The Securities and Exchange Commission shocked Wall Street today
with its accusation, duly filed in Federal District Court in
Goldman Sachs (
engaged in fraud during the subprime debacle.
Shares have taken a dive, losing nearly -13% of their value on
fantastic volume. So the question arises: Is Goldman a good
buy? Or is it lights out for the storied squid?
I wanted to find out. So I read the actual lawsuit. Not the news
coverage of it, but the actual court filing. You should, too.
When you're done, I think you ought to respond to your first
First, stick with me as we break this down piece-by-piece.
It starts as a homebuyer gets a mortgage. Then the bank, for
whatever reason, decides to sell the loan. This happens thousands
of times a day.
Those loans are combined into an entity called a "Residential
Mortgage Backed Security." This is nothing more than a bond backed
by mortgages. Each month, as borrowers make the house payment, a
lot of interest is paid and a little debt is retired.
Those residential mortgage-backed securities can be packaged into
yet another type of security called a collateralized debt
obligation or "CDO." To make sure it's even more complicated, these
are further divided into sections called "tranches" and are then
risk-rated and sold. Now it's a big bond backed by a bunch of
Let's be clear about who buys these. These investments are
only bought by major players who are looking for good returns and
willing to take the risk to get them. "Qualified institutional
buyers" are legally recognized as sophisticated, well informed
investors who need less protection than individuals.
Now: Enter Goldman.
The investment bank was asked by a client to put together a CDO. So
Goldman did. It loaded a lot of risky residential mortgage-backed
securities into a new CDO and then sold pieces of it to investors.
Just like it has done a thousand times before. Just like the other
major investment banks do all the time. Goldman was paid a fee of
$15 million to put the CDO together. For those of you keeping score
at home, that's about 0.0003% of its annual revenue.
What happened? Well, as we all know, the housing market went south.
As properties lost value, borrowers defaulted with insufficient
collateral to cover the debt. The mortgages lost some if not all of
their value and the over-arching CDOs basically became worthless
because no one wanted to buy "toxic assets."
While millions of investors lost money and some institutions even
failed, a few investors did manage to make money on the subprime
One who did: The client that asked Goldman to put together the CDO.
It was a hedge fund called Paulson & Co. After the CDO it
sought had hit the Street, Paulson bet against it by buying
something called a credit-default swap.
Forgive the lingo, but there's no way around it. A "credit-default
swap" is nothing more than a bet between rich dudes. One says
something is going to happen and the other says it's not.
It's kind of like a private insurance policy. Instead of
going to, say, Geico, I pay a rich neighbor $1,000 to cover me for
a year. If my car crashes, he buys me a new one. What's "swapped"
is risk. I was taking it, then I paid someone else, my rich buddy,
to shoulder the burden.
In the Goldman case, the something being bet on was the mortgages.
In banker lingo, a "credit" is a loan. "Default" refers to the risk
that a loan might go bad. So all a fancy "derivative" like a credit
default swap really is is an insurance policy against a bunch of
loans going bad.
And that is what Paulson bought. When the loans went bad, Paulson
got paid. Not quite as complicated as it sounds in the papers,
Paulson made $1 billion on this deal, incidentally. That money came
from the rich dudes who thought the mortgages wouldn't go bad. (And
if they had, then they would have kept the premium, just like the
insurance company keeps the premium even if you don't wreck your
Paulson, for its part, is not being sued by the SEC.
Only Goldman. And a (now) 31-year-old kid who works there. He made
the mistake of writing a couple of damning-sounding emails in which
his ego-driven braggadocio far superceded his prudence and
intelligence. He knew, as most did at the time, that the mortgage
market was imploding and that CDOs were about to take a hit. He
said so. That looks bad, as Goldman was still selling CDOs -- and
institutions hungry for juicy returns were still buying them.
Remember: Every one of these CDOs, even, in some cases, with
extremely poor credit ratings, were
Someone bought them. Someone read the details, took out his
checkbook and said, "I will pay for that." And everyone who did was
a qualified instutional buyer who knew exactly what was going on.
Ignorance is no excuse. It's just ignorance.
The SEC contends that Goldman has some sort of duty to disclose
that Paulson was betting against the CDO.
tell anyone what one of its clients is doing. It doesn't and, I
would guess, it hasn't. In other forms, exploiting or divulging
clients' positions would be no different from front-running trades,
which is and should be illegal.
Remember: Goldman is a broker/dealer. It arranges trades. A buyer
wants something that a seller does not, Goldman puts the two
parties together. It's not Goldman's role to talk a client out of
buying something that it wants. Goldman's role, in this case, was
to make a market. Provide the means for transaction between buyer
and seller. It did that. It did nothing wrong.
Look at it this way: What if you called your broker and sold 100
. Would you want your broker to tell the world that you no longer
wanted to own Big Blue? And if you shorted the shares, does your
broker have an obligation to tell the next customer that wants to
buy IBM that you just bet against the company?
Of course not.
And, again, we're not talking about the individual investors that
the SEC is supposed to protect. We're talking about sophisticated,
well informed masters of finance who knew exactly what they were
doing. It's ludicrous to suggest otherwise. That a lot of banks
lost money on CDOs just means they were all equally stupid and
willfully disregarded the risk.
I mean, c'mon: No one buys a debt instrument with a relatively high
rate of default (as reflected in credit ratings and in the
underlying fundamentals of the instrument, which are available in
detail on any Bloomberg terminal) without understanding that
somewhere someone might be betting against it. As rumors build
against a company, investors short it -- betting it will implode.
Others buy it, thinking it will make a comeback and they will make
There isn't any wrongdoing, even if both parties make their trades
though the firm that underwrote the initial offering!
The broader context must be taken into account. Goldman Sachs is a
great bank. Smart, admirable and decent people work there. They
make good salaries, sure. But that just gives every Goldman
employee all the more reason to play it straight.
Goldman does complicated stuff and makes a ton of money in ways
that most people can't relate to or figure out. They hear words
like "derivatives" and "credit default swap" and "collateralized
debt obligation" and they're lost. Most people wonder how the
housing bubble burst and how everything really went down, and in
the end it's easy to blame an institution like Goldman or Skull
& Bones or the Castro regime for things that otherwise defy an
easy explanation. The same people who would be mad at Goldman for
selling this security at the behest of a client are the same ones
who thought the whole financial crisis would go away if we lowered
a few CEO salaries. It is naive populism knee-jerking its way to
judgment about something it clearly is ignorant of and has no frame
of reference to understand.
This lawsuit is about redistributing wealth. It's about
criminalizing financial sophistication and punishing size and
That's the bad news.
The good news is that the Goldman case will be tried in the most
financially savvy court in the land. The truth will come out. Mark
my words: Goldman will be fine.
So what's your first reaction?
If it's to buy Goldman shares at today's fire-sale price, then I'd
agree. Goldman's a buy.
Editor: Government-Driven Investing
Disclosure: Andy Obermueller does not own shares of any security
mentioned in this article.
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