This is juicy — the New York Times just reported —
Goldman Sachs, which emerged relatively unscathed from the financial crisis, was accused of securities fraud in a civil suit filed Friday by the Securities and Exchange Commission, which claims the bank created and sold a mortgage investment that was secretly devised to fail.
The move marks the first time that regulators have taken action against a Wall Street deal that helped investors capitalize on the collapse of the housing market. Goldman itself profited by betting against the very mortgage investments that it sold to its customers.
Goldman investors lost billions, the article says, but Goldman ended up making money on the “investment instrument.”
The “instrument,” called Abacus 2007-AC1, was packed with mortgage bonds chosen by John A. Paulson, a hedge fund manager widely praised for correctly predicting the bursting of the housing bubble. The SEC says Paulson chose bonds he believed would default. Marketing materials for Abacus claimed the bonds were being chosen by an independent third party, when in fact they were chosen by someone intended to make a lot of money from the deception.
I’m not entirely clear how one might “bet against” a fund, but as I understand it Paulson and Goldman Sachs took a ton of insurance (mostly from AIG) on the fund so that they would clean up when it went bust.
I hope this signals the Obama Administration is getting tougher on the Golden Parachute crowd.
Update: Andrew Leonard at Salon clarifies things a bit:
According to the SEC complaint, in early 2007, at the request of John Paulson, a prominent hedge fund trader, Goldman Sachs created a security — called Abacus 2007 AC-1 — built from underlying mortgage-backed securities that Paulson had cherry-picked as most likely to blow up. While Goldman Sachs then turned around and sold the security to its own clients, Paulson and Goldman bought credit default insurance on the underlying mortgage bonds. Paulson and Goldman cashed in, while Goldman’s clients lost millions. At no time did Goldman divulge Paulson’s involvement to its clients.
Update: Paul Krugman’s column was written before this news came out, obviously, but it sorta kinda relates.
Update:
The case shows how pathological the markets had become. The cart was beginning to drive the horse: rather than packaging mortgage-backed securities together and selling them around the world in order to spread risk, such products were being created for the sole reason to permit traders to short them and make money on their almost certain failure. As blogger Yves Smith pointed out in her withering review of Michael Lewis’s new book, The Big Short, such short sellers kept the subprime market going long after it should have died a natural death by creating products that fooled investors into thinking the market was healthier than it really was.
Even as I keyboard, someone at Reason must be frantically writing a “Hit & Run” blog post that blames government regulation.
Update: The libertarians at Reason so far haven’t commented on the Goldman Sachs situation. So far the only pushback I’ve seen from the Right is that Goldman Sachs was Barack Obama’s biggest Wall Street contributor during the 2008 elections. In other words, it’s the old McCarthyite guilt-by-association trick.
Goldman Sachs was a major contributor to both the Obama and McCain campaigns, according to OpenSecrets.com, although it’s true Goldman Sachs gave more money to Obama. But then, so did just about everybody.
McCain’s top five contributors (individual contributions bundled together by industry):
Merrill Lynch $373,595
Citigroup Inc $322,051
Morgan Stanley $273,452
Goldman Sachs $230,095
JPMorgan Chase & Co $228,107
Looky there — they’re all from the financial sector.
Barack Obama’s top five contributors:
University of California $1,591,395
Goldman Sachs $994,795
Harvard University $854,747
Microsoft Corp $833,617
Google Inc $803,436
A little more variety, there.
Update: Reason, the Cato Institute blog and the Lew Rockwell site still haven’t posted anything about the Goldman Sachs issue as of 5:30 pm. I guess they’re still struggling to find a way to blame government regulation.
Jail time. We want to see jail time. No slap on the wrist. No, we want to see lengthy sentences and forfeiture of both il-gotten gains and any and all licenses the parties may hold.
The only reason that I am not calling for harsher measures is because I am opposed to capitol punishment.
The way you bet against a fund is to buy a credit default swap.
A credit default swap is like a life/disability insurance policy. Imagine someone buys a bond. I can pay an insurance company to (depending on the policy) either pay me the face value of the bond, or the difference between what I get back, and the face value, if the bond offering defaults. As you can imagine, if you sink a lot of money into a bond offering, a credit default swap can be a good way to hedge your risks. Sure, you lose some of your profits (interest on the bonds), but in return, you get assurance that you’ll get your principle back!
“But wait!” you say. “John, you said to imagine ‘someone’ buying a bond, and then you said that you could buy the credit default swap, to hedge your risk. But you’re not at risk if you’re not the bond holder!”
