The Goldman Sachs Accusation Explained

By Peter Cherewyk | May 27, 2010 AAA
The Goldman Sachs Accusation Explained

With any major financial transaction there needs to be a middle man. In many cases, Goldman Sachs (NYSE:GS) is that middle man. Goldman Sachs Group is a powerhouse in the financial industry, providing investment banking and investment management services to corporations and high-net-worth individuals. Basically it does exactly what any bank does, only it caters to very wealthy people. Recently Goldman has been dominating front-page news for its role in a rather complex case of alleged financial fraud. What's happening here isn't as hard to understand as media reports make it seem, and it's an important story for everyone, regardless of net worth.

The Scoop
Goldman Sachs is being charged by the Securities and Exchange Commission (SEC) with fraud for allegedly making misleading statements and omissions regarding a mortgage based investment.

Why It Matters
Goldman Sachs is a a major player in financial services. When the SEC goes after such a large corporation with as much influence as it has, it is a big deal. Goldman Sachs is a company based on trust in its stellar reputation. Any legal suit brought against them could tarnish this image. It could also reduce the trust placed in firms all across the financial industry. At the same time, the SEC is demonstrating that they have the power to find improper behavior and police it. After the subprime mess we saw in 2008 and 2009, there has been an outcry for government agencies to do something just like this. (For related reading, check out The Fuel That Fed The Subprime Meltdown.)

What this Means for You
If you happen to be an investor holding Goldman Sachs, you've already taken a hit to the tune of 14%. This brings the stock back to the same level it was in late February 2010. This shows that investors are worried about the case, but Goldman Sachs is a money generator - many believe it will recover. Retirement accounts and pension funds don't usually enter into these types of risky investments, so they wouldn't have high exposure to them. Even if you are somehow exposed to these derivative contracts through your bank, the Federal Deposit Insurance Corporation (FDIC) insures your deposits up to $250,000 if your bank goes under. (Check out Bank Failure: Will Your Assets Be Protected? for more information.)

Regulations
New regulations for investment banks are in the sights of the government and regulators. This case will help get the much needed public support to reduce some of freedoms in the banking sector. These changes will affect the entire banking industry not just Goldman Sachs.

Jobs
If you are looking for a job, or thinking about a new career, there might be a higher demand for regulators and auditors. This has always been an essential industry, but as managers feel the heat from the top, they might increase their oversight workforce in the coming months. A strong accounting background could put you in a soon-to-be flourishing industry. Take a serious look at ratings agencies and compliance departments. (For more read A Brief History Of Credit Rating Agencies or Get A Job In Compliance.)

If you are just getting into finance, there might be a little less money in investment banking and a couple more disclosure documents to file, but this is a huge industry with a lot of influential groups. A loss or gain of $1 billion is a drop in the bucket and a single transaction can't ruin an entire industry. Investment banking will always be a lure because these banks pay very well for top talent.

Expect More News
Don't expect the Goldman Sachs issue to go away any time soon. What we know is in the SEC filings, and its a pretty straight forward case. You can expect to hear about the evidence as it is revealed in the coming months. Emails, phone calls, insider accounts or even wire taps will be revealed in the litigation discovery process. This case will have plenty more coverage. The fact that it is coinciding with President Obama's push for regulatory reform means even more coverage. It might be a good idea to understand just what went on.

What was the Mortgage Investment?
It was a bet on whether a group of borrowers would pay or not.

The product, known as ABACUS 2007-AC1, was basically a bet on whether a group of mortgages would make their payments. One person bets that they will (the long) and one bets that they won't (the short) - and Goldman Sachs doesn't care either way because they take their fee, $15 million in this case. This is called a synthetic collateralized debt obligation or "synthetic CDO." If it were a regular CDO, it would just be an investment in a group of debt payers; as the debtors pay, the investor gets money. This synthetic CDO was derived from a bet on the ability of the group of borrowers to pay - and everyone knows about derivatives! For this synthetic CDO, as with any bet, there needed to be two sides betting on opposite outcomes. Otherwise, the deal doesn't exist.

Why did the SEC Jump on Them?
This type of derivative bet is a common investment. It requires someone to pick the mortgages, then it needs another party to evaluate them. The SEC didn't like the fact that the same person that helped picked the mortgages also bet that they would fail. This is legal as long as it's disclosed, but apparently it wasn't in the marketing information. This is why Goldman Sachs is being charged with omissions and misleading information.

Who picked the mortgages? Allegedly Paulson & Co. Inc. influenced the selection process - thus gaining inside knowledge of the bet - and then entered into another contract to profit if it failed. This other contract is called a credit default swap. These are normally used to protect an investor just in case borrowers default. Well, the short was correct, and the group of borrowers defaulted. The long was wrong and lost $1 billion. Almost two years later, the SEC is doing something. Who was long? Well one of them was IKB Deutsche Industriebank and it quickly felt the effects of the subprime meltdown in the summer of 2007. Just a week before declaring financial trouble, the bank had stated that earnings expectations would be met.

The Bottom Line
New regulations will take years, but they will attempt to increase disclosure and keep larger institutions a little more honest. It might not affect your bank account, but maybe your pension fund will have a little more insight into what they are buying when they put money into hedge funds.

Get a rundown of the latest financial news in this week's Water Cooler Finance: Buffett Buzz, Toxic CDOs And Facebook Privacy.

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