Designed to Fail

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I’m sure by now you’ve heard that Goldman Sachs (NYSE:GS) has been indicted for fraud. Goldman is accused of creating securities that were designed to fail, so it and its hedge fund cronies could make billions in profits.

Case in point: Abacus 2007-AC1. "Abacus" was a 23-part series of "synthetic collateralized debt obligations" that Goldman Sachs constructed and sold to supposedly sophisticated investors.

According to Bloomberg, a "synthetic collateralized debt obligations" was a mixture of "…credit- default swaps (CDO), used to transfer the risk of losses on debt, and securitization, used to slice the risk in a pool of assets into various new securities."

(We’ve discussed how the securitization process allowed good (prime) and bad (subprime) mortgages to be combined to create new securities that inevitably received undeserved AAA ratings from rating companies.)

Abacus 2007-AC1 was one such synthetic collateralized debt obligation. When Goldman went to sell this security to investors, it didn’t reveal the fact that hedge fund Paulson & Co. (no relation to former Goldman CEO and Treasury Secretary Henry Paulson) had helped choose the securities that would be included. Also not revealed was the fact that Paulson& Co. bet that Abacus 2007-AC1 would default.

Paulson & Co. made $1 billion when the Abacus 2007-AC1 CDO inevitably defaulted. It was designed to fail.

It seems a stretch to think that Goldman Sachs didn’t know that Abacus 2007-AC1 was designed to fail. And there were 22 other Abacus transactions between 2004 and 2007.

*****Now, it is well known that some mortgage loans are more risky than others. Risky loans carry higher interest rates, to offset the risk. This has always been true.

But the securitization process made it possible to hide risky loans alongside low-risk loans. And it’s clear that rating agencies like Moody’s or Standard & Poor’s did not do enough due diligence on these CDOs to find out exactly what was in them.

In my opinion, the ratings agencies deserve some of the blame. But that doesn’t change the fact that the securitization process was a deliberate attempt to "put one over" on the ratings agencies.

*****At this point, I keep coming back to all the people who continue to say there was no way to see the financial crisis coming. It’s a long list, full of bank CEOs, current and former Fed officials, Treasury officials, and Congressmen.

Well, how about this: I’d say that not only was it possible to see the financial crisis coming, the financial crisis was a direct and inevitable result of the types of transactions Goldman Sachs was conducting.

In other words, it wasn’t the housing bubble and the sub-prime loans that created the financial crisis, it was the deliberate concealment of risk through securitization that caused the financial crisis.

*****If investors know they are buying risky assets, then they have to hedge that risk. For instance: if you buy Greek bonds, you know there’s a chance you might not get paid back. And you certainly won’t be able to use those bonds as collateral for other investments.

But what if you buy a Treasury bond that, through the process of securitization, is really just a Greek bond with a better sounding name? And since Treasury bonds are generally considered to be as good as cash, you use it as collateral for other investments? 

Well, when that bond defaults, not only do you lose the money you spent on the bond, you also suddenly do not have the collateral needed to support your other investments. And the whole thing comes crashing down, like a big margin call.

*****So who’s at fault? Clearly, investors didn’t know what they were buying. And ratings agencies didn’t know what they were rating. But still, the SEC is charging Goldman Sachs with fraud, for deliberately misleading both investors and the ratings agencies about the risk of CDOs like Abacus.

If these charges are proven, then investors and ratings agencies may be guilty of being gullible. But Goldman is guilty of lying.

*****And it may not be just Goldman Sachs. JP Morgan (NYSE:JPM), UBS (NYSE:UBS), Deutsche Bank (NYSE:DB), and others created and sold synthetic mortgage-backed CDOs.

According to Bloomberg, UBS has already been sued by Hamburg-based HSH Nordbank AG for "deliberately selecting inferior quality" assets for a synthetic CDO called North Street that was sold in 2002-2004.

It seems inevitable that the SEC will be bringing fraud charges against other investment banks. And quite frankly, I find it hard to believe that the ratings agencies didn’t know their ratings were wrong. I won’t be in the least bit surprised if we discover that the ratings agencies were getting payouts to slap AAA ratings on these synthetic CDOs.

*****There’s not much we as individual investors can do about this now. But there is a lesson, and it’s buyer beware. When it comes to investing, know what you’re buying and who you’re buying it from.

*****And while I’m on the subject, I’ve got to mention AIG (NYSE:AIG). After all, AIG insured tens of billions of dollars of these synthetic CDOs. Did it never occur to anyone at AIG that maybe, just maybe, there was a reason so many banks were asking for CDO insurance?

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