When Wall Street Deals Resemble Casino Wagers

The government’s civil fraud case against Goldman Sachs raises so many provocative questions.

Did the firm deliberately mislead its clients who bought a mortgage-related investment without the knowledge that it was devised to fail? Was it fair that a bearish hedge fund manager helped to pick the parts of an investment marketed as bullish, so that he could bask in the winnings?

Who besides the vice president named in the lawsuit knew details of the deal in question? Were there other deals like this one?

But if there is a larger question, it is this: Why was Goldman, or any regulated bank, allowed to create and sell a product like the synthetic collateralized debt obligation at the center of this case? What purpose does a synthetic C.D.O., which contains no actual mortgage bonds, serve for the capital markets, and for society?

The blaring Goldman Sachs headlines of the last few days have given the public a crash course in synthetic C.D.O.’s. Many more people now know that synthetic C.D.O.’s are a simple wager.

In this case they were a bet on the value of a bundle of mortgages that the investors didn’t even own. (That’s why it is called a derivative.)

One side bets the value will rise, and the other side bets it will fall. It is no different than betting on the New York Yankees vs. the Oakland Athletics, except that if a sports bet goes bad, American taxpayers don’t pay the bookie.

“With a synthetic C.D.O., it’s a pure bet,” said Erik F. Gerding, a former securities lawyer at Cleary Gottlieb Steen & Hamilton who is now a law professor at the University of New Mexico. “It is hard to see what the social value is – it’s hard to see why you’d want to encourage these bets.”

Social value is a timely question because regulating derivatives is the issue du jour in Washington as a set of proposed financial reforms moves though the Senate. The Obama administration’s plan includes a rule to require any banks that create a synthetic C.D.O. to keep a stake of at least 5 percent, in an effort to keep them accountable and eating their own cooking. But is that enough?

Because structuring derivatives like synthetic C.D.O.’s is so lucrative – $20 billion a year, by some estimates – it’s no surprise that Goldman Sachs is among the banks that oppose regulating them.

“The pushback on regulating derivatives is quite amazing,” said David Paul, president of the Fiscal Strategies Group, an advisory firm specializing in municipal and project finance. “It’s all just become a casino. They argue there is social utility – but you know intuitively this is wrong.”

Through their powerful lobbying arms, Goldman Sachs, JPMorgan Chase and others have been trying to convince lawmakers that tough regulation on derivatives would stymie the capital markets.

“I believe that synthetic C.D.O.’s have a very useful purpose in facilitating the management of risk,” said Sean Egan, managing director of Egan-Jones Ratings, echoing the view of many in the industry. “Just as options have a valid position in the investment universe, so do synthetics. Such instruments facilitate the flow of capital.”

Unlike Moody’s and Standard & Poor’s, Mr. Egan’s agency takes fees from investors, not issuers, for its research. Many critics of the big agencies say this approach presents fewer conflicts, presumably yielding a more honest assessment of an asset’s risk.

Still, Mr. Egan needs products to rate, so his position on derivatives is not that surprising. The core problem with the disputed C.D.O., and other structured finance transactions, was that “investors relied on flawed assessments of risk,” Mr. Egan said.

(By the way, we aren’t hearing lots of questions about the role the big agencies played in rating this Goldman C.D.O., but they clearly misrated it. If they had known that the hedge fund tycoon John A. Paulson had shaped the portfolio and was betting against it, would they have provided the same rating?)The Securities and Exchange Commission, in its suit, says that Mr. Paulson asked Goldman to help create a synthetic C.D.O. of lousy mortgage loans that he selected so he could bet that they would go down and then profit on their fall.

Of course, as with any bet of this sort, Goldman needed an investor to take the opposite position. Goldman found that in firms like IKB Deutsche Industriebank and ABN Amro. They weren’t told, however, that Mr. Paulson had heavily influenced which assets were included.

The case against Goldman could pivot on whether this omission was “material” to investors. Goldman says it wasn’t. It maintains that the investors got to see every mortgage in the basket, and that the manager of the deal, ACA Management, replaced some of Mr. Paulson’s picks with its own.

What’s more, Goldman has said over and over that it arranged these trades for sophisticated investors, not casual 401(k) savers. Goldman’s investors had the expertise and should have known better.

It’s an argument that, while true, makes some people cringe.

“It’s astonishing that they always say ‘sophisticated investors did this,’ ” said Mr. Paul, the financial adviser. “Look at the failure of Lehman and Bear. They were all sophisticated investors.”

This kind of high finance can numb the brain, and the legal questions are murky. But when you strip all of that away, this deal was nothing more than a roll of the dice.

Try this mental exercise: Imagine if, a few years ago, an influential investor like Warren Buffett, bullish on real estate, had asked Goldman to develop a synthetic C.D.O. made up of undervalued mortgages.

Now, imagine if Goldman had found John Paulson to take the opposite side of the trade and, lo and behold, a year later Mr. Buffett turned out to be right and Mr. Paulson lost his shirt. Would you call that fraud? Would you be very upset?

Maybe not, but Mr. Paulson sure would be. And he might be inclined to sue over it, especially if he found out that his bet had been rigged against him from the start. Which brings us back to the financial legislation being debated in Washington.

“Ultimately,” Mr. Gering, the securities lawyer, said, “litigation is a poor substitute for regulation.”

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