Saturday, April 17, 2010

Hanged by the Purse

What I've read about the shenanigans at Goldman Sachs sure made it seem like they had done something illegal, but I never really believed they would be prosecuted for it. Now, it seems, they will be. The SEC has filed suit over those arrangements whereby Goldman Sachs sold bundles of mortgages to clients as good investments, while simultaneously betting that those investments would fail:

According to the complaint, Goldman created Abacus 2007-AC1 in February 2007, at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst.

Goldman let Mr. Paulson select mortgage bonds that he wanted to bet against — the ones he believed were most likely to lose value — and packaged those bonds into Abacus 2007-AC1, according to the S.E.C. complaint. Goldman then sold the Abacus deal to investors like foreign banks, pension funds, insurance companies and other hedge funds.

But the deck was stacked against the Abacus investors, the complaint contends, because the investment was filled with bonds chosen by Mr. Paulson as likely to default. Goldman told investors in Abacus marketing materials reviewed by The Times that the bonds would be chosen by an independent manager.

Note, though, that this is a civil suit, which means that the crooks who dreamed this up are not likely to face jail time. Instead Goldman will probably end up having to pay out a lot of money to the investors they bilked, along with a fine. This would be in keeping with the medieval dictum about law: "poor man hanged by the neck, rich man by the purse."

7 comments:

David said...

Like a lot of people, I find it difficult to figure out exactly what was going on here. The phrase "bet against" obscures more than it reveals. It seems that Goldman held certain mortgages, and, as I assume most such banks do, also bought insurance policies on those mortgages in case the recipients defaulted. The scheme seems to have been that they would then sell the mortgages to other investors, but keep the insurance. The payoff came when the actual buyers of the homes defaulted, and the other investors and their insurance companies were responsible for the debt, but Goldman still got paid for its own insurance policies. This is as if I buy you a health insurance policy, you get sick, and I collect the insurance payments, but you still have to pay your doctor. At least, that's my understanding.

What insurance company would sell insurance in such circumstances? Isn't there some law that says if you buy insurance on something, you have to have responsibility or some active interest in the thing insured (as in, if you buy auto insurance, the regular driver of the car should be yourself, or a family member, employee, or something like that)?

John said...

The fraud was assembling mortgage packages made up of the mortgages they thought were most likely to fail, and telling the people who bought the packages that the mortgages were chosen for value. So the underlying business scheme was not illegal, just the way they marketed the mortgage-backed bonds they were selling.

David said...

Yes of course, but everything I've read indicates that Goldman made its money by retaining insurance on the mortgage bundles it sold. Selling the mortgages may have made some revenue, but my impression is that they expected the big profits to come from the insurance.

John said...

That's right. But when a bank acts as a broker, it is supposed to ask with the best interests of its clients in mind. Goldman was clearly acting in the interests of those, including itself, who took out the insurance contracts, and not the interest of the brokerage clients to whom it sold the bonds.

David said...

I understand. I'm simply asking, how is it that they could have insurance on something they no longer owned? Without that, the scheme would have been certainly actionable, dishonorable, and immoral, but it would not have amounted to a speculative bubble dangerous for our whole economy.

John said...

These contracts are "derivatives", that is, their value depends on the value of something else. You can buy a derivative that depends on just about any other value, if you can get somebody to sell it to you. So, yes, you can buy derivatives that depend on the value of things you do not own. For example, you can buy a derivative that depends on the Dow Jones Average. Derivatives that depend on the value of currencies are common. You don't have to own any euros to buy a derivative whose value depends on the value of the euro.

So what they did was buy "insurance" contracts that depended on the value of their bonds, then they sold the bonds; because the "insurance" was just a derivative based on the value of the bond, it didn't matter that they no longer owned the bonds.

David said...

Ah, now things begin to make sense. I've been hearing about derivatives all along, but not really known what they were. Now, having looked the term up as well, the logic of the situation is much clearer--though it is strange to me that things such as derivatives exist.