By Philips, Matthew
Newsweek , Vol. 155, No. 18
Byline: Matthew Philips
The practices at the center of the current controversy didn't begin with Goldman--and they didn't end there, either.
"This is Lloyd on Sunday in New York," the voice mail began. Two days after the SEC sued Goldman Sachs for securities fraud, CEO Lloyd Blankfein left a message for his 30,000 employees, reminding them of the firm's core values: "teamwork, excellence, and service to our clients." He also tried to put into context the government's charges, which allege that Goldman failed to disclose key facts about a security it sold in 2007 called Abacus. "Importantly, we had assumed risk in the deal and we lost money," Blankfein said, "just like the other two long investors."
Goldman says it lost "in excess of $100 million" on Abacus, and may lose a lot more. The SEC is alleging that Goldman, whose near-mythic status on Wall Street has suffered a series of knocks, knew a critical detail the others did not: that hedge-fund manager John Paulson had helped pick the toxic assets that served as collateral for Abacus. Paulson had always planned to bet against the risky vehicle, and his fund made about $1 billion when Abacus blew up within a year of its creation. Two other investors, German bank IKB and Dutch bank ABN AMRO, together lost more than $1 billion. In other words, in exchange for a fee, Goldman allegedly assembled a house using subpar materials so one of its clients could bet on its collapse--and then sold the house to other customers.
Goldman says all investors knew exactly what was in Abacus. It has vowed to "vigorously defend" itself against the SEC charges and has hired former White House lawyer Gregory Craig. So it could be many months before we know who's right or if the bank broke the law. What we do know, however, is that as the housing market peaked in 2006 and 2007 several other big banks, including Merrill Lynch and UBS, did deals very similar to Abacus. The charges against Goldman provide a window into the nature of these arcane financial instruments, which were integral to Wall Street's meltdown.
Abacus is what's known as a synthetic collateralized debt obligation. A CDO is a financial tool that repackages individual loans into a product that can be chopped up, repackaged, and sold on the secondary market. They are "collateralized" in that they are backed by loans, bonds, or other real assets. As interest rates plummeted after 9/11, investors worldwide were eager for the cash flow being generated by millions of new American mortgages. Soon there weren't enough mortgage bonds to satisfy demand, so bankers hit on the idea of the synthetic CDO, basically a bundle of credit default swaps (or insurance contracts) that mimic, or reference, the performance of real bonds. By 2005, the CDO market in the U.S. hit $200 billion, twice the 2004 level. By then, housing prices were sky-high and the Fed had begun raising interest rates. A few smart investors believed the market was overheating and that CDO volume would drop.
Instead, it nearly doubled in 2006, to $386 billion in the U.S., and more than $520 billion worldwide, as banks grew more creative in the way they assembled and marketed the instruments. Some allowed favored clients, often hedge funds, to help choose risky assets, and then bet against the whole thing.
The Chicago-based hedge fund Magnetar Capital was allegedly among the first outfits to employ this strategy. Named for a type of neutron star that crushes anything that gets near it, the fund launched in spring 2005. Magnetar would agree to buy the riskiest piece of a CDO, which helped Wall Street firms draw in other investors. Next, according to an investigation by journalists at the nonprofit ProPublica, Magnetar pressed Wall Street firms to include junky bonds in the CDOs (Magnetar has denied this) so that it could bet against them. When the CDOs defaulted, Magnetar lost the small amount it had invested but made much more on its short bets. …