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Saturday, April 17, 2010

Goldman!! "Two Minutes Hate"

With all the media coverage of the SEC's much publicized lawsuit against Goldman Sachs, can anyone actually tell me what they did that was fraudulent? From what I can gather, the SEC is essentially suing Goldman on the grounds that Goldman followed the investment banking business model, i.e., Goldman did what it and investment banks have done and are asked to do by clients for generations.

The main charge seems to revolve around the fact that a Goldman client, Paulson & Co., compiled a list of securities that he believed would go down in value and then, via Goldman, offered the list to another party, IKB and ACA, to take the other side of the transaction. And, GASP, Goldman didn't tell IKB and ACA that the all knowing, all seeing, omniscient demi-god Paulson was on the other side. According to this report:

Goldman Sachs created and sold CDOs linked to subprime mortgages in early 2007, as the U.S. housing market faltered, without disclosing that hedge fund Paulson & Co. helped pick the underlying securities and bet against the vehicles, the Securities and Exchange Commission said today.

First, if you buy a security, someone MUST sell it to you. If you buy a stock because you think it will go up, guess what - someone is selling it to you because they believe it will go down. In other words, there are always two parties to each transaction. Human beings refer to this as "trading" or "investing."

Second, does a broker have an obligation to tell one party who is on the other side? When you buy a stock, chances are, the person who is selling it to you (through a broker) is selling it because he believes it is going down. Does the broker have an obligation to tell a stock buyer: "hey, you should know, the guy who is selling this stock is pretty smart and did a lot of due dilgence - are you really doubly sure you want to buy it from him?" A broker's job is to get traders on both sides of a transaction so they can make a commission. In Goldman's statement on the matter, they rightly point out:

The SEC’s complaint accuses the firm of fraud because it didn’t disclose to one party of the transaction who was on the other side of that transaction. As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor. [emphasis mine]

Why does it matter to the SEC that it was Paulson & Co.? It is offered as almost prima facie evidence against Goldman, that if the counter party had only known that it was the almighty Paulson on the other side, they would never have purchased it. First of all, as shown above, Goldman has no obligation to reveal this. Second, even if the perceived intelligence of the counterparty was a relevant issue, Paulson was not famous circa 2007. The fact is that Paulson became famous because he profited from being right about the housing market. If Paulson had been wrong, perhaps the SEC could have now sued ACA arguing that if Paulson had only known that the almighty ACA (almighty, because ACA would have gotten rich) he would not have done the trade! Third, the counterparty, ACA, had just as much ability as Paulson to evaluate this list of securities and they CHOSE to buy them believing they would go up in value. It doesn't matter if the list was provided by Paulson, Buffet, or Jesus Christ. The assets were the assets and IKB and ACA could have chosen not to take the trade. By definition, Paulson or any counterparty is "selecting" the trades they want by the very act of engaging in the transaction! Otherwise, they wouldn't do the transaction...

As an investor, if you want to bet against say the housing market you can go to an investment bank and they can create a security in which you take one side and another client, who believes the opposite, takes the other side. In essence, the investment bank facilitates a transaction between two willing parties. They get paid for brokering the transaction. THIS IS WHAT THEY DO. THAT IS THE BUSINESS MODEL. Quoting Goldman's statement:

In 2006, Paulson & Co. indicated its interest in positioning itself for a decline in housing prices. The firm structured a synthetic CDO through which Paulson benefitted from a decline in the value of the underlying securities. Those on the other side of the transaction, IKB and ACA Capital Management, the portfolio selection agent, would benefit from an increase in the value of the securities. ACA had a long established track record as a CDO manager, having 26 separate transactions before the transaction. Goldman Sachs retained a significant residual long risk position in the transaction.

Now, if Goldman distorted the nature of the true offering by, for example, telling customers they were buying grapefruit instead of subprime CDO's, I could understand the case. I am not a legal expert, but to constitute fraud, I imagine that Goldman would have to knowingly and deliberately represent something they knew to be false. At the time, no one knew what the subprime market was going to do. Most people thought it would continue to flourish so investors bought these securities and other investors shorted them.

