Just as Senate Majority Leader Harry Reid vows to take up Wall Street reform, and just as the Republican leadership comes out against any form of meaningful regulation of financial firms, Goldman Sachs gets hit with a civil fraud suit by the Securities and Exchange Commission alleging the investment bank created and sold mortgage investments that were secretly designed to fail. The facts of the case, just like the investment vehicles created, are highly technical. But a quick translation of the jargon reveals nothing more than good old-fashioned fraud.
The investment vehicle at issue of the suit is called the Abacus 2007-AC1. The mastermind behind the deal was prominent hedge fund manager John A. Paulson. Goldman let Paulson hand select mortgage bonds hat he believed carried higher credit ratings than the underlying loans deserved. Goldman would then place insurance on these bonds, called credit-default swaps, inside the Abacus bundle. Goldman then sold the Abacus product to investors like foreign banks, pension funds and insurance companies. At the time Paulson believed the housing market was overheated and destined to crash, and this vehicle allowed Goldman to continue to profit off of bundling and selling mortgages while simultaneously betting those mortgages would fall into default.
Goldman was just one of many Wall Street firms that created these kinds of complex mortgage securities at the height of the housing boom. These securities, known as synthetic collateralized debt obligations were essentially insurance policies written on mortgage bonds. If the mortgage market continued to do well then the investors who bought products like Goldman’s Abacus notes would have made money from the insurance premiums paid by other investors like Paulson who were betting against the housing market. But since the housing market went bust, just like Paulson and Goldman had predicted, the result was that investors lost billions while Goldman and Paulson made billions.
And the only reason they got away from it is because these kinds derivatives, remain unregulated by Congress. Basically a derivative is any kind of financial security, such as an option or a future, that gets its value in part from the value and underlying characteristic of an underlying asset. Typically that underlying asset is a bond, stock, currency, etc… For those who play the derivatives market they are essentially betting that the value derived from that underlying asset will either increase or decrease by a certain amount within a certain fixed period of time.
Derivatives are not in and of themselves inherently bad or dangerous products. In fact, many investors see derivatives as an essential tool in the kit of an informed investor. Of course, that requires that investors be given the full-range of relevant information related to the underlying value of the derivative asset and any other bits of relevant information, such as whether or not the firm selling the derivative is actually betting against its performance.
And that right there is the heart of the claim against Goldman–that it willfully withheld relevant information from investors while simultaneously betting against them. It was a no-lose proposition for the investment bank. They made money on the sale of the original product, so if the housing market continued to rise they faced no risk. But if it didn’t, and we all know it didn’t, then not only in was insured against any losses, but it had effectively passed those losses onto its’ clients.
As Wall Street reform heats up in the coming weeks and months it will be interesting to hear just how those opposing derivative regulation plan to excuse this kind of behavior. Of course Goldman denies it’s done anything wrong. But ask the teachers pension funds, mutual fund holders, and taxpayers who are on the hook for the AIG bailout and you might get a different story.
photo courtesy of aresauburn via Flickr