April 17, 2010

Throw a little vampire calamari on the barbie

The title taken, of course, from Matt Taiibi's superb description of Goldman Sachs: A vampire squid wrapped around the face of humanity. The SEC, rousing itself from the persistent vegetative state which characterized its handling of the Bernie Madoff affair, is hacking away at GS's flailing tentacles in much the same way that Captain Nemo, in James Mason's protrayal in "20,000 Leagues Under the Sea," fought the giant squid trying to wreck the Nautilus.

I'm convinced that Goldman Sachs is guilty of security fraud. What convinces me is the character of its absolute rebuttal: their oft-quoted PR flack, Lucas Van Praag, meticulously and categorically denied everything the SEC alleged except for the one point that matters. A telling omission. Somewhere down at the bottom of the bowl of alphabet soup, the swirling RMBS and CDS and CDO, lies the answer, and it's not good for Goldman Sachs.

Goldman Sachs got too cozy with a big investor, John Paulson of Paulson & Co., who only a couple of years ago was the toast of Wall Street. Paulson devised ways of betting against the U.S. housing market through use of credit default swaps (CDS), which are essentially bets that a given asset or security will decline in value. I remember discussing Paulson's celebrity with my cousin Jim, at one of our breakfasts out on the wharf in Santa Cruz (those breakfasts, like the great American housing market, are gone forever). With Sinatra, as always, playing on the restaurant's stereo system, Jim chuckled in his inimitable way and noted that only in America could someone become a social hero by betting that America would go to hell in a hand basket. Paulson made billions with his CDS bets.

Now we see that Paulson, unlike the intrepid small guys described by Michael Lewis in The Big Short, had his finger on the spinning roulette wheel. He isn't such a hero after all. The fix was in, and he paid GS to rig the game. Paulson ponied up $15 million to Goldman to salt a collateralized debt obligation (CDO) with hand-picked residential mortgage backed securities (RMBS) culled by Paulson from a long list of such RMBS. Paulson specifically chose lousy credit risks - low FICO scores, zero down payment, adujstable rates, no wage documentation, zero equity. Loser loans, in other words. To Paulson's credit, he saw the housing bubble and put his money down.

Paulson's specific investment vehicle, we now know, was something called a synthetic CDO, which is (as described by Michael Lewis) a kind of mirror image of a real CDO built up from mortgages. The synthetic version is comprised of credit default swaps (CDS), and to Morgan Stanley, apparently, must go the honor of this great breakthrough in American financial engineering. The synthetic CDO allows short bettors to scale up their negative bets to the same level as the investors on the long side in MBS CDOs. In the case of the ABACUS CDO involved in the SEC complaint, here is what the SEC then accuses of Goldman of doing:

Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc. (“Paulson”), with economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO, played a significant role in the portfolio selection process. After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (“CDS”) with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure.

To beat the rap on a 10b-5 allegation, here is what the vampire squid would need to be able to say: We told the long-side investor (a German bank and others, including ACA) that the sack full of shit they were investing one billion dollars in had been assembled from turds specifically chosen by another investor, John Paulson, who selected those excremental pieces based upon their foul odor and disgusting appearance.

Here, however, is the squid ink excreted by Goldman in its defense:

Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor. The SEC's complaint accuses the firm of fraud because it didn't disclose to one party of the transaction who was on the other side of that transaction. As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor.

An artful dodge, which is very telling under these excruciating circumstances. The SEC complaint does not base its case on failing to "disclose to one party of the transaction who was on the other side of the that transaction." That would not have told ACA and the German bank much of anything, by itself. What Goldman Sachs did not tell the long-side investors, those redoubtable Germans who believed in the American mortgage-payer, was that the CDO they were buying had been hand-picked to fail by the short-side investor (Paulson), a right granted to Paulson because he greased the Squid's tentacles with fifteen million bucks. Now, if Lucas Van Praag could deny that explosive allegation, now would surely be the time to do so. But he doesn't. Goldman Sachs did not represent "to ACA that Paulson was going to be a long investor," of course, because Paulson was going to be no such thing. This is entirely beside the point.

Where things will really get fun for Goldman Sachs, as the SEC knows, is in the lawsuit that ACA and the German bank will surely file against Goldman Sachs and probably against Our Hero, John Paulson. Since fraud is involved, Goldman could be looking at punitive damages along with the billion in compensatory, humongous legal fees and other fun debit items.

Meanwhile, the American housing market continues its descent into the sink hole of deflation. At least, from time to time, we'll have the distraction of watching those (and GS won't be the last) who once profited from everyone else's misery take their turn in the dock. Too bad my cousin, who really believed in America, or at least in the America that used to be, can't be around to see the final act.

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