Should we be surprised that the SEC shows this level of ineptitude? Keep in mind, while the two aforementioned sophisticated investors were willingly entering into this trade, the SEC had an army of agents at Bernie Madoff's shop, including one who wore a jacket with the word "Enforcement" emblazoned across it, yet could not detect any fraud (an event I analyzed in my post, Cuffy Meigs, Meet Bernie Madoff.)

So, if this case is weak and Goldman will litigate for years, ultimately winning or settling for some neglible amount of money, why is the SEC really bringing this case?

As my colleague astutely pointed out, this case is not about fraud. This case is a publicity stunt engineered by the Democrats to bolster their case for the upcoming financial "reform" bill being written by Sen. Dodd and others. To a public ignorant of the details of the fraud case and mired in altruism, such a case relies on a knee-jerk contempt for the "fat cats" on Wall Street and wariness of any profit seeking business.

Consequently, the politicians rely on this case to not be analyzed by the public or perhaps, even the court. The morality of altruism serves as a kind of filter which strips away facts and details leaving an emotional residue of confusion, fear and hostility. In this ideological milieu, the almost unintelligible minutia of the case serves as reaffirmation of the feeling that someone must have got screwed in some intricate, nefarious scheme.

This all reminds me of Emmanuel Goldstein, a character from Orwell's 1984 :

Goldstein is always the subject of the "Two Minutes Hate," a daily, 2-minute period beginning at 11:00 AM at which a purported image of Goldstein is shown on the telescreen (a one-channel television with surveillance devices in it that can not be turned off). The reader may surmise that a political opposition to Big Brother— namely, Goldstein— was psychologically necessary in order to provide an internal enemy posing a threat to the rule of the Party; the constantly reiterated ritual of the Two Minutes Hate help ensure that popular support for and devotion towards Big Brother is continuous.

Watch the movie version of this scene here Just remember, in the movie, it is Goldstein, not Goldman.


Unknown said...

I guess one of the problems is that many people don't see the benefit of this type of trading. It's not like a physician or a carpenter or something where the value of the service is perceptually obvious. How much of this "outrage" would exist if people weren't ignorant of how financial markets operate? I like how you've described altruism as a sort of gauze that obscures any type of rational investigation of the issue.

Btw, loved your post on "Cuffy Meigs". Apparently his five-year tenure at the Gap didn't prepare him for dealing with billionaire hedge-fund managers--and I say that as someone who has worked retail, but it seems this guy was really out of his depth.

The Rat Cap said...


LOL. Wow. You know, his tenure at the Gap may not have prepared him to audit multi-billion dollar hedge funds, but surely, his experience as "cashier at Banana Republic" provided unique insight!

The Rat Cap said...

Actually, I now see that he worked at Gap, Banana, and Geico concurrently but he listed them as different jobs. Surprised the SEC didn't catch this when he got hired...

The Rat Cap said...


Also, wanted to address a point you made. You said:

"one of the problems is that many people don't see the benefit of this type of trading. It's not like a physician or a carpenter or something where the value of the service is perceptually obvious. How much of this "outrage" would exist if people weren't ignorant of how financial markets operate?"

I don't think the problem is just a function of people's ignorance of financial markets. I think it is a psychologically bred predisposition to regard profit as evil and then look for some justification for the view.

This phenomena is a derivative of altruism. In fact, one of the main contentions of Marxism is this idea that the value of anything IS the physical labor. Altruism creates this kind of knee jerk response to anything other than a perceptual level job that can be regarded as "serving" humanity in some way: doctors, carpenters,...

If a service is seen to profit someone but it is unclear who benefits, this seems unfair or unjust. In a real sense, this should be true. After all, if someone is getting something for nothing, it should be regarded as unjust. However, I am going a step further. I don't think this is the root of why trading provokes contempt although who is served by trading is abstract.

In an egoistic culture, making a profit would not provoke an immediately negative response. When I heard about the Goldman situation, I did not say: "they made a profit, someone got screwed. Now, let's find out who..." In a free market, making a profit is a badge of honor. The reaction should be: "I don't understand how they make a profit because I don't understand their business, but they must have done something GOOD because people voluntarily paid them for their service."

