While reading through news on the SEC’s case against Goldman Sachs, I can’t help but wonder if the charge would have been brought regardless of what happened in the market.
The action against Goldman Sachs comes from their arrangement and sale of mortgage backed collateralized debt obligations (CDOs). In 2006, John Paulson, approached Goldman Sachs with an interest to short housing prices. Paulson clearly believed at the time, correctly, that housing prices were at unsustainable levels; he believed that there was a bubble in the market, and he wanted to make a bet that prices would decrease. In order for Paulson to make a bet against housing prices, there needed to be somebody on the other end to make a bet that housing prices were going to increase. The very essence of a CDO is that there necessarily must be two opposing parties to take different views on a future direction of a product or market.
Goldman Sachs worked with ACA Capital Management and Paulson to put together the basket of mortgages within the portfolio on which the two sides would bet. ACA was also the largest investor betting that the basket would increase in value.
The main issue in the SEC’s case seems to be that Goldman Sachs misled investors by not disclosing to them who was on the other end of the CDOs, Paulson. The SEC does not contend that the investors were unaware that there was someone on the other side, as they were experienced in financial tools, but rather these investors needed to know that Paulson specifically was on the other side.
It seems almost a moot point of determining who is on the other side of a bet. If you are making a bet that you believe to be beneficial, it shouldn’t matter who is on the other side, as long as they are financially sound. If you believe you are making a good bet, the person that is betting against you really shouldn’t matter.
For example, if someone approached you and asked you if you would like to make a bet that the winning horse in this year’s Kentucky Derby will have a final time of two minutes or greater, you might be inclined to take that bet. (Only two winning horses, three total horses, have in the history of the race finished in less than two minutes.) Would you need to know who was betting on the other side that the winning horse would finish in less than two minutes? More than likely you wouldn’t care, as long as you were paid if your bet turned out to be right.
Further, think about the absurdity that would go along with having to introduce all market participants to each other. Investor Y, this is in Investor X, you two are betting against each other, it just doesn’t seem necessary. Another example, when you sell a stock online, or through a broker, someone else is buying that stock, otherwise you wouldn’t be able to sell it, you have no idea who that person is, should the brokerage firm introduce the two of you before the deal is allowed to go through? It seems like it might be more than a little inconvenient, and you probably don’t care who is on the other end of that trade.
Had the investment turned out to be a good one for those investing in the CDOs believing that housing prices would increase, would the SEC still have brought the charges? Nothing would have changed, except that the other side would have made the money. The investors betting for housing prices would have made close to $1 billion and Paulson would have lost close to $1 billion. I would hope, for consistency that the SEC would have brought the same action in that situation if the SEC truly is unhappy about the disclosures that Goldman made about the parties involved in this deal.
I disagree that “[t]he very essence of a CDO is that there necessarily must be two opposing parties to take different views on a future direction of a product or market.”
A CDO is simply an aggregate of hundreds or thousands of mortgages, often subprime mortgages. The goal was to allow investors to benefit from the high interest rate charged on the subprime and adjustable rate mortgages. The purchaser of a share of the CDO would have a guaranteed return equal to the interest received from the homeowners. Basically, you bundle a thousand mortgages with a 10% interest rate into a trust, cut that trust into 50,000 individual shares, and then sell those shares with a guaranteed 10% return (minus administrative costs).
The “tranches” are merely playing to the fact that these were risky mortgages that might not produce the rates of return that would be expected. The first 10,000 shares get the first 10% in, the second 10,000 shares split the second 10% to be paid, and so on. That way, the top shares get paid the full return so long as some money came in. The cost of one share would naturally rise to just below the anticipated earnings of that share.
But there’s no “betting against” anyone in any unique sense. Perhaps all stocks and future markets are “betting against” someone in an abstract sense, but it seems like a stretch of the analogy. More likely, one makes an analysis of the return on the investment and invests based on the potential profit.
Which is why the practice is best described as fraud. The people selling the shares in CDOs misrepresented the likelihood of the expected return on investment (because the underlying mortgages were fraudulently executed, over appraised and unwise). Asking if the case would be brought if the share price kept rising is missing the point–the shares didn’t rise because the underlying mortgages were not what they were represented to be.
The allegation in the complaint is that investors were given the opportunity to bet on whether a basket of securities would increase or decrease in value, and were told that the contents of the basket had been selected by an independent party. If, in truth, the contents of the basket were picked by someone with an interest in seeing the value decline, then that is certainly a material fact that investors would want to know when making their bet on which way the value of the basket would go.
It all sounds arcane and complicated, but it essentiaslly boils down to the allegation that the person held up as being “independent” really was not independent, and that an investor would need to know that fact when evaluating the riskiness of the securities that the so-called “independent” person chose. If the SEC can prove these facts (a big “if,” perhaps), then this is garden variety fraud.
Goldman Sachs is making much of the fact that it lost money on the deal, as proof that it didn’t intend to defraud anyone. However, my understanding is that Goldman Sachs lost money primarily because they couldn’t find enough investors dumb enough to buy the securities and Goldman Sachs ended up stuck with an unsold inventory that declined in value.
You can be sure that Goldman Sachs will be well represented by legal counsel, the SEC staff will be stretched to the breaking point in trying to spread their resources among this and other enforcement priorities, and that the case will eventually settle for a multi-million dollar fine and the entry of some sort of consent decree.
