• SEC Accuses Goldman Sachs of Playing Liar's Poker, Bonfire of Vanities Ensues
  • May 4, 2010
  • Law Firm: Waller Lansden Dortch & Davis, LLP - Nashville Office
  • The SEC’s suit against Goldman Sachs is starting to look like a battle for the soul of the U.S. financial industry, and for good reason.  The SEC’s case gets to the heart of financial engineering as it was practiced during the mortgage-backed securities boom of the mid-aughts, the hangover of which the world economy is still suffering. The transaction in question, the sale of a synthetic Collateral Debt Obligation styled “ABACUS 2007-AC1” to institutional investors, is a case study in how investment banks used mortgage debts to increase their leverage exponentially, but I think that the financial press is missing the real meat of the story.  The real story is that investors that lost on the deal didn’t buy a mortgage-backed security at all -- in fact, the transaction didn’t involve any mortgage assets at all.  The aggrieved investors bought shares in a bet that a collection of mortgage-backed bonds would not default, and they lost.

    My guess is that folks in the Enforcement Division at the SEC read Michael Lewis’s article The End, and have been savvy to the game ever since.  Lewis, whose book Liar’s Poker shed a not-so-nice light on the 1980’s iteration of Wall Street, presents a story that is prescient despite often being profane; the crown jewel of the article is a succinct explanation on page five of how bad home loans in Florida led to insane levels of leverage on Wall Street.  The idea is that because interest rates reflect risk of default, there is effectively no difference between the cash flow produced by an interest-only mortgage and a credit default swap on that mortgage.  The SEC is clearly aware of this -- paragraph 13 of the SEC’s complaint could have been written by Lewis.  This element of financial alchemy meant that an investment bank could double down by engineering a bond that mirrored the performance of any other bond simply with the payments that they received on a side-bet, and they could do so without ever having to own any interest in the underlying assets.  This is the type of security that a man much smarter than me has referred to as “Financial Weapons of  Mass Destruction.”

    In the Goldman Sachs suit, the SEC has identified an interesting example of the life cycle of a synthetic CDO.  The SEC’s suit rests on the theory that because the securities were allegedly designed by a third party who expected them to default and had a financial interest in such, and the alleged failure to disclose that third party’s involvement was a material misstatement or omission.  Still, all the parties involved were financially sophisticated, Goldman Sachs has indicated they intend to put up a good fight, and the SEC will have to prove scienter, or a guilty intent, in order to prevail.  Goldman’s defense?  My guess is it will be an artful formulation of “c’mon, ref -- we’re all big boys.  Let us play!”  The only thing that is certain is that this case will be interesting to watch.