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Simplifying Wall Street Blunders

Posted by on Apr 19, 2010 in Investment Management | 33 comments

Last April 16, 2010 the US Securities and Exchange Commission charged Goldman Sachs with Fraud.  This explosive move by the SEC has tremendously diminished  investor confidence in Goldman and Wallstreet in general.  The SEC charge is a very serious one because it says that Goldman fraudulently sold its CDO’s (Collateralized Debt Obligations) to its clients at the behest of its other client Paulson and Co who “shorted” the same portfolio. The investors lost around $1 Billion while Paulson made the same amount.

The problem according to the SEC was that Goldman failed to mention to the buyers that the CDO’s that they were buying was chosen by the exact same person who wanted to sell it in the first place. Now if it is not clear to you what the Fraud charge is all about, let me  simplify it for you using a crude analogy

DISCLAIMER: The explanation below and conversations between characters are fictitious and are not quoted from any source, it is solely for educational purposes only and should not be construed as fact.

I want you to imagine a shady “used car” transaction:

A used “car lot operator” was approached by a knowledgeable mechanic. The Mechanic proposes a deal to the operator:  “I would like you to loan me a particular car in your garage, place the car in my name, and I want you to sell it to someone else for me”.

The car lot operator asks: “Are you out of your mind, why in the world would I do that?”

The mechanic says: “because I have a good idea which car in your garage is defective and I’m certain that it will conk out right after it is sold, if you loan me the car that I choose and you can find someone to buy it from me, and I’m right that it conks out, I will buy it back from him at a much lower price, make money and I’ll give you a commission. Think about it, if I am right that the Car Conks out, then that means that car would have caused you a lot of trouble and I would have saved you from that problem!”

The operator says: “So you are telling me that you can tell which one of my cars are worth nothing and you want me to sell it to someone else so that I can still get some money for it? Why don’t I just do it myself? why do I need you for?”

Mechanic: “Because I won’t tell you which one it is until you agree, and besides, you need me because I will take on the risks if this doesn’t go well”

The operator asks: “What do you mean you will take on the risks?”

The mechanic says: “Well, if I’m wrong, then I will buy it back from the buyer, even at a higher price and give you back your car. This is why I want you to loan it to me and put it in my name first, that way the defective car is effectively mine and I take all the risk!, but if I’m right, I will take the profit but will still give you a commission”.

The operator thinks it over and says, “So you are telling me, no matter what, I’ll make money an you take the risks?

The mechanic says: “Yes, so will you loan it to me and sell it to another client of yours for me now?”

The operator says: “okay it’s a deal.” (Who wouldn’t right?)

The operator looks for a buyer for the car, BUT does not mention that the car might conk out soon. Why would he, it’s in his best interest not to right?

So, the operator, because of his slick selling skills successfully finds a buyer who pays for the car at the current price, the operator does not give the money to the mechanic just yet but keeps the money in a safe place, both the operator and the mechanic do not touch the money and wait for what happens to the car. A few days later, the car does conk out, the buyer brings it back to the operator, then, the mechanic arrives and offers to buy it back at a much lower price. After a lot of harsh words and threats of law suits, inevitably, to cut his losses, the buyer decides to just give in. The Mechanic pays for the car at bargain prices using the original money that the buyer gave the operator in the first place.

The buyer gets screwed, the lot operator gets rid of the defective car and even gets a commission for it,  and the mechanic goes home with the bulk of the money.

Now, let’s apply this to the Goldman Sachs Fraud case. I will just change the characters of the story and leave the story in tact, read it again below:

Goldman Sachs was approached by Paulson and Co. Paulson and Co proposes a deal to Goldman Sachs:  “I would like you to loan me a particular Investment portfolio, place it in my name, and I want you to sell it to someone else for me”.

Goldman Sachs says: “Are you out of your mind, why in the world would I do that?”

