I wrote this in an email to someone else a few weeks ago, but thought it would make a good post. Most people are probably familiar with the civil fraud case brought against Goldman Sachs by the SEC. This presentation given by a professor at Stanford last month is a useful explaination of the other side of the story - that the SEC brought a highly partisan case against an unpopular firm with little probability of succeeding. Now faced with proving this to an educated judge/jury, a far more likely outcome is that the SEC accepts the futility of this lawsuit and negotiates a Wall Street wide settlement comprised of new (and much needed) rules on derivatives and as well as some meaningless amount of money (like $20B, sounds like a lot to voters but not much when you spread it across dozens of parties).
I personally am unconvinced that Goldman's behavior was illegal in any sense, though the social utility of a synthetic CDO escapes me. While their actions do not look good to mainstream America, people always look bad when they are right and the majority is wrong and looking for a fall guy. If the argument is that market makers in illiquid complex securities should have some fiduciary responsibility to buyers and sellers, then I might find that an interesting point of debate. But unfortunately for the SEC, the law has very different definitions of a fiduciary and market maker, simply put a fiduciary has to act in the client's best interests while a market maker just has to offer a fair market price. I would love to see the flip side of this “fraud” prosecuted wherein investor A mis-prices their securities and through a market maker sells them to investor B whose opinion proves instantly correct resulting in profits, i.e. arbitrage. Should the market maker then be required to inform the participant of the relative wisdom of his decisions prior to executing the order? Of course not, the investor is responsible for evaluating assets prior to buying or selling them.
ACA was the final authority on securities in the portfolio and as much as the SEC would like you to believe otherwise, they had to have approved every single asset in the portfolio. Furthermore, the short position would have to be permitted some input in the formation of portfolio since this was a synthetic collateralized debt obligation (CDO), a zero-sum game where shorts must equal longs. Synthethic CDOs only mirror the performance of other assets, in this case CDOs (click through for explanation of a CDO) comprised of mortgage backed securities (MBS). To grossly oversimplify, this is analogous to wagering on a football game. Two parties each wager $100 and the bets perfectly offset (A bets $100 that team X loses, B bets $100 that team X wins), neither the existence of the bet nor the possibility that Mike Dikta is person B affects the outcome of the actual game. In a similar fashion, who is long or short the synthetic CDO is immaterial, it won't affect the performance of the underlying CDO in any manner. It would make no sense for the person on the short (losing) side of the bet, either football or synthetic CDO, to not care about the identity of the underlying team (bond). No sane investor would give Goldman their money and just tell them to short a random pool of securities. The SEC probably scored some brownie points with its political masters, but the judge/jury that presides over this will have slightly more cognitive ability than your average NY Times reporter or MSNBC talking head.
On a side note, I find it much more disturbing that the Moody’s employee, Eric Kolchinsky, believes a seller or buyer’s identity to be material to the valuation of the asset. That seems to be his argument when he says that he would have rated them differently if he had known that John Paulson would short these. I am frankly appalled that Senators, or at least their staffers, did not recognize the outrageous nature of this statement immediately. For the investing illiterate, imagine that when you purchase a home, the home inspector sizes you up before the inspection. He concludes that you are either very knowledgeable about carpentry, electricity, and plumbing or that you have not a clue. If you are the former, you get a detailed inspection, the latter (95% of all home buyers) just get charged a fee and receive an inspection which is significantly less rigorous. Moody's is supposed to be an impartial observer, evaluating the assets with the same degree of concern regardless of the parties involved. When Kolchinksy attests that he would have paid closer attention to the deal had he know that Paulson held the short position, he is implying that the quality of his work as rater depends on his perception of the investor. It could alternatively mean that Kolchinsky did not understand that a synthetic CDO requires a short investor, but I will go out on a limb and surmise that while he is apparently not a bright individual, he can not possibly be that oblivious. I do personally think Kolchinsky isn't very bright, and offer as evidence his own statement as well as the fact that Paulson's investing prowess wasn't well known until a year after these deals occurred in early 2007. In other words, Kolchinsky is wrong to think Paulson's identity matters, and even less believable for thinking that he would have used it at that time. Be that as it may, if I ever invested in a deal that was rated by Kolchinsky's team, I would begin considering a civil fraud suit against Moody's for any deal that blew up on me.
Interestingly enough, Sen. Levin questioned Daniel Sparks, head of Goldman Sachs' mortgage desk, on this very subject and Mr. Sparks expressed astonishment that a Moody's employee would say something like that. Senator Levin was lost in the sauce (not just at the moment, the entirety of his performance during the panel leads me to question his ability) and the whole episode floated well over his head as well as those of the reporters in the room. It is equally troubling that Pulitzer prize winning reporters don't pick up on this as the real story. Moody's and S&P are the largest rating agencies in the world, and in any given week their credit upgrades/downgrades are responsible for more market movement than the mortgage desk at Goldman Sachs. If they are not competent enough to do their job on a synthetic CDO, what about whole countries like the PIIGS (Portugal, Ireland, Iceland, Greece, and Spain)?
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