Goldman Fraud Charge: It's The Sachs on Wall Street, Not Saks Fifth Avenue

Last Updated Apr 22, 2010 10:08 AM EDT

Today there's a reward, I hope, to readers who have indulged the background posts (1, 2 and 3) of the last few days: my perspective on last week's fraud charge brought by the SEC against Goldman Sachs.

I'm not surprised that the SEC brought the charge: Goldman is the biggest elephant in the financial world these days, and because they are such astute businessmen, they made a boatload of money straight through the financial crisis, and indeed profited from it. The SEC must have found GS an appealing target, figuring no one -- outside the firm, that is -- would object to them being made some sort of scapegoat or allegory for the damage the financial world brought on us.

But to make the fuss over this particular transaction seems misdirected. It was a private deal, among big investors who considered themselves knowledgeable and sophisticated. Such big players prefer to be excluded from the protections afforded to little-guy investors, and accordingly the authorities allow them to trade among themselves in any way they want.

Yes, there were government bailouts made in the end, but these investors went in to the deal willingly, and should have known, or at least contemplated the possibility, that they would be taken to the cleaners. It's Goldman Sachs, after all, not Saks Fifth Avenue. Or as one of my bosses at a sharp-elbow Wall Street firm used to remind us: "This isn't the Red Cross."

The investors and aggrieved parties in this deal -- IKB, a German bank and ACA, a specialist firm in collateralized debt obligations, and companies related to them -- should have known this was a high-stakes, buyer-beware sort of game.

You've probably read a dozen descriptions of that transaction, but I am going to try my hand.

  1. According to the SEC, hedge fund manager John Paulson wanted to get against the subprime mortgage market in a big way. (Remember my pointing out in Part 3 of my buildup that Fed chairman Ben Bernanke felt the same way -- perhaps without the same conviction.) In early 2007, Paulson and his folks surveyed the U.S. mortgage landscape, and selected 123 mortgage bonds that he thought were especially likely to suffer delinquencies.
  2. He asked Goldman to make them into a package -- a collateralized debt obligation -- and find someone to buy it. Goldman did, hiring a CDO specialist called ACA to give the thing credibility. (Paulson also shopped the idea to the late Bear Stearns, according to a recent book on the crisis, but it didn't pass Bear's smell test.)
  3. Crucial to the way this plays out is the SEC's contention that ACA did not know that Paulson, who was visible as the sponsor of the deal, intended to bet against it. (The Financial Times has a great writeup.)
  4. The deal is done! with Goldman taking a small piece, ACA, who assembled the thing, buying $950 million, and IKB, a German bank, taking a $150 million stake.
  5. Paulson sells the CDO short, via a credit default swap.
  6. Less than a year later, the CDO turns to dust. ACA and IKB lose big, and Paulson makes $1 billion on its bet the mortgages would default.
OK, I get what the SEC is doing -- they need to punish someone, and Goldman is the people's choice. But the ones that really need the lesson are ACA and IKB. By entering this deal in the first place, in striving for yields that simply didn't exist in the marketplace at the time, they added to the froth of the mortgage market and increased risk to the financial system.

Granted, the German banks didn't do well throughout any of this, we learn from the FT:

Look at any transaction that turned sour during the financial crisis and there is a good chance there will be a German bank close to the wrong end of the agreement.
But ACA is an expert in this area, or was, and should have, or could have, known how faulty the underlying mortgages were. If there were rules on the books against not paying attention, maybe the SEC would be suing them.

Did you watch The Sopranos? In a few episodes the fellows were running a poker game in a motel out by Kennedy Airport, and they would find patsies interested in playing all night with the big boys (in one episode, Frank Sinatra Jr. was at the table, paying himself, perhaps presaging the role of CDO specialist ACA). Of course they lost money -- how can you expect to win when you sit down at a poker table with Tony Soprano?

Of course someone made a bundle when the CDO failed. Let me be clear, especially to my friends in media relations at Goldman -- I'm not saying Goldman Sachs are gangsters or have broken laws. But they are the toughest guys around.

For large investors to expect that Goldman disclose and divulge every possible detail, and foretell everything that might change or go wrong in the deal, in a market that even the Fed chairman acknowledged was imperiled, is simply naïve. They are the smartest and richest guys around, and everyone in the institutional market knows they didn't get that way by sharing.