In a post 8 days ago I said the Goldman Sachs SEC case was foolish and wouldn't stand up in court. I also surmised that it would likely be settled instead. Various news reports indicate that this is now likely to occur. The SEC isn't dumb, this case won't go to court but the settlement will not likely occur until after the President signs the financial reform bill which is currently in reconciliation. As politics go, this saga was a shrewd move by the White House but somewhat disconcerting in that it was intended to capitalize on the relative naivete of the typical voter or CNN watcher. Perhaps the best takeaway from the whole episode is just how clueless Senators are, Sen. Levin takes the cake in my opinion.
A few readers asked about a better explanation of the synthetic CDO, how it's built and why I wrote that the case was a farce. It's probably best to explain this in steps.
1) Goldman Sachs acted as a market maker for this transaction. A market maker's job, simply put, is to match a buyer and seller in the market place. Occasionally in the finance world this requires that market maker take one side of the transaction. For instance, assume investor A wants to sell 100K shares of General Electric at $16 per share and hires Goldman Sachs to do this. Goldman Sachs finds investor B who wants 90K shares at $15.90. A and B settle on a price of $15.95, B buys 90K shares, and Goldman buys the other 10K to facilitate the transaction. It will then sell these other 10K shares to another investor. The market maker's central role is to find a counter-party to the trade desired by their client, Investor A. They could care less about the price as long as it is fair according to similar market transactions. This is very different from a fiduciary. Most people are familiar with that term in reference to a real estate agent hired by a buyer. The fiduciary must act only in the best interests of their client, the buyer. For those of you who have been part of a real estate transaction, it goes without saying that the agent can not be a fiduciary for both the buyer (seeking to minimize the price) and the seller (maximizing the price). This then is a very different role than one played by Goldman Sachs as a market maker and logically follows that you can not be both market maker and fiduciary.
2) John Paulson, a now famous hedge fund manager with a negative view of the housing market in 2006/7, came to Goldman Sachs and requested to short (bet against) the housing market through the use of a synthetic CDO. As explained below, a synthetic CDO is a zero sum transaction where two parties with opposite views on an underlying asset (the housing market in this case) construct a legal wager through the use of credit default swaps. A credit default swap is very similar to your standard home/life insurance policy, for a yearly fee the purchaser gets insurance which pays out if the underlying mortgages default or some other credit event occurs (downgrade, etc...) instead of a fire/earthquake/tornado or death. As an example, Jeff Greene, who is now running as a Democrat for the Florida Senate seat, had the same view as Paulson and purchased $1 billion in credit default swaps (insurance on mortgage bonds) for a yearly fee of $12 million betting that the bonds would default (source: The Greatest Trade Ever.) Greene apparently made about $500-800 million through this investment strategy, quite the payoff.
3) Goldman hired ACA, an investment management firm, to select the assets (mortgage bonds) that the synthetic CDO "referenced." (In keeping with our home insurance policy example, ACA was responsible for choosing the house and the occupants which is what determines the risk of fire). Paulson had a hand in choosing these as well, but the final approval authority was ACA. As I explained below, this is not unusual if you think of any other wager. You would not bet on a horse race without knowing the participants, distance, surface type and so on. For a successful bet to take place, both parties must agree to all the terms. Only the fool hardy would blindly accept the conditions first proposed by the opposing bettor, children on playgrounds instinctively know this. ACA had to keep Paulson happy otherwise he would walk away from the transaction which would cause it to collapse since it requires two parties, one short and one long.
4) ACA and Goldman then found parties to take the other side of the bet. These large banks, IKB and ABN (as well as Goldman), sold Paulson the credit default swaps. The banks agreed to pay him if a default occurred while Paulson paid them a yearly fee.
5) The bonds defaulted soon afterward and Paulson made a fortune (around $1 billion according to various news reports.)
This is a very simple explanation of what happened. The SEC's complaint centers around Goldman allowing Paulson to have a say in the mortgage bonds which were used and whether the banks were informed of this. An impartial observer would conclude that banks must have known there was a party shorting the transaction and that the other party must have agreed to the underlying mortgage bonds. To me, a non-lawyer, this about as ridiculous an accusation of fraud as you could make.
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