One of the most salient analogies of the financial meltdown was offered by Financial Crisis Inquiry Commission chair Phil Angelides when he grilled Goldman Sachs CEO, Lloyd Blankfein, over the firm’s unsavory proprietary trading. Angelides was questioning Goldman’s practice of minting toxic, mortgage-backed securities and badgering credit-rating companies for the highest rating for those securities, while betting in the market that those securities would later fail.
Angelides likened this business practice to “selling someone a car with faulty brakes and then taking out an insurance policy on the driver.” With Friday’s Securities and Exchange Commission (SEC) filing of civil fraud charges against Goldman Sachs, we learned more about those faulty vehicles. We learned that Goldman had cut the brakes.
How the Scam Worked
The SEC charged on Friday that officers of Goldman had allowed notorious hedge fund manager John Paulson, of Paulson & Co, to deliberately select a cluster of mortgage bonds that he thought would fail. These bonds were then bundled into a “synthetic collateralized debt obligation” (CDO) which was sold to investors. (For the best explanation of this see Joe Nocera, who is back on the beat at the New York Times.) Paulson did not work for Goldman, but was apparently acting as a client (or co-conspirator), paying Goldman $15 million for the opportunity to hand-pick a toxic investment vehicle.
Synthetic CDOs are among the oddest investment vehicles yet devised. Apparently they were created solely for the purpose of giving people like Paulson a way to bet that the housing market would fail. This all may have been well and good in Lloyd Blankfein’s toxic little world, except that before someone could bet against the performance of the CDO, Goldman first had to find some dupes who thought it was gold.
According to the SEC complaint, Goldman not only marketed the CDO to investors, including foreign banks, pension funds and the like, critically, it neglected to tell these investors that the vehicle had been structured to fail by a third party.
The result? According to the SEC complaint, the investors who trusted Goldman and the ratings agencies lost a billion and Paulson made a billion. Literally.
How widespread this practice was is not known at this point, but ProPublica, a small online publication that recently won a Pulitzer prize, documented another case of a similar investment scheme. ProPublica tells the tale of how a hedge fund named Magnetar (for the super-magnetic field created by the last moments of a dying star, get it?) earned outsized returns in the year the financial crisis began in earnest.
ProPublica reports that Magnetar “industrialized” the process, creating more and bigger CDOs working with some of the biggest names in the business including, Merrill Lynch, Citigroup, UBS and JPMorgan Chase. Ninety six percent of Magnetar deals were in default by 2008. Some of these banks lost money, but you can bet the engineers behind Magnetar got very rich.
This single charge regarding a titan of Wall Street trading changes the narrative of the whole financial crisis. Rather than dealing with overly exuberant traders who were taken unawares when the housing bubble burst, we were apparently dealing with very sophisticated traders who were deliberately ramping up the toxicity in the market to make a buck in a manner that harmed other institutions and investors.
These traders helped drive our economy over a cliff, and millions of innocent people, the unemployed, the young who will never go to college and older Americans who can no longer afford to retire, are suffering the consequences. If such behavior is not criminal, it should be.