April 25, 2010 in Business

Goldman fraud case shines light on the shorts

Market’s short sellers are often reviled but are often on the mark
Bernard Condon Associated Press
 

NEW YORK – They were the Cassandras of the housing bubble, warning us it was bound to burst. And they weren’t just talking. They backed their bold claims with big money bets.

But if you’re looking for heroes of the crash on Wall Street who called it, better read the government’s suit charging Goldman Sachs Group Inc. first. It claims the bank defrauded investors in the process of helping one of those prescient housing bears make his negative bets.

The suit alleges Paulson & Co., run by billionaire John Paulson, secretly helped construct a package of mortgage-linked derivatives designed to blow up so he could make a fortune. So-called short sellers, like Paulson, profit when stocks, mortgages or other assets they bet against lose value.

In other words, the game of guessing which way prices would go was allegedly rigged in this case.

That sounds bad enough. But some Wall Street veterans say the real tarnish on our erstwhile housing heroes is the package itself – regardless of whether it was designed to fail. By just linking to mortgages but not actually containing any, the Paulson package and others marketed by banks upped bets on housing to more than even the mortgages in existence, making the overall losses much bigger now that boom has turned to bust.

“Normally short sellers add rationality to a runaway marketplace,” says Charles Smith, who oversees $1 billion at Fort Pitt Capital Group. “But in this case they were adding rocket fuel to the fire.”

The fuel here is devilishly difficult to understand. Called synthetic collateralized debt obligations, these packages contained a series of wagers on whether thousands of homeowners would continue to pay their loans. The key thing to grasp about them, and the part that explains how they magnified housing losses, is that they don’t actually own any mortgages and so aren’t limited by the number of such loans.

Instead, these investments merely make “reference” to real mortgages to determine which side of the wager wins.

These side bets meant that Wall Street, in its “mad, Strangelovian genius” – as Roger Lowenstein documents in his new book, “The End of Wall Street” – was able to make dozens of bets on the fate of a single mortgage.

The result: bigger losses from the housing crash, and bigger taxpayer bills around the globe for the bailout.

In the Goldman case, the bank is accused of having not included in marketing documents that Paulson had helped put together the synthetic CDO. In effect, the bank allegedly duped investors taking the bet that homeowners would pay bills.

Goldman denies the charges.

As it turns out, many of the mortgages “referenced” in this synthetic CDO, mostly subprime ones, performed poorly. That triggered ratings downgrades on the mortgage-backed bonds referenced in the CDO’s portfolio, and payments to Paulson.

The suit says Paulson, which wasn’t charged, made $1 billion on the deal.

Goldman, in its defense, has said that the two counterparties in the deal, a pair of European banks, were highly sophisticated investors who were provided extensive information about the securities. Goldman says they were fully aware that someone else would be making a negative, or short, bet on the portfolio.

Short sellers are not easy to love. They bet against rising prices of shares and other assets, which is usually enough to condemn them in the popular mind.

After all, no one likes a party pooper.

But the shorts, as they’re commonly called on Wall Street, serve a useful purpose. Their bets signal to investors caught in a buying frenzy that they should pause and reconsider. And though sometimes accused of rumor-mongering, they often get it right, too.

Shorts warned of previous reckless lending sprees, including the subprime debt mania that felled firms a decade ago. During the dot-com bubble, they threw cold water (to no avail) on all those hot stocks that eventually did collapse. They spotted trouble at bankrupt energy trader Enron long before ordinary investors did.

More recently, shorts were widely criticized for spreading false rumors about shaky financials at Lehman Brothers, hastening the bank’s bankruptcy. It turns out, according to a 2,209-page official examiner’s report on the bank last month, Lehman was playing around with accounting to make its seem in better shape than it actually was.

Maybe the shorts should have been heeded, not blamed.

Now the housing crisis has thrown up a new set of shorts to praise.

In Michael Lewis’s “The Big Short,” we meet a doctor, obsessed with impending housing troubles, who spends much of his time laying his negative bets. A pair of thirty-something guys working in a Berkeley, Calif., garage do likewise and make a fortune.

Paulson himself, who reportedly made $15 billion on various housing collapse wagers, got a whole book to himself, “The Greatest Trade Ever” by Gregory Zuckerman.

But the side bets allowing some bears to profit have made even some of their fans uncomfortable.

Ann Rutledge of mortgage researcher R&R Consulting was an early critic of the reckless mortgage buying during the boom. Not surprisingly, she has counted some of the big shorts among her clients. But she says they got carried away.

“In a market economy, short selling is how people express contrary opinions,” Rutledge says. But it turned “unhealthy” when the shorts began betting against packages “utterly divorced from real economic value.”

Or as Fort Pitt’s Smith puts it: “I don’t think there were heroes at all here.”

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