Goldman Sachs Lawsuit: Understanding and Implications

On Friday, Goldman Sachs was accused of wrongdoing in a SEC civil lawsuit of fraud. Let me explain, by way of an analogy, what is alleged in the SEC suit. Please note, this is not intended to be a full analysis of lawsuit, only a general explanation intended to help readers of this blog understand some of the issues of this case. These are allegations only and no parties have been proven guilty at this time.

Let’s say the general manager of a baseball team wanted to place a bet in Las Vegas on a baseball game (not legal, but assume it is and follow along). The GM, John Peters, wanted to place a bet against his own team, the Phoenix Mortgages. He went to his manager, A. Choosy, who was preparing the line up. Peters worked with Choosy to put forth the least desirable team of his 25 ball players. Choosy benched the starters for that day and turned in his line up card. Choosy, with Peters’ assistance, started the worst pitcher on the Mortgages for this game.

Peters then went to Las Vegas. He bet $1 Billion that his team, the Phoenix Mortgages would lose the game. When placing the bet, Peters did not disclosure to the casino (professionals at what they do, which is accept bets and wagers) that Peters had helped to select the players involved in the game. However, the casino are professionals and are supposed to be experts at these type of transactions.

You know the outcome. The Phoenix Mortgages lost the game, as the worst players were selected to participate in the game. The casino lost their $1 Billion. Peters however, made out very well, winning $1 Billion.

How does this relate to the Goldman Sachs SEC lawsuit? A hedge fund investor, John Paulson (ie John Peters) thought that the subprime mortgage market was going to do poorly. He went to Goldman in 2007 and requested their assistance in preparing a pool of mortgages, so he could “bet” against them. The suit alleges that Paulson helped to select the mortgages, and tried to find the worst quality ones he could find. Thus, he helped to prepare the lineup card he was going to bet against.

Goldman, per the SEC lawsuit, then went to other experienced, professional institutional investors (not individuals) and sold them the $1 Billion + pool of mortgages, without disclosing that Paulson helped to structure and select the mortgages. They also did not disclose to the investors of the mortgage securities that Paulson was placing a bet against them (or in my example, Peters did not tell the casino that he had been involved in selecting the players for the game). The institutional investors who purchased the pool of mortgages were provided with details of the mortgages, and one of the major investors was also involved in the selection of the mortgages (as a casino would be involved and study a baseball team, before it sets the “spread” of a given game).

In my analogy, the baseball game was over quickly and the bet was won in no time. In the real world, Paulson’s bet was won pretty quickly as well. This deal closed on April 26, 2007. Paulson’s hedge fund paid Goldman $15 million to structure “Abacus” (the name of the pool of mortgage securities). By October 24, 2007, 83% of the mortgages had been downgraded and by January 28, 2008, 99% of the portfolio were downgraded. Investors in Abacus had lost $1 Billion and Paulson’s hedge fund was ahead by $1 Billion.

As investors, this is again a reminder of many concepts. As your financial advisors, we have a fiduciary responsibility to act only in your interest (our interests are aligned with yours). We feel it is important to understand what you are investing in. We do not invest in hedge funds or exotic investment products. We understand the philosophy of the mutual funds that we utilize and they are very transparent about their holdings and actions.

Sources: Wall Street Journal, April 16, 2010; SEC Complaint filed April 16, 2010

Note: this post was updated on 4/19/10, based on Goldman Sachs’ third statement regarding this matter, particularly noting that the investors in this transaction were “two professional institutional investors.” Source: Goldman Sachs statement dated April 19, 2010

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