Your Guide to the Goldman Sachs Lawsuit
But even as those themes hog the limelight, two other recurring, albeit slightly more obscure, characters -- the matchmaker and the credit default swap -- are also starting to peek out from behind the glamorous
Matchmaker, matchmaker. The Goldman product that the
With the Goldman case, of course, the big difference was that investors were instead betting on mortgages. And since the investment products were synthetic, investors were able to place bets on the direction of the housing market without actually owning any physical mortgage bonds.
In arranging these deals, one of Goldman's roles was that of matchmaker. In other words, it was Goldman's job to find some investors who thought that the housing market would stay healthy and others who thought it would tank. Goldman would then pair the two sides up in a transaction.
"Acting as a swaps dealer, Goldman has a commodity. And in order for it to earn a fee for that commodity going out into the marketplace, it has to put together the short side and the long side. So it has to be simultaneously in possession of the names of bona fide longs and shorts," says Kopff. Using a gambling metaphor, he says, "In that sense, [Goldman] has a duel incentive. It wants some people to go short and some people to go long because it's basically like the house. It's making money as long as it pairs up the longs and shorts."
The question then becomes: When should we blame the house? The most obvious answer is that the house could be at fault when the deck is stacked against some of the betters.
In the Goldman case, this issue is particularly relevant. Notably, the
Paulson, of course, effectively shorted the housing market by betting against the bonds, but there were also investors on the long side of the deal in question. The
In fact, they were never even made aware that Paulson was involved in the deal, according to the lawsuit. Instead, according to the
Legal issues aside, these charges raise a number of pressing questions, particularly at a time when
"I think there is a very large concern among American taxpayers that not only did
At the moment, one thing is clear: Goldman's own investors accurately predicted that the housing market would crash, and they placed their bets accordingly. But what remains to be seen is to what extent the investment bank encouraged some of its clients to take the opposite position.
As a result, at least in the court of public opinion, the Goldman case will be a key test of the matchmaker defense. Put another way, was Goldman merely allowing clients who had a bullish outlook toward the housing market to put money on that view? After all, in order for markets to function, intelligent investors need to disagree from time to time.
"In some ways, this is
But another possibility, some say, is that Goldman was knowingly giving its clients bad advice by actively prodding them into taking long positions rather than merely presenting them with the option. "[Goldman is] cynically saying, 'We're not making a recommendation on whether to buy or sell this.' But clearly they are. They're creating the instrument and they're sending their salesmen across the world to meet with institutional players," says Kopff. "To say they're not taking on point of view on that almost belies reality."
From a legal standpoint, the more pertinent question is: Did Goldman conceal the role of Paulson? And if so, would the long investors in the deal in question still have taken the same position had they known that Paulson picked the bonds with the goal of effectively shorting them?
In answering the latter question, the
The 'naked' truth. Another issue that could take center stage in the fallout from the Goldman case is the validity of credit default swaps, the complex deals that are often likened to insurance policies.
With most forms of insurance, people take out policies on items, such as houses and cars, that they own. In some cases, credit default swaps work the same way. In other words, investors can own mortgage bonds in the belief that they will appreciate in value, but at the same time they can hold an insurance policy -- through these swaps -- that will pay out in the event that borrowers default. Used that way, these swaps allow investors to hedge their bets.
But there are also naked swaps, which let people short investments without ever having to own them directly. Using the insurance example, it would be the rough equivalent of a person taking out an insurance policy on his neighbor's house under the belief that the house would be struck by lightning.
That's what happened in the Goldman deal, which was created using a package comprised of various credit default swaps. Investors like Paulson were then able to take the short side of the deal by buying insurance on the bonds referenced in the deal.
In turn, the long investors were the insurers. They received regular payments, much in the same way insurance providers do, from policyholders like Paulson. These payments were much like the interest they would accumulate had they actually owned the bonds outright. In exchange, they agreed to make large payouts to the short investors should the bonds fail, which is exactly what happened.
During the downturn, Goldman was hardly the only firm that allowed investors to employ these naked credit default swaps. In fact, naked shorts are viewed by many as one of the prime reasons why the housing collapse was so painful. "The naked CDS... wreaked havoc on the market," says Greenberger.
That's because when these shorts are part of synthetic deals, investors are not constrained by physical supplies. Kopff uses the example of home insurance. In that industry, people can only buy as many insurance policies as there are actual houses.
"Once everyone's insured, you've hit the maximum. There's no more insurance that can be written," he says. "While that number can be exceedingly high, it is finite. When you allow naked positions, you allow what doesn't exist in the hazard insurance industry... Now you have someone saying, 'Listen, you've got a house over there, and I'm going to bet that lightning hits it.' And then somebody else comes in and says, 'Well, I'm going to bet that lightning doesn't hit it.' And you can have as many bets as you want."
This, in turn, compounded the losses that investors experienced when the housing market went under. "Essentially, [investors] found people who would give them insurance on the question of whether subprime mortgages would be paid," says Greenberger. "So every time a subprime mortgage collapsed, it wasn't just the real loss of the mortgage, but it was the loss of all the betting that was done on whether the mortgage would survive or not survive."
As the Goldman case continues to attract attention, the debate about swaps is likely to intensify. Importantly, this will happen right as
Still, swaps do have ardent defenders who argue that when used correctly, they can actually reduce the riskiness of investors' portfolios. But as the Goldman case illustrates, these defenders are pitted against an American public that is clamoring for tighter regulations. Says Greenberger, "I think there's been a widespread desire to see some accountability for this horrific crisis."
Can SEC Beat Goldman Sachs?
News that the Securities and Exchange Commission filed a civil suit against Goldman Sachs has sent the investment bank's stocks reeling. But are investors overreacting? To be sure, the case is bad news for Goldman, which has come under fire recently for its handling of mortgage-backed securities during the downturn
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Your Guide to the Goldman Sachs Lawsuit | Rob Silverblatt
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