Shorting Goldman Sachs

How solid is the Securities and Exchange Commission’s fraud suit against the venerable investment banking and securities firm Goldman Sachs? And why doesn’t the suit name John Paulson, the investor who helped design the suspect investment vehicle, known as Abacus 2007-AC1?

The SEC charges that Abacus was Wall Street’s version of The Producers’ Springtime for Hitler — designed as a surefire flop that could reliably be bet against. Abacus held 25 mortgage securities chosen with help from hedge fund manager Paulson, who picked securities he thought would lose value. The securities allowed investors like Paulson, who expected the housing market to drop, to buy insurance against mortgage bonds. When housing and the bonds’ value did indeed get flushed down the toilet, investors in Abacus lost their shirts. But Paulson pocketed $1 billion.

The government claims that Goldman never disclosed that Paulson chose securities that he expected to go belly up. Goldman denies wrongdoing, but its market value plunged $21 billion in the two weeks after the SEC sued, and federal prosecutors are now looking into the deal.

BU Today discussed the case with Cornelius Hurley, a School of Law professor of the practice of banking law and director of the school’s Morin Center for Banking and Financial Law, and Elizabeth Nowicki, a LAW visiting associate professor of law and a former SEC staffer.

BU Today: What are the merits of the civil and possible criminal charges against Goldman Sachs?
Nowicki: The SEC case has merit. I think this case is ultimately going to settle, but Goldman Sachs made a big mistake by not settling the case before it was publicly announced. But these were not the sorts of facts that cried out for criminal prosecution.

Hurley: I wouldn’t disagree. But how could Goldman have been waging this public relations campaign, knowing that these proceedings are out there? A public company is not required, in most circumstances, to disclose that it’s under investigation. But did these people play by the rules of good business practice?

What about John Paulson’s culpability?
Nowicki: Paulson didn’t have any disclosure obligation. Paulson was smart in trying to get Goldman to put together a product against which Paulson was going to bet that was really a dog.

Hurley: When I read the complaint I thought — why not this guy? He didn’t have the same obligation, but he was aiding and abetting the transaction. This guy better be lawyering up.

Nowicki: The SEC could bring an aiding and abetting lawsuit against Paulson, because after Enron, the SEC got aiding and abetting authority, by federal statute. But I don’t know that they can make that case.

How do you explain the SEC not going after him?
Nowicki: One, they have their hands full. Two, it serves their purpose not to go after Paulson now. The SEC is going to need to put Paulson and his representatives on the stand if this case goes to trial. I will understand if Paulson’s able to slink away.

Hurley: He’s not out of the woods by any stretch. The SEC wasn’t required to blow its whole wad.

Charlie Rose’s interview with Goldman CEO Lloyd Blankfein asks about the essential conflict of interest in investment banking: selling and buying at the same time, telling different stories to sellers and buyers. Even if Goldman had disclosed Paulson’s involvement, are we that corrupt as a society that we think disclosure cures everything? If I’m driving and putting my blinker on and off and on and off, I’m disclosing that I’m going to drive recklessly. Does that give me license to drive recklessly?

Any opinions on whether the financial reform legislation would address this?
Nowicki: These derivative transactions magnify the negative impact of the transaction to which they are keyed. Abacus didn’t involve any mortgages; it was a bet, not on the Kentucky Derby, but on the bets made in the Kentucky Derby. If the value of the mortgages decreased, the people betting on these derivative transactions lost money.

Hurley: The reform would require derivatives to be traded through a clearinghouse and the pricing of derivatives to be posted on an exchange. Senator Blanche Lincoln (D-Ark.) also proposed that any institution that had federal deposit insurance — the guarantee of the taxpayers behind it — would not do derivatives. I consider her on the side of the angels.

Rich Barlow can be reached at barlowr@bu.edu.