This cultural contempt for profit making is exactly what the politicians are counting on. Anyone who now opposes the financial regulation bill can be castigated as a defender of the fat cats on Wall Street.

Keep in mind, I am not a defender of Goldman. They are politically connected and benefit from the mixed economy or corporatism where they use political pull. But, in this case, the government is wrong and is using them as a Orwellian Goldstein character to drum up support for more power and control in a sector which they already entirely control.

Mo said...

it seems like a populist mentality as well. soak the rich bastards and our economy will improve. never mind that the rich bastards create the wealth. I also think its a zero sum game mentality. if someone becomes rich he must have done so at the expense of the country or a certain sector society e.g. the poor etc.....

mtnrunner2 said...

I was searching Google Reader for where I posted an online comment (couldn't find it) and noticed your post.

I was initially skeptical of this also. However, the actual SEC complaint document ( http://www.sec.gov/news/press/2010/2010-59.htm ) has some damning accusations, namely that Goldman Sachs 1) told IKB that ACA had selected all the securities, whereas Paulson & Co had weeded out the good ones, and 2) IKB was told Paulson & Co. had invested in the fund, which was incorrect. Those are the accusations, anyway.

If true, it turns this from a case of simply having clients with different positions (short and long), to lying to your customer. Those are very different things. The latter would be fraud.

In trying to figure this all out, I was reading about the principle of "material fact", i.e. a fact which would influence the other party's judgment if they knew it. This is an act of deliberate omission. I wonder if there is a place for such a principle in objective fraud law? It seems like an omission that would contradict a different, positive claim is a fraudulent deception. If so, would it be OK if Goldman had simply said nothing at all?

The Rat Cap said...


Au contraire mon ami. I think you have accidentally fallen into the trap. You said:

"...has some damning accusations, namely that Goldman Sachs 1) told IKB that ACA had selected all the securities, whereas Paulson & Co had weeded out the good ones, and 2) IKB was told Paulson & Co. had invested in the fund, which was incorrect. Those are the accusations, anyway."

Only in hindsight do we know which were the "good ones" and which were not. At the time, as is always the case in a trade, this was a matter of opinion, and ACA had full access to the list and CHOSE to buy them.

This would be like if today, I came to you with a list of 30 stocks and said "I want to bet against these. Do you want to take the other side?" Of course I "selected" them. The act of engaging in the transaction, by definition, means both parties "selected" the securities. You would be free to research the stocks and if you thought it was a good bet, you would take it. ACA was a sophisticated mortgage trader who chose to take the other side, as did hundreds and thousands of other investors.

What would it mean if neither party "selected" the securities. They both put blindfolds on and randomly select from a hat and flip a coin to see which side they are on? (I don't mean to be facetious - just trying to make a point)

As I said in the post, let's say it had turned out differently and these securities had gone up dramatically in value. The SEC could now sue ACA saying ACA was so smart and knew these were going to go up and poor Paulson lost a lot of money. They defrauded them...

If you come up with a basket of securities, you can go to an investment bank and try and get someone to take other side. This is how that business works. People can take the other side AT A PRICE that they mutually agree. ACA could have said: "sure, we will take the other side, at half the price you are offering" or whatever.

This is trading! One side is going to be unhappy. Now, if Goldman had said something to ACA like: "you are buying XYZ security" but really it was ABC security, that would be fraud.

ACA was a pretty shaky company that was "stretching" to get exposure to this area.


"In a statement Friday, Paulson said it wasn't involved in the marketing of the CDO program in question, and that ACA, as collateral manager, had sole authority over the selection of all collateral in the CDO. "While it's unfortunate that people lost money investing in mortgage-backed securities, Paulson has never been involved in the origination, distribution or structuring of such securities," Paulson said in an updated statement late Friday."

I'm not sure if Goldman "misled" ACA by claiming Paulson was on same side. My understanding was that they didn't disclose, not that they represented Paulson was a buyer. Goldman's letter seemed to imply that.

That would be a problem but I think a minor one since someone had to be on the other side. In other words, everyone knows some entity is taking an opposite position.

mtnrunner2 said...


