Musings on the Goldman Sachs CDO Complaint: The $1 Billion Technicality that the SEC Missed?

Goldman Sachs is “vigorously” protesting their innocence against the SEC complaint. Here is their second press release: http://finance.yahoo.com/news/Goldman-Sachs-Makes-Further-bw-754781372.html?x=0&.v=1

Of course they are correct; there is no case to answer and unless the politicians can get to the Judge, it will likely be thrown-out at the first hearing. A CDO is a wager between two consenting adults. In this case the “long-end-of the stick” was betting $1 billion that US house prices would go on going  up forever, the “short-end-of-the stick” (held by John Paulson) was betting $15 million that wouldn’t happen. Everyone knew what they were doing and all disclosures of fact were perfectly in accordance with all SEC and other regulations. No one “pressurized” ACA Management to do something stupid, and in any case they were “professionals”, so even if they did, they should have made the right call, and no-one “pressurized” Moody’s to stamp AAA on its backside either. Paulson won the bet; the odds interestingly were 66.6 against – the Antichrist number; that’s pure Wall Street; the value of anything is what you can get someone dumber than you to pay; so much for “God’s Work”.

But there is one little weak point in Goldman’s story which the SEC appears to have not noticed. Nothing to do with Monsieur Tourre; who simply remarked to a friend, what everyone knew in Goldman, which was that house-prices were tanking and so was the financial system.

It’s got to do with motive.

Goldman said:

In 2006, Paulson & Co. indicated its interest in positioning itself for a decline in housing prices. The firm structured a synthetic CDO through which Paulson benefitted from a decline in the value of the underlying securities.

Well that’s true, up to a point, Paulson was “in the market”, and if he hadn’t bought CDS (shorting the housing market) from Goldman starting late 2005 or early 2006 he had been sleeping, and all the evidence is that he was not.Other people had been buying CDS from Goldman including Michael Barry, who was the guy who worked everything out, Greg Lippmann learned the “trade” from him; its quite probable John Paulson either learned the trade, or picked up clues from Burry.  You can read all about that in “The Big Short”, and if the SEC wants to win this thing, they will read that account with care. [ref] http://www.amazon.com/Big-Short-Inside-Doomsday-Machine/dp/0393072231 [/ref]

Burry had been buying Credit Default Swaps from Goldman since 2005; this is what he had to say about that:

 Goldman Sachs e-mailed him a great long list of crappy mortgage bonds to choose from. “This was shocking to me, actually,” he says. “They were all priced according to the lowest rating from one of the big-three ratings agencies.” He could pick from the list without alerting them to the depth of his knowledge. It was as if you could buy flood insurance on the house in the valley for the same price as flood insurance on the house on the mountaintop.

So, if this is right, Goldman’s may have been naive or dumb, OK, but that’s not illegal. But here is the thing. Goldman had been in the business of creating RMBS for quite some time, and they had been throwing in a CDS with the “package” to help push the sales along. But, and this is where it gets clever, they hadn’t “hedged” those (in insurance terms they hadn’t re-insured, they were “self insured”). Fair enough, that’s like if you buy a car and the dealer throws in fully comprehensive insurance with the deal, except he doesn’t bother to buy that insurance from a broker, he takes the risk himself; nothing illegal about that. Then late 2006, the writing started to be on the wall, even Goldman could see it; this is what Burry had to say about that:

Three days later he heard from Goldman Sachs. His saleswoman, Veronica Grinstein, called him on her cell phone instead of from the office phone. (Wall Street firms now recorded all calls made from their trading desks.) “I’d like a special favour,” she asked. She, too, wanted to buy some of his credit-default swaps. “Management is concerned,” she said. They thought the traders had sold all this insurance without having any place they could go to buy it back. Could Mike Burry sell them $25 million of the stuff, at really generous prices, on the subprime-mortgage bonds of his choosing? Just to placate Goldman management, you understand.

They were trying to buy back the CDS that they had issued, in the “good times”, when socially inept “suckers” like Burry were offering to buy them at silly prices. And they wanted to buy them back and give Burry a very healthy margin.

Motive?

By that time AIG had started waking up to “smell the roses”, so Goldman couldn’t offload any of the CDS they had written onto AIG (they say “hedge in Wall Street). So they created a “synthetic CDO”, which is basically a collection of CDS on a pool of RMBS, like a big bet. But as they correctly stated in a press release in December 2009 in response to an article in the NYT on this particular CDO, there needs to be one party holding the long-end-of-the-stick and another holding the short-end, for that to work. So Paulson was in town, he had been buying CDS from Goldman, they had his number on speed-dial; did he roll up one day and say “you got any action?”, or did they call him? It doesn’t matter.

But why didn’t Goldman take the short-end? Probably because it was Goldman who had packaged up the toxic stuff that the CDS were insuring, and it’s one thing to sell bets against the stuff you created, it’s another thing to actually place bets yourself. There are limits, even on Wall Street. And that wasn’t their priority anyway, what they wanted to do was get all those CDS that they had written, off their balance sheet, and onto someone else’s. Like an exposure of about $1 billion. And I have absolutely no doubt that they had the smartest lawyers in the world checking every detail, to ensure that they complied with SEC regulations. Which is why I suspect they may get away with it…unless of course someone can prove motive.