Why Goldman's Explanation Doesn't Work

They must have felt better after Tuesday's hearing, the Senators who got to ventilate their Kabuki outrage and the Goldman witnesses their defiant self-rationalizations. But in the end, Goldman lost ground.

In essence, Goldman argues that it served as an intermediary between long and short investors in ABACUS 2007-AC1, the first synthetic CDO ever to achieve tabloid fame, perhaps eclipsing, however momentarily, Kate Gosselin. Goldman claims it made extensive disclosure to sophisticated investors on both the long and short sides, and let these grownups decide for themselves if they wanted to invest. They should have to bear the risks that they voluntarily undertook, contends Goldman, perhaps overlooking the fact that it didn't bear any of the risks it voluntarily undertook in connection with AIG because the U.S. taxpayer (i.e., you) bailed out AIG, and therefore Goldman.

Synthetic CDOs are, on paper, pure bets. They don't actually hold any underlying investments and the payments investors make for them do not finance the building of factories or the development of advancements in computer memory chips. There is no intrinsic difference between a synthetic CDO and a sports bet. Both are wagers and nothing more.

But ABACUS 2007-AC1 wasn't analogous to an ordinary sports bet. It was like betting with someone who got to pick the lineups for the competing teams; in other words, someone who rigged the game. If you didn't know that--and it became indisputable from yesterday's hearing that IKB, one of the long investors in ABACUS 2007-AC1, didn't know about John Paulson & Co.'s role in choosing the collateral--you could get hosed. Which is exactly what happened to the long investors in ABACUS 2007-AC1.

So Goldman's explanation doesn't work. It wasn't just an intermediary between sophisticated investors that made informed bets on a fully disclosed investment. It was a promoter of a rigged bet that didn't disclose to everyone the playing field had been tilted.

Whether Goldman is legally liable remains for the courts to decide. However, it failed at the principal challenge it faced in yesterday's hearing, which was to diffuse the public controversy over the SEC's case. It had no appealing story for why Horatio Alger would want to grow up to be a synthetic CDO salesman. Goldman's witnesses offered only carefully crafted testimony that brought to mind some politician's line about the absence of controlling legal precedent or another politician's quibbling over the meaning of "is." Goldman couldn't bring even a scintilla of contrition to bear, apparently rejecting the notion that a little humility would come across better than polite arrogance. One thing that was loud and clear is that Goldman's management intends to litigate this case until Hell freezes over. But the SEC seems to have ended up with slightly improved litigation prospects, even though it didn't participate in the hearing. So it won't back down any sooner than Goldman. A long struggle in the courts bears greater risk for Goldman than it does the SEC. Goldman needs to be careful with the trade it just got into.