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It's Not Just Goldman—It's the Clients

What the SEC's surprising charges really mean.

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Can money be made on Wall Street without manipulation? These days, if you believe it can, you're in lonely company.

Take the remarkable example of the Securities and Exchange Commission's case announced today against Goldman Sachs (GS). While Goldman headlines are as rare as air molecules, the Securities and Exchange Commission nonetheless got everyone's attention with this one: "SEC Charges Goldman Sachs With Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages."

Here's what the SEC alleged: That Goldman Sachs helped create a type of security based on subprime mortgages that was designed to fail, and didn't tell investors the details in any of the documents it used to sell the thing. That's a big offense. Here's how it worked: A giant hedge fund that was a big Goldman client paid Goldman to create the security, one of several that bor the name Abacus. The hedge fund picked out the contracts on bad mortgages it wanted in there. Then the hedge fund bought insurance against Abacus in case it failed—which, of course, the hedge fund must have known it would, because the hedge fund created it. Goldman Sachs then sold the hedge fund insurance against Abacus in the form of credit-default swaps. The hedge fund paid Goldman rich fees of $15 million for the alleged deal, a good bargain considering the hedge fund made $1 billion on those credit-default swaps, according to the SEC. Investors, however, took it on the chin. Abacus just kept failing and losing money: Goldman's deal closed in April 2007, and by January 2008, 99 percent of the subprime mortgages it contained had been downgraded.

That's a pretty interesting case of gaming the system—and a very big deal. The markets pitched Goldman stock into the toilet today, taking more than 13 percent off the value of the bank's shares. Goldman is the biggest fish on Wall Street, and the SEC has cast a strong line to hook it.

But wait. By focusing on Goldman, the SEC completely buried the lede: Paulson & Co. was the giant hedge fund that allegedly created and shorted the toxic mortgage bundles.

If the SEC's complaint holds up, that's even bigger news than Goldman's problems. You'll remember Paulson & Co. from absolutely everywhere on TV, in newspapers, and the media, in which the fund has been referred to exclusively in heroic terms for being among the first to see and bet against the subprime crash. The fund, run by John Paulson, made more money than anyone else on the subprime housing crash—the funds were up about $15 billion in 2007, the Wall Street Journal reported at the time. Paulson himself profited richly, with around $3.7 billion in personal profit. Paulson & Co. has grown to $29 billion under management and a Canadian firm even created a special product allowing regular investors like you and me to make the same bets Paulson makes.

Yet the SEC is implying that Paulson didn't just see subprime mortgages crashing and place his bets; he allegedly gamed the system, lumping bunches of contracts on toxic subprime mortgages together in order to bet against them and then keeping his involvement secret with the help of his bankers. Readers of Gregory Zuckerman's immaculately reported book, The Greatest Trade Ever, won't be surprised: on page 179, Zuckerman describes Paulson's extensive meetings with banks including Goldman, Bear Stearns and Deutsche Bank to "ask if they could create CDOs that Paulson & Co. could essentially bet against. Ironically, it was Bear Stearns that rejected the offer: "[Bear Stearns trader Scott Eichel] worried that Paulson would want especially ugly mortgages for the CDOs, like a bettor asking a football owner to bench a star quarterback to improve the odds of his wager against the team...he felt it would be improper." Eichel told Zuckerman, "It didn't pass our ethics standards; it was a reputation issue, and it didn't pass our moral compass.

But here's the real blockbuster. Abacus wasn't just any old mortgage-backed security. It was one of a toxic group that nearly brought down insurance giant AIG, as the New York Times pointed out last December. Goldman Sachs sold credit-default swaps to Paulson, according to the SEC. That left Goldman holding the risk on Abacus. According to a nice breakdown by the Wall Street Journal this week, here's how Goldman handled it: "Goldman bought credit-default swaps from AIG to hedge the securities firm's positions in some of the [Abacus] pools. When many subprime borrowers began defaulting on their loans in 2007 and 2008, the Abacus CDOs dropped in value, and AIG had to post billions of dollars in cash collateral to Goldman."

The Goldman/AIG/Abacus information is old news by now. The SEC's allegation that it was Paulson behind this process is what changes the game.


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