The Emperors new clothes part 2

If one is to believe the Securities and Exchange Commission’s (SEC) version of what occurred leading to its charges of fraud against Goldman Sachs; hedge fund Paulson and Co. identified a group of vulnerable mortgaged backed securities, worked along with Goldman on creating a synthetic collateralized debt obligation (CDO) based on those securities while Goldman went about to find suckers to take the long side of the trade. One of Goldman’s defenses is that it was one of those suckers.

Goldman earned $15 million for its work on creating the CDOs but took an approximate $90 million dollar hit from its long exposure.

The charges state: In sum, (Goldman) arranged a transaction at Paulson’s request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson’s role in the portfolio selection process or its adverse economic interests.

 There is something very stinky in the whole mess. We never jumped on the bandwagon of criticizing short sellers. Coming from the perspective of Futures, we have never held this long side bias and we have realized that short sellers—counter the prevailing sentiment— have provided a service in the various scandals of the past decade. It was short sellers who would not “shut up” when Enron officials refused to explain it complex deals and sold it short when they noticed problems. We see this case as a move in the right direction for the SEC who previously seemed to jump on the blame short sellers bandwagon. As if the banking crisis were caused by short sellers as opposed to them simply recognizing the solvency issues of the major investment banks.

But there is something completely different from recognizing a mispriced or overhyped product, deciding that it is overvalued and selling it short to those people believing that hype and going about creating a product, finding someone to market it to and then selling it short.

To date the SEC has not charged Paulson but one wonders if that is next. And we would like more detail about the role of the rating agencies in this. The SEC filing notes that 99% of the securities in the CDO were downgraded –how was it valued? How was the rating agency paid? How was the CDO marketed?

 Why didn’t Paulson simply sell the securities (123 according to the SEC charges) short. Did the creation of the CDO create a greater expectation, allowing Paulson to short from a high valuation?  These are questions that need to be answered.  

Futures contracts are created to manage risk. An exchange recognizes a risk and engages with people in that industry who hold that risk to create a product that will allow them to transfer that risk. Speculators come later to make a market and make bets based on their knowledge of the underlying asset. That is quite different from a hedge fund or investment bank recognizing a house of cards and creating a product in an attempt to get the last few suckers at the table to put up their money before it all implodes.

You don’t have short sellers asking a bank –or shouldn’t—to create crappy companies with bad management in order to short.

About the Author
Daniel P. Collins

Editor-in-Chief of Futures Magazine, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange. Dan joined Futures in 2001 and in 2005 he was promoted to Managing Editor, responsible for overseeing all the content that went into Futures and Dan’s incisive reporting and no-holds barred commentary places him among the most recognized national media figures covering futures, derivative trading and alternative investments.

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