The Goldman Deal: Adults Living Dangerously

There's an old cliché about investing which holds that every transaction, even the sale of a single share of stock on a regulated exchange, has a winner and a loser. When you buy that share you're obviously betting it will rise, and whoever sold it is figuring that it will fall.

Most small-time investors don't see the market in such starkly zero-sum terms. But sophisticated players surely understand that is what much of investing is about, especially with complicated products like credit default swaps that explicitly let you place bets for or against a market.

It's difficult to know at this point whether Goldman Sachs was a winner or a loser in the now infamous Abacus 2007-AC1 collateralized debt obligation that is at the heart of Securities and Exchange Commission accusations of fraud by the investment bank. The SEC claims that Goldman didn't tell two big investment players who bet on the upside of the housing market through Abacus that hedge-fund operator John Paulson, who was shorting the market, had a hand in selecting the portfolio for the deal.

But the CDO market is a fairly specialized sandbox where adult investors generally play at their own risk. Both of the Abacus players who lost big time, the German bank IKB and ACA Capital, had the opportunity to examine the components of the deal. In fact, one of ACA's units helped select the mortgage-backed securities that determined how Abacus performed. And, Goldman says that it ultimately wound up losing $90 million itself along with IKB and ACA.

At least 99 percent of the media coverage of the SEC charges over last weekend either completely ignored the nuances of the transaction or buried them deep in the coverage. Instead, the storyline was simpler, namely that authorities had charged Goldman with fraud for not disclosing to investors that a financial product it was peddling had been designed by a short seller to fail.

The New York Times was more accurate in its December story about the SEC investigation into Abacus which noted that the CDOs were designed to lose investors billions of dollars "if the housing market imploded," something that was hardly a given among investors at the time. In fact, many investors knew the risks but were happily betting on the housing market's upside and believed that portfolios of subprime mortgages were largely safe. Some of these investors were actually eager to take on the housing bears, figuring they could take them to the cleaners. In his new book The Big Short, Michael Lewis recounts a conversation that Steve Eisman, another guy shorting the housing market, had with an investor who had taken the opposite position in some deals. The other investor was well aware who Eisman was and boasted to him that he was glad for the existence of shorts because they gave him the chance to make a killing in the housing market, which he was sure wouldn't collapse. Yes, the guy was pathetically wrong. But he wasn't a victim, except of his own bad judgment.

Still, because the controversial Goldman Sachs is involved with Abacus it has prompted all sorts of commentary that's at odds with itself. Speaking on TV on Sunday about the Goldman case, former President Clinton said that lax enforcement at the SEC had contributed to the environment permitting such deals, and he added that if his SEC chair, Arthur Levitt, had remained in place, much of what occurred in financial markets would have been prevented. But Levitt himself, speaking to Bloomberg radio on Monday morning in New York, said he thought the SEC had overreached itself with the Abacus case and worried about the precedent of the commission intervening in deals among sophisticated investors who understood the risks in such contracts.

In the end, one of the real lessons of investments like Abacus which we're in danger of missing is not that big players lacked important information, but rather that they could get into these deals without adequate capital backing their bets. As a result, when the market tanked some of these contracts not only exploded, but they brought the financial system down with it. That's one reason why financial reform in Washington needs to emphasize that even private contracts among big players, especially those which magnify the risk to the system, need to be backed by sufficient capital in the same way that less sophisticated transactions, like buying stocks with borrowed money, have capital requirements.

There is also a question about whether less sophisticated investors should be banned from buying into these volatile deals. Although there is a real problem with identifying who is "sophisticated" enough in such instances, there is one class of investor I know should be protected from themselves: states and municipalities who bet big-time with taxpayer money on complex investments like swaps.

In the last decade politicians eager to insulate their variable-rate municipal bonds from interest-rate swings entered into swaps contracts with Wall Street firms that have exploded since the economy soured. In Pennsylvania alone more than 100 school districts cut swaps deals in which school boards bet that rates would rise. One school district alone, in Bethlehem, has lost at least $10 million, and the state legislature is currently considering legislation that would ban municipalities from entering into such contracts.

As the auditor general of Pennsylvania found out when investigating his state's swap mess, politicians and school board members who authorized these deals couldn't adequately describe them to him and clearly didn't understand them. That's a case of children being allowed to play in an adult investment sandbox. It's not surprising that trouble ensued. But that's also not what happened with Goldman and the Abacus investors.