Paulson and Co says: “because I have a good idea which portfolio of yours is defective and I’m certain that it will be worthless right after it is sold, if you loan me the portfolio that I choose and you can find someone to buy it from me, and I’m right that it becomes worthless, I will buy it back from that buyer at a much lower price, make money and I’ll give you a commission. Think about it, if I am right that that particular portfolio of yours is worthless, then that means that portfolio would have cost you a lot of money and I would have saved you from disaster!”

Goldman Sachs says: “So you are telling me that you can tell which one of my portfolios are worth nothing and you want me to sell it to someone else so that I can still get some money for it? Why don’t I just do it myself? why do I need you for?”

Paulson: “Because I won’t tell you which one it is until you agree, and besides, you need me because I will take on the risks if this doesn’t go well”

Goldman: “What do you mean you will take on the risks?”

Paulson: “Well, if I’m wrong, then I will buy it back from the buyer, even at a higher price and give you back your portfolio. This is why I want you to loan it to me and put it in my name first, that way the defective portfolio is effectively mine and I take all the risk!, but if I’m right, I will take the profit but will still give you a commission”.

Goldman thinks it over and says, “So you are telling me, no matter what, I’ll make money an you take the risks?

Paulson: “Yes, so will you loan it to me and sell it to another client of yours for me now?”

Goldman: “okay it’s a deal.” (Who wouldn’t right?)

Goldman looks for a buyer for the portfolio (which was chosen by Paulson to be Collateral Debt Obligations), BUT does not mention that the particular CDO was chosen by Paulson himself and might conk out soon. Why would Goldman do that, it’s in his best interest not to right?

So, Goldman, because of their slick selling skills successfully finds a buyer who pays for the CDO’s  at the current price, Goldman does not give the money to Paulson just yet but keeps the money in escrow, both Goldman and Paulson and Co do not touch the money and wait for what happens to the CDO. 6 months later, the CDO triggers a series of events leading to the worldwide recession, the buyers bring it back to Goldman, then, Paulson and Co offers to buy the CDO’s it back at a much lower price. After a ton of margin calls, a lot of harsh words and law suits, inevitably, to cut their losses, the buyers decide to just give in. Paulson pays for the CDO’s at bargain prices using the original money that  Goldman has been holding in escrow in the first place.

The buyer gets screwed, Goldman gets rid of the defective CDO’s and even gets a commission for it,  and Paulson goes home with the bulk of the money amounting to at least 1 Billion US Dollars.

Understand it now?

-Mark So

P.S. Please do comment on this thread, I’d love to hear from you.

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33 Comments

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  1. Elmer

    Hi Mark, since this is causing the USD to rise and is giving us opportunity to go long on USD. On the other side, would this weaken the peso?

    • markso

      Hi elmer, yes but not as much. As far as I can see, the peso is currently moving higher and may continue that path until June due to OFW remmittances. However I do not think the Peso will rise more than 43 to the dollar.

  2. Pierre

    Hello Mark, I like very much the analogy. In the need it is the investor who gets screwed. However what Paulson and Co did is teetering on a thin line between legal or not. It seems legal because Paulson is getting the risk that the investment will not “conk” out. What do you think should they charge Paulson and Co or not? Should they have also informed the investors that they are shorting the investment?

  3. markso

    Hi Pierre, Paulson and Co according to the SEC so far is not charged because although they picked the security to short, they did not fool anybody. In my analogy and in real life they really did take all the risks. The fraud charge as it stands right now is solely on the Goldman Sachs Vice President who was overseeing the particular Abacus transaction. The Fraud charge is about Goldman not disclosing to the Buyers that what they are buying was picked by the one who was shorting/selling it. According to the SEC, Goldman mentioned that the particular Abacus portfolio which contained the CDO’s were picked by an “Independent Third Party” According to SEC, that makes all the difference in the world.

  4. Sherwin

    Hi, Mark! I’m still alive and kicking! hehe. Thanks for explaining this really shocking event. Don’t you think the market’s reaction is just a knee-jerk reaction and it may actually be good time to get in (if you are into stock trading)? I don’t know why I’m finding the market’s reaction a little bit over the top seeing as how the US economy has already seen worse hits than this (I’m not sure it’s an appropriate comparison but 1 Billion is peanuts to Madoff— cant seem to remember if the market reacted this way back then). BTW, didn’t Buffet invest in this company?