My point in item #1 is not Paulson's intent (which I don't regard as wrong), but the complaint that Goldman specifically told IKB that ACA was the only selector of the securities.

As for #2 either they misrepresented or they didn't. My point with both is merely that if those specific complaints were true, they seem like fraud to me.

In turn, that had me wondering, if Goldman had simply said nothing in both cases, would it have been OK?

That's why I was curious about the legal idea of a "material fact", i.e. a fact that is relevant to a party engaging in a contractual agreement.

My understanding has been that fraud requires a specific positive claim that is false. However, "material fact" seems a little wider than that, and seems to have two distinct meanings. It seems to apply both to 1) statements that were made but were false (obviously wrong), and 2) statements that should have been made for the second party to make a reasonable decision (not sure about this one).

I have difficulty with the second meaning, because it seems like it compels an awful lot of disclosure, effectively forcing the seller to do the buyer's research, and it also would require a lot more investigation to prove, which in our day and age inevitably means: regulatory oversight. Any thoughts? Do you think this principle fits an objective definition of fraud?

The Rat Cap said...


First, thanks for your good comments as always.

You said:
"My point in item #1 is not Paulson's intent (which I don't regard as wrong), but the complaint that Goldman specifically told IKB that ACA was the only selector of the securities."

If that were true, what would it even mean? There must be someone on the other side of the transaction so, in essence, some counter party "selected" assets to be short. I'm arguing that this issue of "selection" is a total red herring.

In a stock trade, one person selects to buy and one selects to sell. By the nature of the transaction or any transaction, a selection is taking place. As long as both sides had access to the list and freely chose to take a side, I don't understand the relevance of this claim.

You raise an interesting point re "material facts." I'm no lawyer so perhaps someone else can comment since I'm sure there are treatises written on this. You point out that there can be "obviously wrong" statements and statements that should have been made but were not. Let me take a layman crack at this.

I would think it comes down to the contract either written or verbal. Let's say we agree that you will fix my roof. All our contract says is you will fix my roof and I will pay you $1000.

Then, let's say you put spaghetti on my roof and say it is fixed. You then say "you never specified what fixed meant and I think fixed means putting spaghetti on the roof."

There is certainly a reasonability argument with respect to the meaning of the word "fix" and so I'm sure a court would side with the homeowner but it would have been best to have specified what "fix" means in the contract in terms of what materials are being used and what constitutes substantial completion.

There is also the issue of what is common practice in terms of disclosure and the nature of the contract in a certain industry. In other words, any court who hears these cases will expect a certain level of specificity and disclosure in these contracts or I would think could deem them to be inherently flawed, i.e., there is so much open to interpretation it is guess work to infer meaning.

Also, it's not like Goldman was selling subprime CDO's to orphans and widows. ACA and IKB were big boys and had the ability to assess the risk of these securities. As I quoted in the post, it was not standard for Goldman to disclose the counterparty.

Here are some stats on how common these were:


As many are now pointing out and I claimed in the post, this action was not a coincidence. I really think the SEC was looking for anything with some gray area so that they could create publicity and the FEELING that something was nefarious as a precursor to their drive for financial regulation.

mtnrunner2 said...


I gotcha. In other words, Goldman could have claimed the sky was purple, which might have been factually untrue but irrelevant to the transaction. I didn't analyze from that angle but will ponder it.

I have no doubt the SEC is working in league with the rest of government to try to support the push for financial legislation. Those people are working every arm of government to promote their goals.

And the fact that they are using my money, such as with their media and email campaigns, is very offensive to me.

Regarding material facts I agree it's probably something that comes down to a "reasonability" standard or standard practice. Hopefully there is a rather objective yardstick that can be applied.

Thanks for your thoughts.

The Rat Cap said...


I am not even contending it was factually untrue. If you go to a grocery store and they have a bag of Doritos for sale, it could be said that they selected the Doritos for you, but if you choose to buy them, it could be said that you selected the Doritos too.

