The deal that killed Wall Street

As I understand it (from the WSJ article, the SEC complaint and Gerding) here's how it worked:

• Goldman through its employee Fabrice Tourre arranged a "synthetic CDO" (ABACUS 2007-AC1) sale to IKB Deutsche Industriebank AG (IKB).
• The complaint alleges that "[g]iven its financial short interest, Paulson had an economic incentive to choose [residential mortgage-backed securities] that it expected to experience credit events in the near future."
• The collateral manager which purportedly put together the portfolio was ACA Management LLC. ABN AMRO Bank N.V. (ABN) assumed some of ACA's credit risk in the transaction.
• Goldman and ACA knew the portfolio was actually selected by John Paulson the notorious hedge funder who had been betting against the housing market, ultimately made a killing when it tanked, and who was planning to and did bet against the ABACUS 2007-AC1 through a credit default swap transaction with Goldman. However, ACA did not know Paulson was planning to bet against the CDO.
• "GS&Co did not disclose Paulson's adverse economic interests or its role in the portfolio selection process * * * to investors" [i.e., IKB and ABN].

The SEC is alleging civil fraud claims under the 1933 and 1934 Acts against GS and Tourre. Private investor suits against Goldman, and maybe even derivative suits on Goldman's behalf against its managers for doing the deal, likely will follow.

The key to the case, as far as I can see, is the materiality of Paulson's undisclosed role in the transaction. Everybody knew that Paulson was bearish on the real estate market. The banks arguably wouldn't knowingly go into a deal to make money on the upside knowing a notorious bear was on the other side.

The problem with this argument is that Paulson had been losing his bets. The market simply didn't believe what he knew, which was that the risk in the real estate market wasn't fully priced into the securities. Or else they thought they would be able to get off the merry-go-round before it stopped spinning.

But given the market's blindness, why would buyers care if they knew that Paulson was on the other side? Presumably ABN and IKB knew that they would lose if the portfolio of securities they were investing in went down. Note also that ACA knew about and didn't disclose Paulson's involvement in the deal and yet hasn't been sued.

So the real problem here, and the key to the whole case, is that neither ACA nor IKB and ABN knew that Paulson selected the securities knowing he was going to bet against them, and so presumably so as to enhance the possibility of failure. In other words, the SEC will try to show that the deal was made to lose, that Goldman knew this and knew the investors wouldn't like it, but Goldman didn't disclose because it was making fees coming and going.

The question is whether Paulson's undisclosed role in portfolio selection was material. This is not clear. So the case against Goldman isn't a slam dunk. But if Goldman fights and loses, private suits can use the SEC's judgment to establish liability. Goldman is under a lot of pressure to settle.

Obviously the SEC is fighting for the reputation that it lost to Madoff and more recently Stanford. But, more importantly, this could be the deal that saves financial regulation and brings down the derivatives business. As the WSJ reports:

[T]he impact of the Goldman charges shouldn't be underestimated. Robert Litan, head of research at the Kauffman Foundation, points to the Sarbanes-Oxley Act, a law passed in 2002 that aimed to tighten corporate accounting and governance. Back then, the collapse of WorldCom played a big role in reviving support for the bill, says Mr. Litan. At the very least, the Goldman allegations will make it easier for Senate Democrats to stand by provisions in their bill that are aimed at strengthening the over-the-counter derivatives market.

The SEC's complaint obviously understands this when it notes that "[s]ynthetic CDOs like ABACUS 2007-AC1 contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market." The idea is that evil bankers like Goldman were making zillions selling toxic securities that ended up in ordinary people getting tossed out on the street. And even worse they shared in the bailout money put up by the taxpayers.

Of course, nobody will remember that the government tapped the banks supposedly in order to save a failing economy, or that bets like those made by Paulson and facilitated by Goldman were very risky when they were made. Anti-derivatives regulation will diminish the role of Wall Street's profit-mongering capitalists, who have brought great riches along with occasional busts, and replace them with bureaucrats. The federal government will now have the opportunity to apply to the financial derivatives market the same care and expertise that was on display with Madoff. This is not clearly a cause for celebration.

Comments

[Fat Man]

I read the complaint and I thought it was pretty weak beer.

Tourre was only a VP, which is not very high in the GS hierarchy (Thursday the WSJ ran an article about GS's new building -- VPs don't get their own offices). His former superiors may disagree with his characterization of the deal.

However, the SEC did accomplish one thing with the complaint. The article about the IG's report on Stanford, which was pretty astounding in and of itself, was pushed into the second section of today's WSJ.

[save_the_rustbelt]

A failed bank robber is still guilty of bank robbery.

An incompetent con artist still committed a con.

Simplistic? Yes. True? Yes.

Lying, or withholding material information, is fraud, Even if Paulson and GS both lost eventually.

Free market capitalism must be honest free market capitalism, otherwise I'm with the regulators and plaintiff (yuck) lawyers.

[Larry Ribstein]

Not simplistic, just wrong and beside the point. The question is whether it's material. If it isn't, it's not fraud -- even if Paulson and GS gained. None of which goes to my main point about what the SEC is up to here.

[For What Its Worth]

So in the end....

Investment managers who could only invest in AAA rated securities (because many of them had a fiduciary responsibility to invest safely and with minimal risk) have become shark bait.

I'd say this is an unsuccessful outcome of the free market system at work.

From Princeton University paper, Computational Complexity and Information Asymmetry in Financial Products Arora, Barak, Brunnermeiery, Ge October 19, 2009

"...We show that designers of financial products can rely on computational intractability to disguise their information via suitable "cherry picking." They can generate extra profits from this hidden information, far beyond what would be possible in a fully rational setting."

http://www.cs.princeton.edu/~rongge/derivative.pdf