Last Friday, April 16, 2010 the US Securities and Exchange Commission charged Goldman Sachs with Fraud.  This explosive move by the SEC has tremendously diminished  investor confidence in Goldman and Wallstreet in general.  The SEC charge is a very serious one because it says that Goldman fraudulently sold its CDO’s (Collateralized Debt Obligations) to its clients at the behest of its other client Paulson and Co who “shorted” the same portfolio. The investors lost around $1 Billion while Paulson made the same amount.

The problem according to the SEC was that Goldman failed to mention to the buyers that the CDO’s that they were buying was chosen by the exact same person who wanted to sell it in the first place. Now if it is not clear to you what the Fraud charge is all about, let me  simplify it for you using a crude analogy

DISCLAIMER: The explanation below and conversations between characters are fictitious and are not quoted from any source, it is solely for educational purposes only and should not be construed as fact.

I want you to imagine a shady “used car” transaction:

A used “car lot operator” was approached by a knowledgeable mechanic. The Mechanic proposes a deal to the operator:  “I would like you to loan me a particular car in your garage, place the car in my name, and I want you to sell it to someone else for me”.

The car lot operator asks: “Are you out of your mind, why in the world would I do that?”

The mechanic says: “because I have a good idea which car in your garage is defective and I’m certain that it will conk out right after it is sold, if you loan me the car that I choose and you can find someone to buy it from me, and I’m right that it conks out, I will buy it back from him at a much lower price, make money and I’ll give you a commission. Think about it, if I am right that the Car Conks out, then that means that car would have caused you a lot of trouble and I would have saved you from that problem!”

The operator says: “So you are telling me that you can tell which one of my cars are worth nothing and you want me to sell it to someone else so that I can still get some money for it? Why don’t I just do it myself? why do I need you for?”

Mechanic: “Because I won’t tell you which one it is until you agree, and besides, you need me because I will take on the risks if this doesn’t go well”

The operator asks: “What do you mean you will take on the risks?”

The mechanic says: “Well, if I’m wrong, then I will buy it back from the buyer, even at a higher price and give you back your car. This is why I want you to loan it to me and put it in my name first, that way the defective car is effectively mine and I take all the risk!, but if I’m right, I will take the profit but will still give you a commission”.

The operator thinks it over and says, “So you are telling me, no matter what, I’ll make money an you take the risks?

The mechanic says: “Yes, so will you loan it to me and sell it to another client of yours for me now?”

The operator says: “okay it’s a deal.” (Who wouldn’t right?)

The operator looks for a buyer for the car, BUT does not mention that the car might conk out soon. Why would he, it’s in his best interest not to right?

So, the operator, because of his slick selling skills successfully finds a buyer who pays for the car at the current price, the operator does not give the money to the mechanic just yet but keeps the money in a safe place, both the operator and the mechanic do not touch the money and wait for what happens to the car. A few days later, the car does conk out, the buyer brings it back to the operator, then, the mechanic arrives and offers to buy it back at a much lower price. After a lot of harsh words and threats of law suits, inevitably, to cut his losses, the buyer decides to just give in. The Mechanic pays for the car at bargain prices using the original money that the buyer gave the operator in the first place.

The buyer gets screwed, the lot operator gets rid of the defective car and even gets a commission for it,  and the mechanic goes home with the bulk of the money.

Now, let’s apply this to the Goldman Sachs Fraud case. I will just change the characters of the story and leave the story in tact, read it again below:

Goldman Sachs was approached by Paulson and Co. Paulson and Co proposes a deal to Goldman Sachs:  “I would like you to loan me a particular Investment portfolio, place it in my name, and I want you to sell it to someone else for me”.

Goldman Sachs says: “Are you out of your mind, why in the world would I do that?”

Paulson and Co says: “because I have a good idea which portfolio of yours is defective and I’m certain that it will be worthless right after it is sold, if you loan me the portfolio that I choose and you can find someone to buy it from me, and I’m right that it becomes worthless, I will buy it back from that buyer at a much lower price, make money and I’ll give you a commission. Think about it, if I am right that that particular portfolio of yours is worthless, then that means that portfolio would have cost you a lot of money and I would have saved you from disaster!”

Goldman Sachs says: “So you are telling me that you can tell which one of my portfolios are worth nothing and you want me to sell it to someone else so that I can still get some money for it? Why don’t I just do it myself? why do I need you for?”

Paulson: “Because I won’t tell you which one it is until you agree, and besides, you need me because I will take on the risks if this doesn’t go well”

Goldman: “What do you mean you will take on the risks?”

Paulson: “Well, if I’m wrong, then I will buy it back from the buyer, even at a higher price and give you back your portfolio. This is why I want you to loan it to me and put it in my name first, that way the defective portfolio is effectively mine and I take all the risk!, but if I’m right, I will take the profit but will still give you a commission”.

Goldman thinks it over and says, “So you are telling me, no matter what, I’ll make money an you take the risks?

Paulson: “Yes, so will you loan it to me and sell it to another client of yours for me now?”

Goldman: “okay it’s a deal.” (Who wouldn’t right?)

Goldman looks for a buyer for the portfolio (which was chosen by Paulson to be Collateral Debt Obligations), BUT does not mention that the particular CDO was chosen by Paulson himself and might conk out soon. Why would Goldman do that, it’s in his best interest not to right?

So, Goldman, because of their slick selling skills successfully finds a buyer who pays for the CDO’s  at the current price, Goldman does not give the money to Paulson just yet but keeps the money in escrow, both Goldman and Paulson and Co do not touch the money and wait for what happens to the CDO. 6 months later, the CDO triggers a series of events leading to the worldwide recession, the buyers bring it back to Goldman, then, Paulson and Co offers to buy the CDO’s it back at a much lower price. After a ton of margin calls, a lot of harsh words and law suits, inevitably, to cut their losses, the buyers decide to just give in. Paulson pays for the CDO’s at bargain prices using the original money that  Goldman has been holding in escrow in the first place.

The buyer gets screwed, Goldman gets rid of the defective CDO’s and even gets a commission for it,  and Paulson goes home with the bulk of the money amounting to at least 1 Billion US Dollars.

Understand it now?

Monsterpips to All!

-Mark So

P.S. Please do comment on this thread, I’d love to hear from you.

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