Goldman, SEC & the Making of a Meltdown

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The financial media is buzzing about the lawsuit that the Security and Exchange Commission recently filed against giant investment bank Goldman Sachs (Stock Quote: GS). You’re probably thinking, “what does that matter to me? I don’t have any money with Goldman Sachs.”

Well, this lawsuit isn’t about one bank breaking an obscure rule. In fact, it gets to the heart of the financial meltdown and the bailouts that followed. You know, the bailouts that you paid for with your tax dollars?

Wall Street types sometimes like to say that they didn’t see the financial crisis coming. That it took them by surprise. For some people, maybe that’s true. But for others, not only did they see it coming, but they stood to make big money when it did. That’s what this story is about.

Here’s what’s going on.

First some background. Before the Great Recession, if you wanted a home loan, you could get one even though you might not have the best credit score or a large down payment. In fact, many banks were giving mortgages to just about anyone. Why were banks doing this? Some say banks thought real estate would always be increasing in value, so even if they were making risky loans, they couldn’t lose because the properties would ultimately be worth more than the value of the mortgage.

But there’s another reason why banks were giving mortgages out to anyone and everyone, and it’s that reason that gets at the heart of the SEC’s lawsuit against Goldman.

Many of the mortgages were bundled into investment packages that people and companies could buy shares of. You may have heard the term “collateralized debt obligations” tossed around, and these investments are what this term refers to (we’ll call them “mortgage funds” just to keep things simple).

Some mortgage funds were considered safe . These were the ones filled with mortgages taken out by people who could likely afford to pay off the loan. But there were also mortgage funds that were considered not so safe. These were filled with risky loans given to people who were likely to have trouble paying the balance. These are generally called sub-prime mortgages. The mortgage funds that were filled with sub-prime loans had a higher rate of return for investors.

You with me so far?  The banks were giving everyone mortgages, then bundling those loans into mortgage funds and selling shares of those funds to investors. The riskiest funds paid the best returns.

Now, here’s the really important part. Banks and investors are always looking for ways to hedge their bets when they make an investment. Mortgage funds were no different. Investors were able to buy something called a ‘credit default swap’ (CDS) – a type of insurance policy - for this very reason. An investor could buy a bunch of shares of a risky sub-prime mortgage fund and for a few bucks more they could also buy a CDS, which made certain that even if the risky mortgages defaulted, investors would still make money.

So, what if you’re an investor and you knew about a mortgage fund that was filled with very risky sub-prime mortgages? Even better, what if you had a way to make sure that the fund was filled with mortgages that you thought were very likely to go into foreclosure? Well, as long as you have a CDS, you’ve found a bet that most people would call a sure thing.

That’s what the SEC is accusing Goldman Sachs and Fabrice Tourre of taking part in.

In 2007, Goldman was selling shares of a mortgage fund called Abacus that was filled with sub-prime loans. The Goldman employee in charge of the fund, Fabrice Tourre, was consulting with a large hedge fund called Paulson & Co., which allegedly influenced the kinds of mortgages selected to go into Abacus. Tourre told investors that Paulson had invested in the fund just like everyone else, but really Paulson had bought lots of credit default swaps, betting the fund would fail. The SEC says Goldman and Tourre knew Paulson’s bet, but didn’t tell other investors. (I wonder how big Tourre’s bonus was this year…)

The Abacus deal closed April 26, 2007. Five months later, the fund’s investors had lost $1 billion and Paulson had made $1 billion thanks to its credit default swaps. Goldman made tens of millions of dollars in fees from both Paulson and fund investors.

Here’s Goldman’s predicable response to the charges from a press release: “The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation.”

Good luck with that.

If this is still a bit confusing, then take a half-hour and listen to the this episode of NPR program This American Life, which was co-reported with the non-profit investigative journalism outfit ProPublica. It explains a similar case involving a hedge fund called Magnetar.

Shares of Goldman along with many of the other big banks were way down today (ProPublica is reporting about a bunch of other banks that did deals similar to Abacus), so if you’re still wondering what all of this means to you, you might want to check your IRA and 401(k).

There seems to me that one group involved in this mess seems to be getting off easy. Ironically, it’s the party that benefitted the most from the Goldman deal, and who, if we’re to believe the SEC lawsuit, bears much of the responsibility for the mess. I’m talking about Paulson. Why weren’t they charged with anything?

The Wall Street Journal reports that the SEC’s head of enforcement, Robert Khuzami, said, “Goldman was responsible for the representation to the investors, and Paulson was not.”

Sounds fishy to me.  We can only hope that the SEC has something special planned for them and is just playing it cool for now.

But if you’ve been thinking about dropping your big bank in favor of a smaller community bank that wasn’t complicit in the greatest financial crisis in a generation, now might be the time to send that message.

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