Joseph’s post takes a very common sense approach to the topic of risk and the kinds of risks that investors can be assumed to be aware of. But I would argue that when we look at these very specialized and sophisticated types of derivative securities, the common sense frame of reference (based on our everyday experience) becomes less relevant. Instead, we should limit our focus to what was represented and whether those representations were accurate and/or complete.
No. The action taken by the SEC was not inevitable and the examples you provide highlight the complexities of CDOs. In the interest of full disclosure, I have not read the actual complaint.
Goldman created a CDO and sold it to investors with either explicit or implied assurances that the CDO was a worthy investment. As you correctly pointed out, the fact that someone bet against this product is not the issue. The issue is that John Paulson sold the CDO and later bet against it.
For instance, Imagine I sold you a house and made assurances on the house’s workmanship, quality and superior wiring. If I then secure fire insurance on the house that I sold you, there is at least some hint of fraud or unfairness. Further, the cost of insurance is less than the cost of the initial investment. When that house burns down, people begin to ask questions.
Its like “The Producers.” Goldman realized that a failed CDO would be worth more than a successful one.
If you still feel its not important who the “other party” is then shoot me an email. I have plenty of homes for sale.
While I am saying that I do not believe that it is important “who” was on the other side, I do believe that it was important “what” was on the other side. Within ABACUS 2007- AC1 were specific types of securities, which I do believe were important for people to look at, but I believe that’s more important than who put them together. If you don’t believe that what is in the CDO is a good investment you should not invest in it, or better yet, take the same side as Paulson.
Furthermore, to the point that Paulson picked out the mortgages that were in the CDO, that is not what is said by either the SEC or Goldman, both are stating that ACA managed the securities within the CDO. (See the link to Goldman’s response, and the SEC complain, part D below.) While Paulson had a hand in determining the securities involved, ultimately it was ACA that approved the bundle of securities. Through this process, ACA denied over half of the securities that Paulson suggested.
Finally, ACA was the largest investor with $951 million worth of exposure, and they certainly knew Paulson was on the other end, as they had worked with him.
Complaint: http://online.wsj.com/public/resources/documents/secgoldman2010-04-16.pdf
Goldman’s Response: http://online.wsj.com/public/resources/documents/Goldmanresponse418.pdf
Joseph, thank you for posting the links to the SEC complaint and the Goldman response, and a belated thanks for your initial post, which has inspired one of the best exchanges on the nature of the SEC case against Goldman Sachs that I have seen anywhere on the blogosphere thus far.
I think that if the facts turn out to be as alleged in the Goldman Sachs response, the SEC’s case falls apart. Everyone is waiting to see what “smoking gun” the SEC has in its back pocket. I assume they have one, otherwise the SEC would not have risked proceeding to trial.
However, if the facts are as alleged in the SEC complaint, then I think that those facts do raise a prima facia case of securities fraud under established doctrine. This is not a situation where the SEC complaint assumes a novel or extended interpretation of the securities laws (the way, for example, the Martha Stewart prosecution did). So, while the battle over the evidence is interesting to watch, I do not foresee a similar battle over the scope of the securities laws.
Given this situation, the attempts by some to spin a narrative where Goldman Sachs is cast as the “little guy” being subjected to arbitrary or unfair treatment by the federal government (as implausible as that piece of casting appears) won’t really gain traction with the public. Likewise, the attempts by some to politicize the prosecution, by pointing out the divided vote of the Commissioners, won’t hold water if ultimately everything boils down to the weight of the evidence.
It is worth noting that Paulson and Company has (or will) testify that they specifically advised ACA that they were taking a bearish bet:
http://www.cnbc.com/id/36685026
Thus, the SEC’s prime allegation is likely to be undermined.
Moreover, given the nature of the product, I’m not sure that whether GS informed ACA that Paulson (or anyone else) was making a bearish bet is material.
In simplified terms, Paulson wanted to buy a put option on the CDOs, in which Paulson would make a small outlay (twenty million dollars) in hopes that the market would crash and he would get a potentially large payout (in this case, one billion dollars). The investors on the other side of the trade had to know their exposure (there are derivative pricing models such as the Black Scholes model, which enable an investor to manage their risk).
Certainly, selling options can be a worthwhile and profitable strategy — you get the benefit of the time value of money and most out-of-the-money options expire worthless — so you usually win. However, the risk needed to be managed.
Here, ACA could have and should have managed its exposure and there were thousands of different ways for it to have done so. For example, they could have bought CDOs with different strikes prices or covering additional time frame to reduce their exposure to price swings. (Under the Black Scholes model, this exposure would be represented by Delta.)
Frankly, IMO, ACA is soley to blame for taking an unhedged negative delta position.
Thank you Nick for better explaining the risks involved with CDOs. Technically, if done properly, everybody can be “winners” with a CDO, though clearly that was not the case recently.
Here is a an interesting look “inside” the SEC’s decision to bring civil charges against Goldman Sachs:
http://online.wsj.com/article/SB10001424052748704250104575238170222303084.html?mod=WSJ_hpp_LEFTTopStories
Surprise (not). A settlement was announced today:
http://www.nytimes.com/2010/07/16/business/16goldman.html?_r=1&hpw