So the SEC brings a civil suit against Goldman Sachs for defrauding investors. Cutting through the bullshit, the suit is based on the allegation that GS intentionally misled investors in synthetic CDO’s (collateralized debt obligations) they sold as to the party that actually structured what was in the CDO . Honestly, I have real problems with all this because it was a synthetic trade which, frankly, shouldn’t have been allowed in the first place.
Breaking down the news, there’s one critical piece undisclosed… did investors know the CDO was synthetic? In that event, GS would appear to have an affirmative defense since the very nature of a synthetic CDO is that someone has to be short the reference security (in this case, actual CDO’s made up of low grade debt instruments… in this case, slices of some deep sub-prime mortgages) for investors IN the CDO to make money. It’s an insurance trade, so one party pays premiums (the person short the reference security, in this case John Paulson) which simulate the actual payments which were being made on the reference security to the party who buys the CDO. If the value of the reference security then becomes worthless, then the buyers are wiped out and the short seller makes all the money. If the reference security doesn’t lose value, then eventually the short seller will be wiped out and all the money will be transferred to the buyer.
If buyers knew the trade was synthetic then they can’t be upset about no one telling them the counterparty was a short seller (simply put, it’s implied by the nature of the trade and the security). They can be upset and can take action in only one circumstance… if they lied about who selected the reference securities in the CDO.
I don’t like the very nature of a synthetic security since it’s underlying basis is, frankly, a side bet. It’s gambling using a financial instrument created solely to make the bet itself possible. It’s also responsible for dramatically magnifying the losses experienced by investors all over the world. Instead of having just one $1 billion pool of mortgages default and investors losing money, there were 20 other synthetic pools that mirrored the first.
Finally, if the investors DID know this was a synthetic trade, I have no sympathy for them. They were stupid to have purchased it in the first place. At the end of the day, they could have done their due diligence and asked Goldman for a list of the reference securities and investigated them to find out they were all trash. But they didn’t so I could give two shits about them and their managers.
Here’s one thing no one is paying much attention to…
The SEC case increases pressure on the Justice Department, which has been investigating many of the same Wall Street firms to look for possible criminal wrongdoing at the root of the financial crisis.
If there is a criminal complaint filed and the result is either a guilty verdict or a no contest plea, GS can lose it’s primary dealer status in US Treasury securities. That would be a devastating blow to the company since dealing in US debt is a lucrative business.
Of course, the obvious effect is that many of their customers will think twice before accepting a trade from GS wondering what’s really behind it. It’s the optics of it all that can cause real, nasty, long term problems.
On a political note, you gotta be wondering how long it will take the stupid Republicans to reverse course on their fight against regulatory reform…