According to the SEC complaint, Goldman let a large hedge fund (Paulson & Co.) influence its structuring of synthetic CDOs, which were subsequently sold on to bullish clients (buyers such as pension funds and other large investors) under the premise of their being assembled by an independent party.
Wall Street Journal has the details:
"According to the SEC, Goldman structured and marketed a synthetic collateralized-debt obligation, or CDO, that hinged on the performance of subprime residential-mortgage-backed securities. The CDO was created in early 2007 when the U.S. housing market and related securities were beginning to show signs of distress, the SEC complaint said.
"Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc., with economic interests directly adverse to investors in the [CDO], played a significant role in the portfolio selection process," the complaint said.
The complaint said Paulson had an incentive to stuff the CDO with mortgage-backed securities that were likely to get into trouble. SEC enforcement chief Robert Khuzami alleged that Goldman misled investors by telling them that the securities "were selected by an independent, objective third party..."
The SEC's suit against Goldman Sachs has been the buzz of the day. Everyone is talking about it in the blogosphere, the business news media, and on Twitter and Stocktwits.
People want to discuss the political implications of the story, as well as forecast what is likely to happen to the principal parties involved: will there be a large fine/settlement, who will be thrown under the bus, why did this news just happen to come out on an option expiration Friday, and so on. Business Insider has even dedicated a special section to the Goldman Sachs story.
Meanwhile, it's interesting to note that the details of Goldman's CDO deals with Paulson & Co. were openly detailed in chapter 9 of Greg Zuckerman's book, The Greatest Trade Ever. John Paulson and his team met with various Wall Street firms (Deutsche Bank, Goldman Sachs, Bear Stearns) to discuss and negotiate the creation of new CDOs from pools of risky mortgages.
Paulson & Co. were open about their desire to short most tranches of the CDOs through the purchase of credit default swaps (CDS) on these CDO instruments. Some bankers (Scott Eichel at Bear Stearns, among others) turned down Paulson's proposed deals, while others (like Goldman) gladly accepted and negotiated with Paulson on the collateral backing the deals.
According to Zuckerman's book and Paulson's quotes, the bankers were ultimately responsible for what went into the CD0s that were sold to investors. It's worth pointing out that all those who took the bullish side of the trade did so of their own accord, and that "some investors were even consulted as the mortgage debt was picked for the CDOs to make sure it would appeal to them." (Zuckerman, page 181).
Having said that, Goldman probably should have been more forthright in dealing with its clients, instead of telling them (as the SEC complaint alleges) that the mortgage-backed CDOs they were buying were structured with the help of an "independent, third party".
Update: NPR interviewed Greg Zuckerman to get his thoughts on the Goldman Sachs charges and John Paulson's role in the CDO deals. Do check this out, as he quickly fills us in on some main points that people were guessing about (or just wildly wrong about) on Friday.
Related articles and posts:
1. Michael Burry explains his subprime CDS trade - Finance Trends.
2. FSN interview: Richard Eckert (Lahde Capital) - Finance Trends.
3. Lessons from John Paulson - Finance Trends.
4. NPR talks to Greg Zuckerman (Greatest Trade Ever) - NPR.org.