It appears true that Paulson "initially" selected the assets, but then ACA could be said to have selected the assets to go long since they researched these holdings and chose to take the other side. The concept of selectivity applies equally to both sides of a transaction. It is the flip side of the same coin. I don't see how the initial selection process is even relevant as long as both parties had equal ability to research these holdings and freely entered the transaction. They can both be said to have selected this transaction.

Second, I linked to some takes on Goldman's call below, and Goldman makes a great argument. Even if you buy the selection claim, it is not material since EVERYTHING in that sector went down dramatically in 2009. It's not as if only the securities that Paulson magically divined would go down indeed went down.


Anonymous said...

Doug: Excellent commentary. In the MSM, perhaps you read this startlingly clear exposition of the Goldman-Sachs frame-up, by columnist Mallaby, in the Washington Post, of all places. http://www.washingtonpost.com/wp-dyn/content/article/2010/04/20/AR2010042003528.html?wpisrc=nl_opinions

I have the Radford DVD of 1984. What you linked to is one of the most compelling film openings I've ever seen, and I'm glad you share my appreciation for it. You're right to characterize the Goldman-Sachs and Paulson interrogations as a form of the Two Minutes Hate, and wholly engineered by the state, cashing in on its own regulatory power and generations of Americans indoctrinated in various venues with altruism and "social justice."

An authoritarian state must always have an enemy to divert the attention of the people from what the state is doing to them.

The Rat Cap said...


Thanks for Mallaby's article. It is excellent (because it agrees with me!). Seriously, he debunks the claims in a very concise way and I recommend everyone read it for a simpler (or better) version of my post.

Glad you find the 1984 movie clip provocative too. It is really chilling. And, I think that is the essence of my post - the idea that the state relies on a culture ripened by altruism to execute these kind of show trials. No one stops to consider the actual facts. I hope Goldman fights it and I hope we can be successful in transforming the culture to a morality of egoism.

Unknown said...

What I don't understand is who complained? If all parties to the transaction are satisfied, where's the issue. Is the looser claiming fraud, if so, don't they have civil claims that can address whether there was fraud or not in a court of law without the need for the SEC to be involved?

This is clearly a politically timed event to get the Financial Reform Bill traction and acceptance from the people. Our freedoms continue to be tread upon....

The Rat Cap said...


Great point! Funny, no one in the MSM or any politician bothered to ask: "if it was so bad, why didn't ACA sue them?"

Apparently, only the SEC knows...although may have been distracted surfing porn:



Unknown said...

For what it's worth I'd rather have them looking at porn then into my business.

The net cost to the taxpayer is less then immoral enforcement policies of any regulatory agency.

Burgess Laughlin said...

> "Funny, no one in the MSM or any politician bothered to ask: 'if it was so bad, why didn't ACA sue them?'"

I am not a lawyer. I am relying only on general information gathered over the years.

My understanding is that civil law attorneys prefer to wait for the completion of criminal cases (where applicable) because doing so makes a client's case easier to bring to court (assuming a conviction or near-conviction of the defendant).

First, the reason is that the criminal trial will bring out mounds of evidence at no cost to the plaintiff. Second, the trial will bring out sworn testimony, which can be used against the defendant in a civil case -- where the standards of proof are more relaxed (or so I have read).

An example of such a strategy was the civil suit against O. J. Simpson. It followed the failure of the criminal case against Simpson, but easily won in a civil court.

I hope an attorney will correct my errors, if any.

The Rat Cap said...


The SEC case is a civil case.

Burgess Laughlin said...

If that is the case, then what incentive would a plaintiff have for filing a case of their own? Would not the same advantages still apply?

The Rat Cap said...

Asness' point was just that if this was so bad, why didn't ACA sue Goldman? They didn't, and I suppose never had any intention because they recognized that they just made a bad trade, and there are no valid grounds for a lawsuit. Of course, this does not trouble the SEC, who is really only pursuing this as a publicity stunt.

You said that perhaps ACA is awaiting criminal charges as that would make there potential case easier, but I pointed out that the SEC case is civil, not criminal.

I imagine that ACA will wait and see what happens. If Goldman loses then I suppose that would give ACA legal standing to pursue a claim or more likely - extract a monetary settlement based on the political calculus that Goldman will have trouble getting a fair hearing.