Goldman Sachs and Fraud
By Austin
Big story today: Goldman Sachs is being sued by the SEC. Read this for background. Yves Smith at Naked Capitalism has a nice little explanation.
The long and short of it (no pun intended)? Goldman Sachs may have intentionally sold investors products they knew would fail, and had a different department in the firm set up to cash in when they did. This is called shorting.
It works like this. Goldman Sachs sold Credit Default Obligations to investors. These are basically “insurance policies” on debt that Goldman Sachs had. Say Sachs gave a loan to party A. Sachs needs to have X amount of collateral according to certain rules. But Sachs wants that collateral to invest in other things. So, they ask their investors to sell them “insurance” on that collateral. If part A defaults, the investor will be on the hook for the money. If they do not, Sachs will pay an insurance premium plus fees to the investor (making them happy), while not having to have collateral.
So, they sold these CDO’s to investors (the product was called Abacus 2007-AC1). Then, they acted as a broker to traders inside their firm, particularly the hedge fund manager John Paulson. He then short sold these products. The catch? John Paulson was the one who chose the mortgages in the CDO’s in the first place.
Think about this for a second. A short sale works like this:
a. An investor has some security, like a CDO.
b. A broker, like Goldman Sachs, lends this security to a trader.
c. A trader, in this case Paul Johnson, sells these securities for a certain price (say $100 a share), because the trader expects the price to go down.
d. When the price goes down (say to $80 a share), the trader buys them back at the lower price (pocketing the difference of $20), and gives them back to the investor.
The problem? The CDO’s were chosen by Paulson! In other words, he knew what was in them, and then bet they would go down in value! And when the mortgages started defaulting, and the investors were on the hook for the money, the value of the securities plummeted. As they did, Goldman Sachs ate up the profits from short selling.
What a world.
SEC fine = 2 wks of profit at Goldman. Slap on the wrist?
See: http://euandus3.wordpress.com/2010/07/19/990/