In Search of a Villain

In SEC v. Goldman Sachs, the government makes Wall Street the fall guy.

By Andrew C. McCarthy
http://www.nationalreview.com/
April 20, 2010 4:00 A.M.

When the Securities and Exchange Commission threw down the gauntlet against Goldman Sachs on Friday, Henry Kissinger’s bon mot on the brutal 1980s war between Iran and Iraq sprang to mind: “Too bad they can’t both lose.”

Succinctly summing up the allegations, SEC enforcement chief Robert Khuzami quipped that the financial “product” at the heart of the suit “was new and complex, but the deception is old and simple.” Khuzami, an old pal and my partner on the Blind Sheikh terrorism prosecution, is smart, tough, and knows the securities laws through and through. To paraphrase the great football coach Bill Parcells: Goldman better bring its lunch, because it’s going to be a long day.

Still, the choice of words is telling: “deception,” not “lie.” The other side of this coin is evident in Goldman’s vigorous denial of wrongdoing. As the Wall Street Journal put it, the company insists “it made the proper disclosure” on the transaction at issue. This case comes down to what the law calls “material omissions”: Goldman claims everything it said about the securities it marketed was true; the SEC counters that Goldman failed to say everything it was obliged to say.

What is the card that Goldman is accused of withholding? It is the fact that the securities in question, a species of collateralized debt obligation (CDO), were designed by hedge-fund magnate John Paulson, who dearly hoped his creation would prove worthless. And he had good reason to believe that it would: CDOs are basically pools of mortgages sold to investors as securities, and Paulson had the smarts to foresee the housing meltdown before it was on the national radar.

In the Age of Obama, Paulson is the perfect villain: the corporate tycoon who is responsible for the whole mess — which the Obama administration would have you believe proximately caused the financial meltdown of 2007–08 — and yet rides away unscathed. Yes, he made a tidy $4 billion when the bubble burst and the mortgage market crashed, but he is not charged in the SEC’s Goldman suit. As Khuzami put it, “Goldman made the representations, Paulson did not.”

So, Democrats chime in on cue, we must have the umpty-umpth regulatory overhaul of the financial system to do what we were promised the last one (Sarbanes-Oxley) would do: perfect disclosure, eliminate risk, and ensure that anyone who makes a profit because he’s better than the rest of us at reading the tea leaves gets his comeuppance. But Paulson did not escape the noose because of a regulatory loophole: He is not charged because it is not a crime to be smart — not yet, anyway.

Paulson figured out that the government had tried to turn the dream of home ownership into a right of home ownership through a series of extortionate devices such as the Clinton-era amendments to the Carter-era Community Reinvestment Act; the Clinton-era crackdown on “redlining,” which saw the government accusing banks of racially invidious practices for failing to make loans to people who couldn’t afford to repay them; and a Bush-era delusion called the American Dream Down Payment Act, which was in fact a down payment on compassionate conservatism’s dream of creating an additional 5.5 million minority homeowners by 2010 — a dream that turns out to have come at a nightmarish cost of hundreds of billions of dollars, and counting.


Each of these initiatives had the effect of pressuring banks into making risky mortgage loans. The government thumb on the scale induced credit raters to abdicate their responsibilities, while private-public chimeras Fannie Mae and Freddie Mac poured fuel on the fire, backing ever more risky loans with an implied guarantee that taxpayers would pony up when, inevitably, the debtors couldn’t.

Paulson assayed the playing field and drew two conclusions: first, that the system was headed for collapse, and, second, that the government was remorselessly committed to the system. So, he paid market-maker Goldman Sachs $15 million to peddle an investment vehicle he fashioned from the riskiest mortgages: not because he thought it would thrive, but because he wanted to bet against it. As Goldman sold these CDOs to investors, Paulson countered by putting his money into credit-default swaps, so he’d be covered when the crash he thought inevitable finally hit. He was right and the CDO investors were wrong, so he made a killing and they lost their shirts. But Paulson didn’t lie to make his killing. He correctly calculated that the system was unsustainable and shorted it. The other guys bet the other way and lost.

So if Paulson is just a smart guy who didn’t do anything wrong in manufacturing the CDOs, why is Goldman in the soup for selling them? In SEC logic, it’s because the seller knew the manufacturer had a dirty mind but didn’t let the buyers in on that detail.

That is absurd. The supposedly duped investors were no babes in the woods. They were highly sophisticated players. Indeed, the specific investment vehicle at issue is not merely a CDO but something even more esoteric: a synthetic CDO. As the Wall Street Journal’s editors explain, this sort of CDO is not actually composed of the risky mortgages themselves, or even of securities derived from the mortgages. Instead, the synthetic CDO (known as “ABACUS 2007-AC1”) was a financial instrument contrived specifically to enable investors to gamble on whether the value of the underlying assets (the risky mortgages) would rise or fall. We’re not talking about a schoolyard pick-up game here — this is the big leagues. The players are pros, and when they play, it is understood that there will be winners and losers.

In this instance, the investors assumed that a government-run gravy train never ends and that there is no day of reckoning. In contrast, Paulson assumed that at some point the piper must always be paid. Paulson, of course, was right.

Unless the SEC has more than what is laid out in its complaint, this isn’t fraud. It’s politics. If you want to talk material omissions, to charge Goldman but not charge Paulson is pretty darn material. If what Goldman was selling was fraudulent, it can only be because what Paulson manufactured for sale was fraudulent. The two were in cahoots. If what Paulson did was perfectly lawful, Goldman can’t be legally culpable for helping him do it.


Paulson is not like a mob bookie who secretly pays the better team to shave points. He’s an analyst who realized that the team everybody was betting on was actually awful. He didn’t do anything to stop them from beating the point spread — he just realized there was no way they could do it. He saw that the government had rigged the rules, treating unqualified borrowers as qualified. He had plenty of skin in the game, and he’d have been the big-time loser if the government had proved able to realize its fantasy of increasing homeownership without increasing mortgage risk. Paulson correctly figured that once the game was actually being played — the game of life in which people’s dreams run up against people’s means — the unqualified borrowers would never get near the goal line.

To extend the metaphor, Goldman just took Paulson’s action, as it was allowed to do — as, indeed, it is its business to do. Goldman and the sophisticated CDO investors wagered that subprime borrowers would meet mortgage obligations that were out of their stars — a belief actively encouraged by the same government that now has Goldman in its crosshairs. They were wrong: Goldman says it lost $90 million on the transaction. That is, knowing everything there was to know about Paulson’s role in structuring the product, Goldman bet with the investors against Paulson. The investors were no more deceived than Goldman itself was. And the deception wasn’t caused by Paulson (which the SEC implicitly admits by not charging him). It was caused by the delusion that government could forever suspend the laws of economics.

The statists who gave us the financial meltdown are making a wager more insidious than anything Paulson or Goldman ever came up with. They are betting that Americans will be duped into believing that something other than pandering — something other than the government’s scheme to use taxpayers’ dollars to purchase the loyalty of low-income and minority voters — is responsible for our current straits. Obama & Co. are constructing a narrative that says a near-depression was triggered by greedy Wall Street predators who dragged investors under water. If you buy that, they get a double boon: They escape blame, and they bolster their campaign to grab more control of the private sector under the guise of “regulation.”

Don’t buy it.

— Andrew C. McCarthy is a senior fellow at the National Review Institute and the author of Willful Blindness: A Memoir of the Jihad (Encounter Books, 2008).