The government's civil fraud case against Goldman Sachs raises so many provocative questions.
Did the firm deliberately mislead its clients who bought a mortgage-related investment without the knowledge that it was devised to fail? Was it fair that a bearish hedge fund manager helped to pick the parts of an investment marketed as bullish so that he could bask in the winnings?
Who besides the vice president named in the lawsuit knew details of the deal in question? Were there other deals like this one?
But if there is a larger question, it is this: Why was Goldman, or any regulated bank, allowed to create and sell a product like the synthetic collateralized debt obligation at the center of this case? What purpose does a synthetic CDO, which contains no actual mortgage bonds, serve for the capital markets, and for society?
The blaring Goldman Sachs headlines of the past few days have given the public a crash course in synthetic CDOs. Many more people now know that synthetic CDOs are a simple wager.
In this case, they were a bet on the value of a bundle of mortgages that the investors didn't even own. (That's why it is called a derivative.)
One side bets the value will rise, and the other side bets it will fall. It is no different from betting on the New York Yankees vs. the Oakland Athletics, except that if a sports bet goes bad, American taxpayers don't pay the bookie.
"With a synthetic CDO, it's a pure bet," said Erik F. Gering, a former securities lawyer at Cleary Gottlieb Steen & Hamilton who is now a law professor at the University of New Mexico. "It is hard to see what the social value is — it's hard to see why you'd want to encourage these bets."
Social value is a timely question because regulating derivatives is the issue du jour in Washington as a set of proposed financial reforms moves though the Senate. The Obama administration's plan includes a rule to require any banks that create a synthetic CDO to keep a stake of at least 5 percent, in an effort to keep them accountable and eating their own cooking. But is that enough?
Because structuring derivatives like synthetic CDOs is so lucrative — $20 billion a year, by some estimates — it's no surprise that Goldman Sachs is among the banks that oppose regulating them.
"The pushback on regulating derivatives is quite amazing," said David Paul, president of the Fiscal Strategies Group, an advisory firm specializing in municipal and project finance. "It's all just become a casino. They argue there is social utility — but you know intuitively this is wrong."
Through their powerful lobbying arms, Goldman Sachs, JPMorgan Chase and others have been trying to convince lawmakers that tough regulation on derivatives would stymie the capital markets.
"I believe synthetic CDOs have a very useful purpose in facilitating the management of risk," said Sean Egan, managing director of Egan-Jones Ratings, echoing the view of many in the industry. "Just as options have a valid position in the investment universe, so do synthetics. Such instruments facilitate the flow of capital."
The Securities and Exchange Commission, in its suit, says that hedge fund tycoon John Paulson asked Goldman to help create a synthetic CDO of lousy mortgage loans that he selected so he could bet that they would go down and then profit on their fall.
Of course, as with any bet of this sort, Goldman needed an investor to take the opposite position. Goldman found that in firms like IKB Deutsche Industriebank and ABN Amro. They weren't told, however, that Paulson had heavily influenced which assets were included.
The case against Goldman could pivot on whether this omission was "material" to investors. Goldman says it wasn't. It maintains that the investors got to see every mortgage in the basket, and that the manager of the deal, ACA Management, replaced some of Paulson's picks with its own.
This kind of high finance can numb the brain, and the legal questions are murky. But when you strip all of that away, this deal was nothing more than a roll of the dice.
Imagine if, a few years ago, an influential investor like Warren Buffett, bullish on real estate, had asked Goldman to develop a synthetic CDO made up of undervalued mortgages.
Now, imagine if Goldman had found John Paulson to take the opposite side of the trade and, lo and behold, a year later Buffett turned out to be right and Paulson lost his shirt. Would you call that fraud? Would you be very upset? Maybe not, but Paulson sure would be. And he might be inclined to sue over it, especially if he found out that his bet had been rigged against him from the start. Which brings us back to the financial legislation being debated in Washington.
"Ultimately," Gering, the securities lawyer, said, "litigation is a poor substitute for regulation."