Goldman Sachs brouhaha

[Robillard]

I'm having a little trouble following the Goldman Sachs controversy that cropped up last week. If you are following this issue, could you please comment or clarify things?

It is my understanding that Goldman is being sued by the SEC for failing to disclose adequate information to investors in a collateralised debt obligation (CDO) that they were arranging. That CDO was partly arranged (or advised) by Paulson & Co., which was intending short the CDO in the hopes of profiting from the collapse in value in residential property. Paulson & Co. helped pick which sub-prime mortgages would underlie the CDO. This point was not disclosed to investors. Of course, the rest is history.

While I can understand that regulators and investors are upset about the asymmetric information and weak disclosure issue, this does not appear to be why people are so bothered by this situation. I think that people are more upset that Goldman had a hand in arranging CDOs, period. People may also be bothered by an investment dealer appearing to collude with a short seller.

Negligent information disclosure aside, I'm not convinced that it was morally indefensible to arrange CDOs, or to facilitate short sellers for that matter. As an investment bank, it is Goldman's job to bring together parties that supply and demand capital. Structuring the CDO was part of this job. In this situation, I'm not clear whether it was Goldman's job to protect the investors (ignoring the information disclosure issue). Goldman was not really acting as their agent. And I think the investors in this case were supposed to be pretty sophisticated financial institutions and investment funds.

Maybe I'm missing part of the story here. From the perspective of the devil's advocate, aside from the information disclosure issue, what was it that Goldman Sachs did that so terrible?

[OptsyEagle]

You got it. That's it.

I think the biggest issue is that Goldman Sachs help create many of the mortgage related securities that went belly up and caused an economic meltdown. The part the average Joe cannot stomach is that not only did Goldman Sachs make billions on these things, but after it is all said and done, with taxpayers forking over Trillions of dollars and about 20 million American's losing their jobs and homes, they are back making billions again.

The real issue is, however, did they do anything that anyone of us (assuming we are all ethical) would not have done. I suspect not, but politically they make a good villain.

[Dana]

You got it. That's it.

I think the biggest issue is that Goldman Sachs help create many of the mortgage related securities that went belly up and caused an economic meltdown.

At the same time they created a hedge product in partnership with Paulsen hedging against the very ABCP products they conceived. They had a vested interest in these products going under. The feds are alleging a huge, undisclosed conflict of interest.

At least that's how I understand it.

[CanadianCapitalist]

My understanding is Goldman is accused of helping Paulson pick out the CDOs he wanted to bet against, while selling the same CDOs to other investors. The Feds see a conflict of interest here.

[$1600 Gold by 2011]

Regulators allege “Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party,” SEC Enforcement Director Robert Khuzami said in a statement. In other words, Goldman and a hedge fund client put together a ball of sub-prime crap designed to fail and bet against it. Goldman also took out insurance on those same mortgage backed securities from AIG–yes, the same AIG taxpayers bailed out to the tune of $180 billion.

This is just the tip of the iceberg. The bank of international settlements put the (totally unregulated) otc derivatives market at $600 trillion and some say that's being conservative.

[Robillard]

@Dana

A collateralised debt obligation is not the same as asset-backed commercial paper, though they are similar in that they are backed by other securities as collateral. Paulson & Co. is a hedge fund, but from the sounds of what they were doing, they were not hedging in this case. They were speculating on the collapse in the value of residential property. A CDO is not a "hedge product" (I'm not sure what you mean here). CDOs are a kind of flow-through fixed income product, in which the interest and repayments of principal from the collateral are redirected to the investors based upon the tranche in which they have invested.

@$1600 Gold by 2011
The figure that you have mentioned about the size of the OTC derivatives market may be a bit misleading to people who don't know much about derivatives. The $600 trillion figure refers to the "notional value" of outstanding OTC derivative contracts. It does not reflect the value that the counterparties have at risk.

If I engage in fixed-to-floating interest rate swap on a notional amount of $1 million, I do not exchange the $1 million with my counterparty. Instead, we exchange the interest rate payments. Furthermore, there is no situation in which I would be on the hook for paying $1 million to the counterparty.

@CanadianCapitalist
That is also my general understanding of the case, though Goldman Sachs is not accused of having a conflict of interest. It is instead accused of failing to disclose the advisory relationship (and short position intentions) of Paulson & Co. to investors. While failing to disclose this was wrong (if true) IMHO, I don't think that Goldman's role on its own was morally wrong. As I see it, Goldman was simply connecting willing buyers and sellers. Paulson (the seller) specified which mortgage pools it wanted to (short) sell. Goldman structured a CDO that would let Paulson get its short position, while letting the investors get the long position they desired. Granted, the investors didn't know that Paulson was on the short side, but I don't think that this knowledge would have necessarily changed their investment decision.

What duty of care did Goldman owe to the investors? As far as I can tell, none. Maybe I'm missing something here. In this situation, Goldman Sachs may be analogous to a used car salesman selling a lemon. Just because a used car salesman sells a lemon, doesn't mean that they have done anything wrong. It is only wrong if the salesman lies or deceives about whether the car is a lemon. If Goldman lied and deceived investors, then I think they deserve all the opprobrium they have received; however, I don't (yet) think there was anything wrong with Goldman arranging the deal.

[CanadianCapitalist]

The allegations in the SEC complaint are not limited to just the fact that Goldman failed to disclose Paulson had a short position in the subprime mortgages. It seems to me the primary case is that Paulson helped select the mortgages in the portfolio and Paulson had a short position in those mortgages.

SEC Charges Goldman Sachs With Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages

According to the SEC's complaint, filed in U.S. District Court for the Southern District of New York, the marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. The SEC alleges that undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.

[CanadianCapitalist]

From BACCHUS to ABACUS: Exhibit A in Defense of Goldman Sachs


Robillard, you might be interested in this post by Jeff Matthews. He thinks SEC's case is weak as well because the buyers weren't exactly small investors and should have known better. I read in some news report that Bear Stearns passed up the opportunity to do this deal fearing "reputational" risk. I'm a total non-expert, so it sounds to me then that this is a gray area.

[forgetmeknots]

The SEC is really one to talk....

I wonder who made this trade, right before the GS announcement...

[Berubeland]

http://abcnews.go.com/Business/goldm...ry?id=10917635