Well folks, here we go. The fallout from the housing crisis is beginning to hit the biggest players in the industry. A few days ago, the SEC (the government organization tasked with policing the financial industry) formally filed a civil lawsuit against what was until then perceived to be the proverbial Iron Man on Wall Street – Goldman Sachs. In the lawsuit, the SEC basically accuses GS of intentionally misleading clients who invested in a product that the bank sold them. The ramifications of this can potentially be huge, and this is likely only the first shoe to drop in a series of lawsuits. But I wanted to take a look at exactly what’s going on, how I think it’ll play out, and, in true InvestingDecoded fashion, how you can potentially profit from it.
Exactly what events allegedly transpired to put GS in this situation is kind of tricky to explain. What I’d like to do is set up the scenario without using financial jargon that’ll just end up confusing most people. Let’s set up a real world scenario that parallels the SEC allegations:
Say you own a casino, and a man, let’s call him Mr. Paulsen, comes to your casino and asks you to put a specific model slot machine into this casino. The slot machine Mr. Paulsen is asking to put in the casino is well known to gamblers at the casino as it has historically given healthy pay-outs. Basically everyone who plays on that model slot machine has been winning money. But Mr. Paulsen thinks differently – he thinks that the slot machines are overrated and will eventually stop paying out healthy gains and gamblers will lose money. So he asks you to put the slot machine into your casino so he can get as many gamblers possible playing on it and make money once it stops paying out the cash.
Well, you as the casino owner agree to do it. But before you do that, you want to make sure the slot machine isn’t broken or tampered with. You hire an outside contractor to come inspect the casino to make sure it’s OK. But the vendor, NOT knowing that Mr. Paulsen is convinced the machine will stop paying out, OK’s the slot machine assuming there’s no conflict of interest between Mr. Paulsen and the players.
So you put the slot machine on your casino floor and gamblers clamor to play on it. But you don’t tell them something key – the person who asked you to put the machine there is convinced that you’re going to lose money. Now, as a gambler if the guy who had the clout to get that slot machine on the floor is convinced that the slot machine is overrated an will eventually stop paying out, wouldn’t you think twice about playing on the machine? However, as the casino owner, you don’t disclose this fact to the players. All you do is put a sign on the slot machine saying it was inspected by a third party and it works fine.
Low and behold, the machine stops paying out. Gamblers keep playing and keep losing money and walk away empty-handed. In the mean time, Mr. Paulsen reaps in the rewards from the gambler’s money, on the order of $1 Billion, and you the casino owner keep a share for your services.
This, in a very small nutshell, is what happened in this case. But the casino is Goldman Sachs, the slot machine is Collatorized Debt Obligation (basically a package of mortgages that investors can buy/sell, see past posts for more details) and the gamblers are investors. Furthermore, Mr. Paulsen is actually John Paulsen, a hedge fund manager who correctly bet against the housing market in 2007 and made billions of dollars. What Mr. Paulsen did was ask GS to create a CDO with mortgages that he thought were not as strong as they were perceived to be. He did this by analyzing the quality of these mortgages and comparing them to the credit rating given to them by the big credit rating agencies. The ones that the thought were literally overrated he wanted GS to put in the CDO. GS then hired ACA Management as an independent reviewer of the assets in the CDO (i.e. the independent contractor in the analogy). ACA was tasked to review the mortgages Mr. Paulsen requested to be put in the CDO. But what ACA didn’t know was that Paulsen was holding a short position on those very mortgages.
GS then took the CDO and sold it to investors (mostly foreign governments and banks). But GS didn’t disclose the fact that the person who selected the mortgages in the CDO thinks they’re going to collapse. Do you see the issue here? The bottom line, the SEC is accusing GS of creating a product and selling it to investors while not disclosing the entire story.
You might be thinking that this is a grey area of disclosure, and you’d be correct in thinking this. In my next post, we’ll discuss the holes in the SEC’s case, and how I think the story will play out.
What are your thoughts?
Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!
The Standard Disclaimer:
The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.
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