And you’re correct. That’s how you bet against a fund. You buy a credit default swap that pays off if the fund defaults.
And yet GS could argue that it was being responsible by hedging its bet when it bought credit insurance. A lot of traders (who wish to survive long term) operate this way – take a position, but pay a small additional amount for insurance should the position go south. In other words, GS’ trade has the appearance of responsible trading.
Minimally, the Feds have to prove that GS knew the fund would likely blow up, but did not reveal this to its customers.
“A lot of traders (who wish to survive long term) operate this way – take a position, but pay a small additional amount for insurance should the position go south”
This doesn’t sound like it meets the “market is always right” mythology so prominent among people these days. You are probably right, but it takes the *risk* out of the free market and I don’t like it.
CAUP:
The CDS doesn’t actually take the risk out of the free market – it transfers the risk to another party. The problem was that the other party didn’t (couldn’t) value the risk appropriately.
Here’s the hilarious thing about this blowup. Credit default swaps were available for a low price. Why? Well, they were on AAA rated bonds; the bond rating agencies wouldn’t rate these mortgage-based bonds as AAA if they weren’t good bonds. Good bonds almost never default! The price of the swap is pure profit!
Meanwhile, back at the rating agencies, the raters were saying “We should rate these bonds as AAA. They’re almost certain not to default. You know how we know this? The insurance companies charge tiny premiums for a credit default swap. The insurance companies would charge a boatload of money for a credit default swap if these were likely to default!”
Now, both of these are oversimplifications, but that seems to be a large part of the reasoning. Both the insurers and the credit rating agencies figured “the other guy must be doing his or her job right” and made their judgments accordingly. They were disastrously wrong.
And at its root was still the idea that the bottom wouldn’t drop out of the real estate market. As long as housing prices continued to climb, the mortgage backed securities *would* hold value. So, both the credit raters and insurers were covered, up until the bottom *did* fall out.
Check out this weeks This American Life (“Inside Job”). The entire crash was engineered.
I’m with Chief — forfeiture and jail time.
With derivatives which are insurance policies in the form of financial instruments which pay a certain amount depending upon the future value of some other financial instrument. They can be daisy-chained so that you can purchase derivatives based upon derivatives.
I can’t remember the exact figure but the pile of derivatives based on trading prices of oil exceeds by many-fold the actual value of the oil itself that is being traded. Wickipedia states that the world stock market has value of 36 trillion but the derivatives based upon that market are valued at 791 trillion…basically bets on where the stock market or its derivatives might be at some point in time.
There is a legitimate use for eliminating downside risk by investors, as are puts and calls that can be made with almost any brokerage firm but derivatives can also be structured so that losses are many times more than losses suffered by the actual stocks underlying the rat’s nest of derivatives.
Matt Taibbi of Rolling Stone gets into it quite a bit and has done a great job of shining the light on the practices that were formerly only understood by insiders and which can be structured in such a complicated manner so as to defy the understanding of those who are sold these financial instruments, not to mention those in congress.
They also offer a situation ripe for subterfuge since they are gambling at their core. This allows, as in the case of Gold-in-Sacks, insider knowledge of bad investments to lead to huge profits as bets are made against it. There is a very fine line between Goldman Sachs saying that they bet against their own financial instruments to protect themselves from downside loss or because they knew how bad those instruments really were — the only differentiator being “did they know?” Evidently the SEC thinks they really did know so derivatives purchased by any having that knowledge constitutes insider trading of sorts.
The problem arises when risky derivatives bundles make their way into pensions, the funds in your grandparents retirement portfolios, bank holdings (and not on the books as “leverage”) or funds offered as limited selections to teachers and other professionals, without their knowledge, assent or even understanding. The results can be horrific and everyone gets rich EXCEPT the ones who the salemen claimed would benefit.
One of Taibbi’s most recent RS articles describes how the city of Birmingham, AL needed a 250 million dollar sewage treament facility and after a few crooks in office and big investment house got hold of them they were left with a bill of 1.5 billion. Only a few who help office are serving time, the city is bankrupt and derivatives which defied the understanding of those who purchased them played a major role. But from the perspective on the big financial firms it is all legal and they will see no jail time.
This is what those in Congress have wrought and the GOP steadfastly opposes fixing it. It is the money from the crooks who engineered the de-regulation that made these practices possible which keeps a large part of the GOP in office.
