise itself; only who picked it. Imagine going into a used car lot and the salesman says "this nice old lady traded it in". Who hasn't heard that before? The implication is that she treated the car well, which we all know is just a sales tactic. Caveat emptor right? So you make the saleman let you test drive it, look at the maintenance records, see CarFax and he even lets your mechanic look it over. Does it matter whether it was a nice old lady or a careless slob who traded it in? Does it matter which sales manager chose to accept the trade in? After all, you had all the necessary information to make an informed decision and no one forced you to buy it.

The SEC claims that using ACA to ostensibly choose the bonds was misleading and thus fraudulent because ACA was supposed to be the sole entity choosing the bonds. Regardless of who suggested the bonds, it was both up to ACA to ultimately choose. ACA did ultimately choose and put their stamp of approval on it. Why didn't the SEC charge ACA then? Well, the SEC claims GS mislead ACA too! GS hinted to ACA that Paulson was interested in part of the long position, ergo GS fraudulently misrepresented material information to ACA. Even if true, ACA was still responsible for choosing bonds, they met with Paulson himself, they didn't need his input and why didn't they simply ask Paulson his motive? In other words, even if GS misrepresented, ACA hardly cared that Paulson was so involved even though their reputation was at stake.

What we're left with is, as far as I can tell, a weak case against Goldman. The vote to act was split 3-2 and although this happened two years ago was brought to light at exactly the time that financial reform is being hotly debated in Congress and on the front page. Perhaps the SEC is making this a PR push to gain more power? If I had to guess, this case gets settled quietly right after the finance reform bill passes. Of course, that isn't to say Goldman is some sweet, innocent angel. Going 5mph over the speed limit (which everyone considers simply normal driving) doesn't make you a reckless drunk driver who is endangering the public either. But if you are lobbying for more traffic cops, then  "ignoring public safety by willfully flouting the speed limit" is certainly a crime of the highest order right? Which isn't to say we also don't need more traffic cops and isn't to say you aren't a meth dealer too.