SEC Investigation of Goldman Trading Against Its Clients Widens
The latest shoe to drop on the Goldman front is the report on Wednesday that the SEC was investigating yet another one of its synthetic CDOs, this one a $2 billion confection called Hudson. It isn’t clear whether the SEC will file charges, but this one has the potential to be particularly damaging in the court of public opinion, since this CDO was created solely as a proprietary trading position to help the firm get short subprime risk in late 2006, when the market was clearly on its last legs.
By way of background, the assets in a synthetic CDOs are credit default swaps. In the case of Hudson, they referenced $800 million of BBB subprime bonds, 2005 and 2006 vintage, and $1.2 billion of the ABX. The deal was a wipeout.
What makes Hudson different from the Abacus CDO that is the subject of an SEC lawsuit is that it was not even arguably intermediated between customers. Goldman was not only the initial short counterparty (as was indicated in the contract as standard verbiage), it was every and always intended to be the ultimate short counterparty. Why does this matter?
Synthetic CDOs were sold to investors as the economic equivalent of cash CDOs, ones whose assets were subprime bonds rather than credit default swaps. That was always more than a bit disingenuous. Cash CDOs had for some time been the way that underwriters would dispose of the pieces of subprime bonds they were unable to sell, namely the riskier tranches. Conceptually, it was like taking unwanted parts from (presumably) healthy pigs, grinding it up with a little bit of better meat plus some spices and turning it into sausage.
But the short players like Goldman set out to create sausage from pigs known to be sick because that would be more profitable for them, and this was a zero sum game: their profit came at the expense of their customers. Note that this is NOT inherent to investing, that the dealer’s gain is necessarily the customer’s loss. A dealer might exit a trade that he sees as unprofitable because he expect the price to fall in the next few days. The customer may have a completely different time horizon, and the success of his investment will not be affected much by what would be for him trading “noise” over the next few days.
Let’s put it more simply: how many of you would knowingly choose to be on the other side of a Goldman prop trade, particularly if you knew Goldman had designed the instrument to enable it to go short? Answer: probably zero.
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