A huge development that will drive the news for a while: The Securities and Exchange Commission has filed a civil suit against Goldman Sachs, accusing the company of designing complex financial instruments that would fail, then selling them to clients while betting against them. Here are the charges. The heart of the matter:
As the ... deals plunged in value, Goldman and certain hedge funds made money on their negative bets, while the Goldman clients who bought the $10.9 billion in investments lost billions of dollars.According to the complaint, Goldman created Abacus 2007-AC1 in February 2007, at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst.
Goldman let Mr. Paulson select mortgage bonds that he wanted to bet against — the ones he believed were most likely to lose value — and packaged those bonds into Abacus 2007-AC1, according to the S.E.C. complaint. Goldman then sold the Abacus deal to investors like foreign banks, pension funds, insurance companies and other hedge funds.
These concerns were highlighted when Goldman CEO Lloyd Blankfein, pictured above, testified before the Financial Crisis Inquiry Commission a few months ago; Chair Phil Angelides brought up the CDOs:
ANGELIDES: Well, I'm just going to be blunt with you. It sounds to me a little bit like selling a car with faulty brakes and then buying an insurance policy on the buyer of those cars. It just -- it doesn't seem to me that that's a practice that inspires confidence in the markets.
BLANKFEIN: Every purchaser is an institution, probably professional only investors dedicated, in most cases, to this business.
ANGELIDES: Representing pension funds which have the life savings of police officers, teachers...
BLANKFEIN: These are the professional investors who want this exposure.
One note of caution: These are hard cases to prove. Even if Goldman Sachs officials knew how crappy these financial instruments were, they also got solid ratings from the bond-ratings agencies, giving Goldman a real out. If the SEC brought this case, they must have a high level of confidence, but now they need to execute what will undoubtedly be one of the most high-profile financial fraud case since Enron.
Incidentally, the fact that hedge-funder John Paulson played a role in picking these securities helps confirm the argument that I made in my review of Michael Lewis' book The Big Short: Even the investors with the foresight to see the bubble and bet against it were acting as pernicious speculators who helped drive the bubble up and exacerbate its consequences, not as hero intellectuals tweaking the nasty big banks. These were symbiotic relationships that hurt regular Americans and the economy, make no mistake about it.
This news will only give more momentum to the Democratic financial-reform plan and, hopefully, more impetus toward strengthening the bill in any number of key areas where it could be improved.
-- Tim Fernholz
