Yesterday’s news that the SEC charged Goldman Sachs with “defrauding investors” for selling a subprime mortgage product is eerie because much of the process that created it was profiled in last year’s widely reviewed book The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History, by The Wall Street Journal’s Gregory Zuckerman.

At the center of the SEC’s complaint is a Goldman product loaded with dicey synthetic collateralized debt obligations, or CDOs. It was sold to institutional investors and, suffice to say, a losing proposition. The question is whether the losses were preordained with Goldman’s knowledge, in which case the investors were sucker-punched. Or, to quote the phrase that’s become widely used in the last 24 hours in describing the fund, was the product “designed to fail”?
The flip side of the failure, intentional or not, is that hedge fund honcho John Paulson profited in spades from the fund’s implosion in what Zuckerman coins as the “the greatest trade ever.” In fact, Paulson helped design the product that a) failed and b) created enormous profits for him. Was there a connection between the two? To be precise, did a) preordain b)? The SEC seems to think so. Nonetheless, there’s a fine line between trying to outlaw failure and regulating against creating products that are intentionally designed to stumble in order to create profits for insiders. Clearly, the ability to fail must be and should be preserved in the financial system, but only if it’s part of promoting a legitimate and fair-minded embrace of risk and capital formation. It’s not clear that this is what was happening with the Goldman and Paulson deal, although perhaps we’ll learn otherwise as the case unfolds in the days and weeks ahead.
Meantime, “What makes it feel like dirty pool,” writes Joe Nocera in The New York Times, “is the allegation that Paulson & Company and Goldman Sachs were actively involved in choosing the bonds that would be bet on — knowing they were going to be short.”
How we got to this point is outlined in Zuckerman’s book. Paulson reportedly had been looking for an investment bank that would be willing to cobble together a fund of CDOs with a bearish aura before he came across Goldman. At one point Paulson was in contact with Scott Eichel of Bear Stearns about the proposed idea. Zuckerman writes that “Paulson would want especially ugly mortgages for the CDOs, like a bettor asking a football owner to bench a star quarterback to improve the odds of his wager against the team.” Paulson, in other words, would be shorting the mortgage components of the fund. The problem was that someone would need to take the other side of the trade by owning the fund. Zuckerman goes on to report,

“On the one hand, we’d be selling the deals” to investors, without telling them that a bearish hedge fund was the impetus for the transaction, Eichel told a colleague; on the other, Bear Stearns would be helping Paulson wager against the deals.

“We had three meetings with John, we were working on a trade together,” says Eichel. “He had a bearish view and was very open about what he wanted to do, he was more up front than most of them.

“But it didn’t pass the ethics standards; it was a reputation issue, and it didn’t pass our moral compass. We didn’t think we should sell deals that someone was shorting on the other side,” Eichel says.

For his part, Paulson says that investment banks like Bear Stearns didn’t need to worry about including only risky debt for the CDOs because “it was a negotiation; we threw out some names, they threw out some names, but the bankers ultimately picked the collateral. We didn’t create any securities, we never sold the securities to investors….We always thought they were bad loans.”

Besides, every time he bought subprime-mortgage protection, someone had to be found to sell it to him, Paulson notes, so these big CDOs were no different.

Indeed, other bankers, including those at Deutsche Bank and Goldman Sachs, didn’t see anything wrong with Paulson’s request and agreed to work with his team. Paulson & Co. eventually bet against a handful of CDOs with a value of about $5 billion.

The rest, as they say is history… still unfolding in real time.