April 19, 2010

I've got the horse right here, his name is Paul Revere

As a public service, I offer one or two comments on the legal framework relevant to an evaluation of the SEC's case against Goldman Sachs. I am moved to describe this framework by the highly undedifying spectacle of watching Maria Bartiromo on CNBC hysterically defend GS against the SEC's "unfair" allegations against this venerable den of financiers currently infesting Wall Street.

Maria wonders whether Goldman is being accused of "fraud" or of merely being "unethical." Further, she wonders whether it's fair to require the "seller" of a security to disclose the buyer and vice versa, something, she assures us, "has never been done." Her remarks tend to demonstrate that someone who has been chosen for her high profile position on the basis of the size of her eyes and her hairdo is not necessarily the best arbiter of the legal details involved, but does tend to prove that Goldman's PR flackery is effective insofar as it provides the talking heads with irrelevant gibberish to deflect public opinion away from the actual issue.

The gist of the SEC case is based (as in many, many cases of securities fraud) on the simple yet highly utile provisions of Rule 10b-5 of the Securities & Exchange Act of 1934, that Depression Era legislation which miraculously survived both Reaganism and Greenspan's tour of duty as Fed Chairman (Greenspan, like his heroine, Ayn Rand, thought the "market" should regulate fraud without government intereference). Rule 10b-5 (so named because of the subsection it occupies within the statutory enactment):

"Rule 10b-5: Employment of Manipulative and Deceptive Practices":

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security."

That's it, the whole statute. Refreshingly pithy, direct, effective. Goldman is up against subsection (b) of the rule. It omitted "to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.

Here are the statements which Goldman made to the German bank and other investors in the Abacus CDO: okay, meine Freunden, here are some wonderful mortgage bonds for you to invest a billion dollars in, easy money, fixed income, and all secured by hard-working Americans religiously devoted to making timely payments, and also you should know that ACA, that big asset manager you like so much, played a role in choosing the specific collateral (American houses) in the portfolio.

So far so good. But you also need to avoid the omission of a statement necessary to make sense of the statements actually made, so that they're not misleading. Did Goldman omit to say anything? Well, yes. While it's true that the person "on the other side of the deal," in this case John Paulson, is not ordinarily disclosed, Paulson was somewhat more than just the person "on the other side of the deal" in this situation. Paulson was actually the guy choosing the collateral for the CDO, and he was choosing it not for its strong, Amerikanischer creditworthiness, but instead for its essential crappiness. Instead of those idealized Americans of the German fantasy with the picket fence and Priuses in the two-car garage, Paulson was looking for part-time lap dancers in over-limit status on their Discover Cards who claimed, on an unverified basis, that they made $200 k a year writhing and squirming in the Ultra Room of the Flamingo, and scored five houses to flip on just such credentials.

Details slightly exaggerated for effect; your parody may differ.

You see, Paulson wanted the short side of the bet, because he had a more realistic appreciation of his fellow Americans. But for a short side to work, you need a sucker on the long side. Just as a bookie who takes a bet on the Lakers, give the 6-1/2 points, Goldman needs to find someone who thinks the OK Thunder can beat the spread. This is what Goldman means by saying it acts as an "intermediary;" they're the tout, and their cut of the action was $15 million from Paulson to make this tanked game work.

What can we say? Paulson and Goldman had home court advantage. Pays to know the players before you start throwing a billion around, especially when you're relying on a shifty book like the one run by the fine "investment bankers" at Goldman Sachs. It's the oldest permanently established floating con game in New York.

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