Sorry to blogificate on so but this really pisses me off.
And I’d like to know how a corporation like AIG, a primary issuer of contracts insuring bonds if the issuer defaulted, was allowed to obligate itself to the tune of $500 billion when it had 5 times less than that in assets – especially since what it was insuring was toxic.
And then there’s John Paulson. If a person can be toxic waste, he would qualify. As a former Bear-Stearns (remember them) employee, he made about $3 billion in ’07-early ’08 by shorting subprime mortgages. And it wasn’t like he was flying by the seat of his pants because in ’07 it was common knowledge that 30%of mortgagees were not able to make their first payment.
The whole damn Street is and always has been (remember 1929) a massive criminal operation allowed to practice unfettered by the politicians who stuff themselves at its trough. Jail time, of course, but how about restitution to individual investors etc. who lost their shirts. (And if I hear “buyer beware” one more time from the Street types, I’ll puke.)
Bat$hit Crazy Overdrive. I’d really like to see her getting checked in to the in$titution her and her Py$chiatri$t hu$band own. He could do a full frontal lobotomy (who would know the difference?) – I want to know would she still get to keep her $250,000.00 farm $ub$idy? – You Betchya)
http://thinkprogress.org/2010/04/16/bachmann-fed-owns-banks/
More G(NO)P comedy. Oh Grover, its okay – just say “The Sheriff is Near” – we know you want to. Faux/Pravda will just say your comment was taken out of context by liberal main stream media. “Saint Rupert please forgive me for I know not what I say (Shouldn’t that qualify me to be a “Faux and Freinds” commentator?)
http://thinkprogress.org/2010/04/16/norquist-barbour-english/#comments
Barry Ritholz, often seen on financial news TV, explains it:
Chief,
This is the one case where I might, just might, be OK with torture…
But not in the governments hands, let the people get a hold of them and decide. Those that live can now say they “survived the new market of idea’s.”
Just kidding! 🙂 I’m ok with jail time and forfeiture. Life in prison for all, and ALL family asset’s seized. Hey, if you can spend the rest of your days in jail for taking the life of ONE person, how much time is too much time for killing the economic future of millions?
To paraphrase Obama, ‘I’m just keeping you away from the torches and pitchforks.’ Democrat’s, do the right thing, make a federal case of this, punish the guilty, and set up strong regulations. It might help in November. It sure couldn’t hurt…
The best I could come up with was Mel Brook’s The Producers. They purposefully tried to create the worst play ever, lose their investors money and pocket the proceeds.
I totally get it now.
To paraphrase Obama, ‘I’m just keeping you away from the torches and pitchforks.’
Obama needs to give up on that and let justice take its course. Show GS what they bought for their almost $1 million in campaign contributions… a responsible president. The Righties may forget that the majority of Obama’s campaign funds came from small donors, but I’d like to think Obama and his inner circle remember. I hope I’m not being naive.
btw, I have a dumb question… is John Paulson related to Hank? That would not surprise me.
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I’m not a lawyer, butit seems to me that the investors who lost billions were victims of fraud – in a legal sense. In some cases and under some jurisdictions, that means the victim can sue for triple damages.
The SEC is doing all the heavy lifting in a legal sense. They can demand documents that GS dare not shread – those same documents would be hagged over page-by-page over a period of years if a private suit was being brought.
So hypothetically, the gov’t legal action may open the door to a class-action suit by investors that will knock their socks off. Together – over a period of years – the cumilative effect to investor confidence in GS should be devastating.
But I’m not a lawyer.
As somebody mentioned, it is the scam in ‘The Producers’, except they went even further and got AIG involved. Imagine if Zero Mostel and Gene Wilder had AIG too…
So Boehner’s argument is that Obama is bad because he did something against the interest of a major campaign contributor? And, by implication, that the Republicans would never do that? That’s a winning argument , for sure.
It’s OT now I know but I went back to “Still Deranged and Confused” and it was closed to posts. It was so pertinent to that post and the one that preceded it.
John Cleese of Monty Python really nails it on extremism…
Reading about Paulson’s 3 billion plus a year earnings makes me nostalgic for the good old days when Michael Milken was the leader of the pack with his measly 400 million dollar skim. To think that we used such harsh adjectives like obscene to describe Milken’s take from wall street at the time, when in retrospect we can see he was a such modest taker.
It makes me sick that these people got away with scaming so many people. I hope they get convictions, and those convictions lead to changes that make sure this type of thing never happens again.