Corporate Governance

SEC v. Goldman: The Failure of the Market and the Need for Substantive Reform (The Role of Paulson & Co)

By J Robert Brown Jr.

One thing is clear, however this case comes out.  Paulson & Co. was not a bad actor (despite suggestions to the contrary in the press), at least based on the facts set out in the complaint, and it was appropriate that the Commission did not charge the Hedge Fund.

In advance of almost everyone else, Paulson & Co discerned the oncoming financial collapse in the housing market.  It effectively sold the market short by purchasing insurance (often in the form of credit default swaps).  As is now widely recognized, the approach was a demonstration of sophisticated business acumen that earned the founder of the firm, John Paulson, somewhere around $4 billion. 

To make its bet, Paulson unsurprisingly wanted to buy insurance (the swaps) on bond portfolios that were, according to its analysis, most likely to deteriorate.  The firm, however, needed to find swap sellers, a task presumably made more difficult in early 2007 by the growing awareness of the problems in the subprime market.   

According to the complaint, Paulson wanted Goldman "to help it buy protection . . . on the [mortgage backed bonds] it had adversely selected".  In other words, Paulson intended to continue to bet against the housing market and sought help from Goldman to find the counterparties.  Moreover, as a savvy investor, Paulson only wanted to bet against the securities with the greatest risk of default, those full of:   borrowers with low credit scores, variable mortgages, and mortgages issued in states already beginning to suffer the worst of the housing crisis.

It was Goldman's task to find the counterparties.  Ultimately, this was accomplished through the creation of the synthetic CDO.  Yet Paulson's goal wasn't a synthetic CDO per se.  Presumably Paulson would have been content to buy the swaps from AIG or from anyone else willing to take the long side of the risk.  Indeed, as the complaint points out, Paulson discussed multiple potential transactions with Goldman (see para. 16), only one of which was the synthetic CDO.  See Para. 16 ("Among the transactions considered were synthetic CDOs whose performance was tied to Triple B-rated RMBS."). 

The complaint does suggest that Paulson had considerable involvement in the selection of the securities used in the synthetic CDO.  Para 25 ("Paulson informed GS&Co that it wanted the reference portfolio for the contemplated transaction to include the RMBS it identified or bonds with similar characteristics.").  But this is merely another way of saying that Paulson wanted only to bet against certain securities.  

The complaint presents no facts that suggest that Paulson participated in the drafting of the relevant disclosure documents used by Goldman.  The complaint presents no facts that suggest Paulson participated in the marketing of the CDOs.  Finally, there are no facts in the complaint that suggest Paulson conditioned the purchase of the swaps on the non-disclosure of its role as a counterparty.  At least as the complaint describes, Paulson is guilty of nothing more than wanting to bet against some highly risky bonds and successfully convincing Goldman to come up with the counterparties. 

The complaint is posted on the DU Corporate Governance web site. 

Full post as published by The Race to the Bottom on April 19, 2010 (boomark / email).