by James Dunne – The CREative Department
One topic has been impossible to avoid in business news the past few weeks: the case against Goldman Sachs.Â Civil charges filed by the SEC, a grilling by the Senateâ€™s Subcommittee on Investigations, and now a criminal investigation by the Justice Department. Â With all the opinions and analysis flying around out there, I felt the need to pitch my two-cents in.
Clearly, the senate hearings were just intended to be a public flogging, one that gave politicians a chance to scold the big money makers at Goldman while scoring some populist points with their constituencies. There was no smoking gun, nor was anyone really expecting anything material to arise out of the Senate hearing â€“ that will be the job of the SEC, as they are alleging fraud, which from what I gather, theyâ€™re going to have a tough time proving. The case will boil down to disclosure, and if material information regarding the Abacus Synthetic was withheld.
To summarize the allegations, the SEC has filled civil charges claiming that Goldman did not disclose conditions surrounding the Abacus 2007-AC1 Synthetic to investors; specifically, it claims that Goldman failed to disclose that Paulson & Co. (a hedge fund) had a say in constructing the specific reference CDO that was used as the reference for the Abacus Synthetic. The SEC also claims that Goldman did not disclose to ACA (an independent third party that was selected to manage the security) that Paulson & Co. planned to short the Abacus Synthetic, but rather ACA was told that Paulson would take a long position on Abacus.
Unless youâ€™re an investment professional this may all sound like a lot of financial mumbo-jumbo, so let me attempt to explain.Â The Abacus security in question is a â€śsyntheticâ€ť CDO.Â A CDO, or collateralized debt obligation, is a portfolio of mortgages, which is typically sliced into traunches of varying risk for which bonds are issued at each risk level.Â A synthetic is a derivative- meaning it derives its value from another underlying product, in this case, a CDO, but ultimately hinges on the performance of sub-prime mortgages and whether or not the owners default on them. Â However, Synthetic CDOs, which Abacus was, are actually structured as a credit default swap (CDS), which is essentially insurance on something â€“ in this case the insurance is on the performance of the sub-prime mortgages that make up the reference CDO.Â Confused yet?
The crux is that this product was synthetic, and because neither counter-party to the trade actually owned the reference securities, it was essentially a bet on the housing market- the investors taking the long position betting the market would continue to rise, and the short position betting the market would fall.Â The counter-parties to the trade were both taking a risk, and despite language from Goldman traders making â€ślemonade from big old lemons,â€ť Goldman continues to maintain that the investors who took the long position (who lost large amount of money because the sub-prime mortgages defaulted), were intelligent and informed institutional investors, which it seems they were (ABN Amro & IKB Deutsche Indusriebank were the two largest institutions that lost money).Â Paulson & Co., who took the short position and bet that homeowners would default, made $1 Billion on the bet.
In April of 2007, when this deal was structured, the housing boom was still roaring â€“ I should know, I was working as a real estate agent at the time to pay for my college expenses, and at that time investors were throwing money at anything with the words â€śreal estateâ€ť attached to it, so Iâ€™m sure Goldman had no problem finding willing buyers to take the long position on Abacus.Â The opinion on the Street is that Goldman did not do anything legally wrong; however, there are ethical questions that are raised.Â Real estate agents in New York are bound by their fiduciary responsibility, meaning that they must work in an ethical manner and must only work in the best interest of their client or customer (either the seller or the buyer).Â Dual Agency is allowed, but only if it is disclosed to and agreed to by both parties in writing.Â Goldman is a market maker for securities, and under current securities laws they can advise both sides of the trade, and trade on their own account in the security.Â This is analogous to a real estate agent trying to look after the best interests of the buyer, the seller, and the best interests of him or herself.Â The problem here is not Goldman Sachs, but the current regulations that allow this to take place.Â While as a general rule, Iâ€™m in favor of less regulation, securities regulators should look at the real estate industryâ€™s notion of fiduciary responsibility before any new laws are passed.