When Wall Street Deals Resemble Casino Wagers

By ANDREW ROSS SORKI
April 19, 2010
The government’s civil fraud case against Goldman Sachs raises so many provocative questions.
Did the firm deliberately mislead its clients who bought a mortgage-related investment without the knowledge that it was devised to fail? Was it fair that a bearish hedge fund manager helped to pick the parts of an investment marketed as bullish, so that he could bask in the winnings?
Who besides the vice president named in the lawsuit knew details of the deal in question? Were there other deals like this one?
But if there is a larger question, it is this: Why was Goldman, or any regulated bank, allowed to create and sell a product like the synthetic collateralized debt obligation at the center of this case? What purpose does a synthetic C.D.O., which contains no actual mortgage bonds, serve for the capital markets, and for society?
The blaring Goldman Sachs headlines of the last few days have given the public a crash course in synthetic C.D.O.’s. Many more people now know that synthetic C.D.O.’s are a simple wager.
In this case they were a bet on the value of a bundle of mortgages that the investors didn’t even own. (That’s why it is called a derivative.)
One side bets the value will rise, and the other side bets it will fall. It is no different than betting on the New York Yankees vs. the Oakland Athletics, except that if a sports bet goes bad, American taxpayers don’t pay the bookie.
“With a synthetic C.D.O., it’s a pure bet,” said Erik F. Gerding, a former securities lawyer at Cleary Gottlieb Steen & Hamilton who is now a law professor at the University of New Mexico. “It is hard to see what the social value is — it’s hard to see why you’d want to encourage these bets.”
Social value is a timely question because regulating derivatives is the issue du jour in Washington as a set of proposed financial reforms moves though the Senate. The Obama administration’s plan includes a rule to require any banks that create a synthetic C.D.O. to keep a stake of at least 5 percent, in an effort to keep them accountable and eating their own cooking. But is that enough?
Because structuring derivatives like synthetic C.D.O.’s is so lucrative — $20 billion a year, by some estimates — it’s no surprise that Goldman Sachs is among the banks that oppose regulating them.
“The pushback on regulating derivatives is quite amazing,” said David Paul, president of the Fiscal Strategies Group, an advisory firm specializing in municipal and project finance. “It’s all just become a casino. They argue there is social utility — but you know intuitively this is wrong.”
Through their powerful lobbying arms, Goldman Sachs, JPMorgan Chase and others have been trying to convince lawmakers that tough regulation on derivatives would stymie the capital markets.
“I believe that synthetic C.D.O.’s have a very useful purpose in facilitating the management of risk,” said Sean Egan, managing director of Egan-Jones Ratings, echoing the view of many in the industry. “Just as options have a valid position in the investment universe, so do synthetics. Such instruments facilitate the flow of capital.”
Unlike Moody’s and Standard & Poor’s, Mr. Egan’s agency takes fees from investors, not issuers, for its research. Many critics of the big agencies say this approach presents fewer conflicts, presumably yielding a more honest assessment of an asset’s risk.
Still, Mr. Egan needs products to rate, so his position on derivatives is not that surprising. The core problem with the disputed C.D.O., and other structured finance transactions, was that “investors relied on flawed assessments of risk,” Mr. Egan said.
(By the way, we aren’t hearing lots of questions about the role the big agencies played in rating this Goldman C.D.O., but they clearly misrated it. If they had known that the hedge fund tycoon John A. Paulson had shaped the portfolio and was betting against it, would they have provided the same rating?)The Securities and Exchange Commission, in its suit, says that Mr. Paulson asked Goldman to help create a synthetic C.D.O. of lousy mortgage loans that he selected so he could bet that they would go down and then profit on their fall.
Of course, as with any bet of this sort, Goldman needed an investor to take the opposite position. Goldman found that in firms like IKB Deutsche Industriebank and ABN Amro. They weren’t told, however, that Mr. Paulson had heavily influenced which assets were included.
The case against Goldman could pivot on whether this omission was “material” to investors. Goldman says it wasn’t. It maintains that the investors got to see every mortgage in the basket, and that the manager of the deal, ACA Management, replaced some of Mr. Paulson’s picks with its own.
What’s more, Goldman has said over and over that it arranged these trades for sophisticated investors, not casual 401(k) savers. Goldman’s investors had the expertise and should have known better.
It’s an argument that, while true, makes some people cringe.
“It’s astonishing that they always say ‘sophisticated investors did this,’ ” said Mr. Paul, the financial adviser. “Look at the failure of Lehman and Bear. They were all sophisticated investors.”
This kind of high finance can numb the brain, and the legal questions are murky. But when you strip all of that away, this deal was nothing more than a roll of the dice.
Try this mental exercise: Imagine if, a few years ago, an influential investor like Warren Buffett, bullish on real estate, had asked Goldman to develop a synthetic C.D.O. made up of undervalued mortgages.
Now, imagine if Goldman had found John Paulson to take the opposite side of the trade and, lo and behold, a year later Mr. Buffett turned out to be right and Mr. Paulson lost his shirt. Would you call that fraud? Would you be very upset?
Maybe not, but Mr. Paulson sure would be. And he might be inclined to sue over it, especially if he found out that his bet had been rigged against him from the start. Which brings us back to the financial legislation being debated in Washington.
“Ultimately,” Mr. Gering, the securities lawyer, said, “litigation is a poor substitute for regulation.”
The latest news on mergers and acquisitions can be found at nytimes.com/dealbook.
A version of this article appeared in print on April 20, 2010, on page B1 of the New York edition.

