The move marks the first time that regulators have taken action against a Wall Street deal that helped investors capitalize on the collapse of the housing market. Goldman itself profited by betting against the very mortgage investments that it sold to its customers.
The suit also named Fabrice Tourre, a vice president at Goldman who helped create and sell the investment.
In a statement, Goldman called the S.E.C. accusations “completely unfounded in law
and fact” and said the firm would “vigorously contest them and defend the firm and its reputation.”
The instrument in the S.E.C. case, called Abacus 2007-AC1, was one of 25 deals that Goldman created so the bank and select clients could bet against the housing market. Those deals, which were the subject of an article in The New York Times in December, initially protected Goldman from losses when the mortgage market disintegrated and later yielded profits for the bank.
As the Abacus deals plunged in value, Goldman and certain hedge funds made money on their negative bets, while the Goldman clients who bought the $10.9 billion in investments lost billions of dollars.
Basically, Goldman Sachs got together with a hedge fund manager named John Paulson to create a product destined to fail so that both could bet against it. Paulson hand picked some of the worst mortgages in the world and those mortgages were put into a portfolio of Collaterilized Debt Obligations called Abacus 2007-AC1. Then, that was sold to investors by Goldman Sachs. Sachs never told these investors of their deal with Paulson nor did they tell them they were betting against them, themselves.
How does this happen? Let's start with the fact that these "synthetic" CDO's are one step below rocket science. Here's just one portion of their Wikipedia page.
Synthetic CDOs do not own cash assets like bonds or loans. Instead, synthetic
CDOs gain credit exposure to a portfolio of fixed income assets without owning
those assets through the use of credit default swaps, a derivatives instrument.
(Under such a swap, the credit protection seller, the CDO, receives periodic
cash payments, called premiums, in exchange for agreeing to assume the risk of
loss on a specific asset in the event that asset experiences a default or other
credit event.) Like a cash CDO, the risk of loss on the CDO's portfolio is
divided into tranches. Losses will first affect the equity tranche, next the
mezzanine tranches, and finally the senior tranche. Each tranche receives a
periodic payment (the swap premium), with the junior tranches offering higher
If you think you're confused just because this isn't your business, you're wrong. You're confused because this is mind numbingly confusing. You've got all sorts investments, securities, and other products all put together to create something that's unbelievably complicated. That's tailor made for fraud. If they buyer can't make heads or tails, they can easily be defrauded. I asked an attorney with experience on the legal end of CDO's to explain them and here's the explanation.
a derivative product (that have elements of bonds, convertible notes and options)
That's just about all investment products all rolled into one. If you're confused, that might have been the point.