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SEC goes after Goldman

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Patty left out one important fact: Goldman did not make a big fat profit on this deal. In fact, it lost a good deal of money ($90 million or so) because it bet against Paulson & Co.
Disclosure: I am a Goldman shareholder.

-Charles

@ Brady & Heather

Can I bore you with another analogy?

Let's assume all investors look at a construction site of a wooden building they might invest in. And there is a pile of rotten wood lying on site (that is the construction material) which all could have seen.

Now if both are investors, let's assume the one realizes that it is going to crash and even bets against it while the other stupid one invests. Then I agree it's the investors own fault.

But now what if the clever investor is also the architect? Wouldn't be bother that the architect deliberately builds a house that will most likely collapse?

Cheers, Andreas

Most market transaction have long and short positions. The valuations by potential buyers should be based on the underlying assets and not another market actor's opinion of those assets. The firms that purchased those debt obligations either did not do their due diligence (and underestimated the risks) or ignored the risks in the face of rising home values. Paulson's short position and involvement in the selection of the assets that backed those debt obligations did not affect their likelihood to increase or decrease in value. Investment bank employees should not be buying any triple-A rated security. Their job is to value securities, evaluate risk, and make decisions. They only did the last part and lost their shirts. That's what happens to lazy investors.

As for the ratings agencies, this is a two part story. First, the ratings agencies suffer from a conflict of interest because they are paid by the same firms whose securities they are rating. Secondly, the invest banks have been reverse-engineering the ratings process so they could design securities to meet AAA standards. However, this is most likely due to the fact that many agencies are legally required to hold AAA securities. It may be better to do away with the ratings agencies all together and force investment banks, sovereign wealth funds, etc. to evaluate securities themselves rather than relying on a third party with a conflict of interest using a methodology they don't necessarily understand. If we continue to use ratings agencies, they should be paid indirectly by banks or investors through some type of government or market mechanism or the government should rate the securities. Personally, I think ratings agencies allow investors to be imprudent and purchase investment vehicles they don't understand.

Paddy,

Great piece. I think there is some confusion regarding disclosure when it comes to securities, and it would be nice if you could clear it up.

My understanding is it is not simply disclosure of the security vehicles that was necessary; the Securities Acts of '33 and '34 also require that any material information that would affect an investors decision to invest must be disclosed. We cannot speak of Paulson & Co. in a vacuum; John Paulson's firm is THE MOST profitable hedge fund in history. If investors knew that he was betting against ABACUS, and knew just how much he was betting against it, not to mention that he picked the ABACUS stuff, then it is quite possible many investors would have stepped away from the deal. After all, even if you think that the market is going up, wouldn't you be more than a little suspicious if you knew that the guy betting short also constructed the securities you're betting on? It's like buying a house built by a guy who is planning to collect on the fire insurance.

And, what about the ratings agencies?

I am going to have to agree with Michael Brady here. As long as what he said about Goldman having full disclosure about what "the horses are being fed" then I don't see this as being any different from any other securities market transaction. There are always risks to investing and again, the source of the problem really lies with those that did not educate themselves on a mortgage as well as the banks that provided those mortgages to them even though they knew they wouldn't be able to afford them.

The best of many inadequate analogies in the press lately. The longs had access the the same info on the dog food as Paulson did. Paulson had no unique information, only a unique opinion about the implications. Besides, these deals had to have shorts. The longs knew that, but thought that they knew better about the value of the food/horse. And they were right for a long time.

Once again a great job by Patty of explaining the complicated in simple terms.
It should also be noted that some of the "ingredients" of the dog food was "cheap" money provided by the government.

The horse racing analogy leaves out a key fact about the market - the investors were also horse trainers (investment banks) and should have known that feeding dog food (synthetics on mortgage-back securities) would cause the horse to lose the race (lose value). Goldman Sachs disclosed all of the assets in the investment vehicle. The investment banks evaluated the product (which was rated AAA) and decided they would earn money on those assets. I doubt the SEC would have brought this case if Paulson (and not the long investors) was wrong and the assets increased in value. The investment banks made a bad bet and lost money. Whether or not the investment banks knew of Paulson's involvement wouldn't have made people start paying their mortgages.

Martha Stewart went to prison for insider trading. Weren't Goldman and Paulson guilty of the same thing? They had information that the public didn't know and benefited from that knowledge. Cannot the SEC pursue them on these grounds?

My questions is Abacus was filled with "Dog food". The "best of the worst" mortgages. How come big financial institutions like ABN Amro and others did not smell the stink coming out of Abacus?

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