Did you mail your 2010 Census Form back ?

By David Samuels
-4-14-2010

1. If we don't know how many school kids there are.


2. How do we know how many classrooms we need ?


3. When you answer 10 simple questions


4. You can help our community for the next 10 years.


5. ---It's in your hands


6. We can't move forward until you mail it back .


7. United States


8. Census 2010


9. It's in your hands


10. 2010 Census.gov -------davidradiotv2000@yahoo.com

FCC loses Comcast's court challenge, a major setback for agency on Internet policies

Tuesday, April 6, 2010; 11:20 AM
By Cecilia Kang Washington Post
Comcast on Tuesday won its federal lawsuit against the Federal Communications Commission, in a ruling that undermines the agency's ability to regulate Internet service providers just as it unrolls a sweeping broadband agenda.
The decision also sparks pressing questions on how the agency will respond, with public interest groups advocating that the FCC attempt to move those services into a regulatory regime clearly under the agency's control.
The U.S. Court of Appeals for the Distrit of Columbia, in a 3-0 decision, ruled that the FCC lacked the authority to require Comcast, the nation's biggest broadband services provider, to treat all Internet traffic equally on its network.
That decision -- based on a 2008 ruling under former FCC Chairman Kevin Martin -- addresses Comcast's argument that the agency didn't follow proper procedures and that it "failed to justify exercising jurisdiction" when it ruled Comcast violated broadband principles by blocking or slowing a peer-sharing Web site, Bit Torrent.
But it also unleashed a broader debate over the agency's ability to regulate broadband service providers such as AT&T, Comcast, and Verizon Communications.
The judges focused on whether the FCC has legal authority over broaband services, which are categorized separately from phone, cable television and wireless services. The agency currently has only "ancillary authority" over broadband services, a decision made by past agency leaders in an attempt to keep the fast moving Internet services market at an arms distance from the agency.
The Commission may exercise this 'ancillary' authority only if it demonstrates that its action . . . is "'reasonally ancillary to the .. effective performance of its stautorily mandated responsibilities." The Commission has failed to make that showing.
The court's decision comes just days before the agency accepts final comments on a separate open Internet regulatory effort this Thursday. And the agency will be faced with a steep legal challenge going forward as it attempts to convert itself from a broadcast- and phone-era agency into one that draws new rules for the Internet era.
Andrew Schwartzman, policy director for Media Access Project said the ruling, "represents a severe restriction on the FCC's powers."
Public interest group have urged the agency to reclassify broadband services so that they are more concretely under the agency's authority. The FCC has been reluctant to say if it would do so and a spokesperson didn't immediately respond to a request for comment.
Analysts said the agency may not be able to proceed on its net neutrality policy -- a rule that Internet service providers have fought against. And there is doubt the agency could reform an $8 billion federal phone subsidy to include money to bring broadband services to rural areas.
Bruce Mehlman, former Assistant Secretary of Commerce.for Technology Policy, however said the decision may help speed the development of faster, and more robust networks.
"It may drive greater investment in broadband networks by removing regulatory uncertainty and perceived disincentives to invest in infrastructure," Mehlman said.