Now, just exactly what was the crime or even the problem? Essentially, GS packaged up a bunch of the bad home mortgages bankers were forced by the government to issue to people who plainly couldn't repay the loans with good loans to spread the risk and then sold the instruments, called derivatives, to investors who actually thought the borrowers would meet their financial obligations. Goldman Sachs didn't think they would and hedged their bet. The investors lost the bet and Goldman Sachs won.
The Financial Edge explains -
Goldman Sachs is being charged by the Securities and Exchange Commission (SEC) with fraud for allegedly making misleading statements and omissions regarding a mortgage based investment.
Why It Matters
Goldman Sachs is a a major player in financial services. When the SEC goes after such a large corporation with as much influence as it has, it is a big deal. Goldman Sachs is a company based on trust in its stellar reputation. Any legal suit brought against them could tarnish this image. It could also reduce the trust placed in firms all across the financial industry. At the same time, the SEC is demonstrating that they have the power to find improper behavior and police it. After the subprime mess we saw in 2008 and 2009, there has been an outcry for government agencies to do something just like this.
What was the Mortgage Investment?
It was a bet on whether a group of borrowers would pay or not.
The product, known as ABACUS 2007-AC1, was basically a bet on whether a group of mortgages would make their payments. One person bets that they will (the long) and one bets that they won't (the short) - and Goldman Sachs doesn't care either way because they take their fee, $15 million in this case. This is called a synthetic collateralized debt obligation or "synthetic CDO." If it were a regular CDO, it would just be an investment in a group of debt payers; as the debtors pay, the investor gets money. This synthetic CDO was derived from a bet on the ability of the group of borrowers to pay - and everyone knows about derivatives! For this synthetic CDO, as with any bet, there needed to be two sides betting on opposite outcomes. Otherwise, the deal doesn't exist.
Why did the SEC Jump on Them?
This type of derivative bet is a common investment. It requires someone to pick the mortgages, then it needs another party to evaluate them. The SEC didn't like the fact that the same person that helped picked the mortgages also bet that they would fail. This is legal as long as it's disclosed, but apparently it wasn't in the marketing information. This is why Goldman Sachs is being charged with omissions and misleading information.
Who picked the mortgages? Allegedly Paulson & Co. Inc. influenced the selection process - thus gaining inside knowledge of the bet - and then entered into another contract to profit if it failed. This other contract is called a credit default swap. These are normally used to protect an investor just in case borrowers default. Well, the short was correct, and the group of borrowers defaulted. The long was wrong and lost $1 billion. Almost two years later, the SEC is doing something. Who was long? Well one of them was IKB Deutsche Industriebank and it quickly felt the effects of the subprime meltdown in the summer of 2007. Just a week before declaring financial trouble, the bank had stated that earnings expectations would be met.
New regulations will take years, but they will attempt to increase disclosure and keep larger institutions a little more honest. It might not affect your bank account, but maybe your pension fund will have a little more insight into what they are buying when they put money into hedge funds.
It's just that simple and Goldman Sachs will slip the surly bonds of regulation because they will say everybody was doing it circumventing the governments assertion this was a unique occurrence.
The life of Indigo Red is full of adventure. Tune in next time for the Further Adventures of Indigo Red.