SEC vs. Goldman Sachs Q&A

As has been widely reported, Goldman Sachs was charged Friday by the Securities and Exchange Commission with defrauding investors in the sale of securities tied to subprime mortgages.

There are so many twists and turns to this story -- allegations followed by denials, what the investors knew and didn't know, charges of omission and misleading statements -- that it gets hard at times for readers on Main Street to make head or tails of yet another account of corporate greed when they're having enough trouble just making ends meet.

To help clear up some confusion over this "Wall Street Gone Wild'" saga, I consulted with a few financial experts to help sort out the complex details of what exactly Goldman Sachs is being charged with.

Let's start right from the beginning and ask:

What exactly is Goldman Sachs and what are its responsibilities?

According to Yaniv Grinstein, Associate Professor of Finance at Cornell University, "Goldman is an investment bank. [Actually, Goldman outgrew that label in 2008 when it became a bank holding company.] One of the investment banks' businesses is to design securities for which they think that there is a demand by the market. The profits of the bank are based on commissions from the parties that trade these securities. This is in general a good thing. A simple example might be designing a future contract that fixes a price of a particular fruit in the future. Growers of the fruit might be happy to sell such a contract (i.e., if the spot price of the fruit is high, they will need to pay to the other party the difference between the fixed price and the spot price, and if the spot price of the fruit is low, they will get from the other party the difference between the fixed and the spot).

"Buyers of the fruits might be interested in going long on such a contract because it takes fluctuations in the purchasing price of the fruit. This is the "good side" of investment banks. As mediators, they make markets more efficient. Their motivation to do so is the commissions that they make.''

Were investors misled in this case?

Grinstein thinks: "An interesting analogy is that of a realtor. A realtor's job is to help potential buyers of houses meet potential sellers of houses. When a buyer of a real estate goes to a realtor, he expects the realtor not to conceal information about the condition of the house. If the realtor, by trying to push for the sale, is "cutting corners" and not telling the buyer about problems in the house, then the buyer will suffer. The problem might be even more severe if the realtor is making additional gains from the sale -- (i.e., being an interested party).''

Looking at it strictly from a legal perspective, does the SEC have a case against Goldman, especially with the way it designed the security (Abacus CDO)?

"The security'' Grinstein maintains, "is used by investors to speculate or hedge themselves against fluctuations in the real estate mortgage market. So far so good.

"However, the way it was structured smells badly. It turns out that the security was pushed for by an interested party (Paulson) who was betting on a fall in the mortgage-backed securities market. This by itself is not an issue as long as there are other investors who were betting on the market staying strong. However, if Goldman knew information about the potential collapse in the market (possibly from Paulson), and if they were not telling the potential buyers this information then this creates a problem, much like a realtor who knows that the house is damaged but still pushes for the deal because of the commission.''

Goldman was accused by the SEC of not fully disclosing the facts about the CDO, which was named ABACUS 2007-AC1. What exactly is a CDO and how does it work?

Luis M. Viceira, professor at the Harvard Business School tells me: "A CDO is not very different, in essence, to the balance sheet of any company out there: it holds assets on the left hand side of the balance sheet, and it issues claims against those assets and the cash flows they produce. Like in any corporation, these claims have different seniority rankings: there is equity, there is junior debt, and there is senior debt. Senior debt holders have top priority on the assets of the firm (e.g., CDO), but in exchange for that, they accept lower interest payments than holders of more junior claims. Mezzanine debt is next, junior debt is next, and finally equity is at the bottom of the priority chain. If we think of a balance sheet as an apartment building, the equity holders live in the lower floors, while the senior debt holders live in the upper floors. When the flood comes in, the first ones to suffer losses are those living in the lowest floors. Only as the flood becomes worse, those living in the upper floors start to suffer losses.''

One critical component of the SEC's case against Goldman is that hedge fund manager John Paulson's involvement -- that his fund was betting that the housing market would crash and was thus planning to short the CDO -- wasn't made known to investors. Is it really as sinister as it seems that investors should have been made aware of Paulson's involvement? (Paulson has not been charged in the case.)

Warren B. Bailey, professor of finance at Cornell University answers: "The idea is that potential purchasers of the other side of this deal should have known who the other party was, in which case they may have thought twice about trading with him.

"However, in any financial market, we have to assume that there are differences of opinion. For example, those people who took the other side of Paulson's trade may have been as clever and well-informed as he was, but just reached a different conclusion.''

If 100% disclosure of "who is on the other side" was imposed on financial markets, many of them would dry up. Differences of opinion make the game, and it is up to the participants to "do their homework" and understand what they may be getting into. In addition to the sales people at an investment bank, the clients themselves may be too greedy and hasty, and make poor choices as a consequence.''

Finally, with people's trust in Wall Street at an all-time low, I wondered if the Goldman case wears down the people's trust in the financial system even further?

Anil K Kashyap, professor of economics and finance at the University of Chicago Booth School of Business, thinks that, "for the average investor, many aspects of investing require trusting rules and institutions to protect people. The allegations suggest that these protections failed and in the process some of the largest other players in the financial system were taken advantage of. If this is proved it will further erode people's trust in the financial system.''