    • markso

      Hi Sherwin, I don’t think so because whether Goldman is found Guilty or not, the mere fact that the SEC came out and publicly charged Goldman sent a message to the market that we have enough evidence to prove the wrong doing in court. As you know, the ONLY thing of value for a financial firm like Goldman is the perception of trustworthiness which was damaged severely. Remember what happened to Bear Sterns? It was perception that brought it down to its knees. And if more investors start to pull out of Goldman, it could result in another disaster. Now whatever happens moving forward, some damage has already been done.

      • markso

        …And Yes, Buffet has shares in Goldman, and I’m betting that he cringed as well when the SEC came out swinging. However I do think that Buffet’s exposure is still very manageable as a whole, and besides he came in at super bargain prices to begin with. I believe that this was a well played move by Goldman during the height of the recession to keep the perception of the Market that if Buffet still has confidence in Goldman, so should you.

  5. omar manalo

    GOLMAN is just a financial intermediary that matches investors who are willing to SELL(Paulson and Co) with those who are willing to BUY. Investors who are convinced to BUY or SELL investment products should be the one responsible for their decision. Can we really blame GOLDMAN on this? Should GOLDMAN advice every investor on who’s long and who’s short and who to believe in?

    • markso

      Actually Omar, Goldman acted as a Market Maker, that means they put together a buyer and a seller to perform a market transaction. But in order to find a buyer or a seller the market maker has to disclose who chose the security in question. In the case of Goldman, the SEC is saying, if Goldman had disclosed to the buyers that it was Paulson and Co, the same entity that the buyers will be “betting” against, by going long CDO’s then there would be no issue. Problem was, Goldman only told the buyers that the CDO was picked by a “Third Party Entity” which is an outright lie and covered up the fact that the security in question (the CDO) was never picked by an independent third party and was picked by someone who had a vested interest in seeing the CDO’s drop. This is what the SEC is calling Fraud.

      • Pierre

        Hello Mark,

        Would the CDO be less marketable if investors knew that Paulson was on the short side of this investment?

        • markso

          @ Carlo, Hard to say, but the SEC was alluding to that there was a conflict of interest from the beginning. That’s the whole theme of the charge.

  6. Ric

    wow! nice analogy. straight and sweet! it would have taken me days to understand the whole thing. nice one mark! thanks!

  7. Jeff Adapon

    This article reminds me of Peter Schiff’s comment about Wall Street selling stocks to private individuals because hedge funds and brokerages wants to get rid of same stocks.

  8. Den

    Hi guys thanks for the wonderful bedtime story sir mark. So the guy (paulson) who this brilliant idea to begin with may not be charged by SEC, is that it?

  9. Elmer

    Citigroup has cut the party short as it overshadow the Goldman Sach fraud issue…have we seen the last of it at least for the stock market?

    • markso

      Nope, citigroup is a ray of light, Goldman will still be an issue keep watching cnbc and bloomberg. Also the dow has continued to trade down. Risk aversion is still in play

  10. Sangeeta

    Thank you for simplifying it Mark!I wonder is this the error of judgement on Goldman Sach’s part or they think could get away with this.

  11. Megansf

    Thanks for making this so simple to understand! I’m a student now and was trying to incorporate this into one of my papers and couldn’t find a succinct way of understanding this. Thank you so much!

  12. Rahul Salvi

    Excellent markso..
    God Bless You..

  13. mel

    wow thanks for the simple and clear explanation. i didn’t know Goldman transfered all risks to the stockholders. it all looks so much like an orchestrated robbery. they were smart, but i’m glad they are exposed now. hope they end up paying up for this crime.

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  16. Pararoalo

    Hello! Just want to say thank you for this interesting article! =) Peace, Joy.

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  20. andrew

    salamat sir mark ang ganda ng explanation mo.

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