Goldman Sachs, among other Wall Street banks, and certain of favored hedge fund clients that were tipped off by the banks, reaped huge profits by shorting (betting against) “synthetic” collateralized debt obligations (CDOs) linked to residential mortgages, which the banks created and sold to other clients, according to Gretchen Morgenson and Louise Story in their New Times article, “Banks Bundled Bad Debt, Bet Against It and Won.”
To say the least, the conduct created a huge conflict of interest between Goldman and its “sucker” clients, and violated securities laws and regulatory rules, including the “fair dealing” requirement of the Financial Industry Regulatory Authority (FINRA), which is responsible for regulating the sales practices of such firms.
From 2005 through 2007, Goldman issued billion of these CDOs, according to Dealogic, a financial data firm. These CDOs include Abacus and Hudson Mezzanine, which were created and sold by Goldman. The CDOs consisted of credit default swaps, a type of insurance that pays out when a borrower defaults. The swaps made it much easier to place large bets on mortgage failures. Just 18 months after Goldman created Hudson Mezzanine, so many borrowers had defaulted that holders of the security paid approximately $310 million to Goldman and others who shorted it, according to the article.
“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”
As Morgenson and Story point out, the banks saw the mortgage meltdown coming and made the financial crisis worse than it might otherwise have been, effectively multiplying losses by providing more securities to bet against.
As early as 2005, Goldman and other banks saw the mortgage meltdown coming, and were figuring out how they could increase their profits at the expense of their clients when it came, by building unusual, self-dealing features into their deals. For example, according to the article, the banks devised a scheme to dramatically increase and speed up the transfer of their clients’ money to themselves. The situation the banks were trying to change was that CDO purchasers would only have to make payments to short sellers like the banks (and thus incur losses) in certain “dire credit events,” as when the mortgage linked to the CDO defaulted or their issuers went bankrupt. To cure this “problem,” the banks persuaded the International Swaps and Derivatives Association, which governs derivatives trading, to adopt a new system that would require CDO holders to pay short sellers under less dire circumstances like a ratings downgrade. These hair “triggers” meant that the banks could collect on their short bets more easily and fully. “These things were built in to provide the dealers with a big payoff when something bad happened,” said one investor.
At some point between 2004 and 2006, Goldman and other banks changed their stance on the mortgage market from positive to negative, without disclosing it publicly, and made big money by using the ABX and credit default swaps to bet against the housing market. Goldman and the other banks have argued that they were merely engaged in normal hedging and satisfying the demand of sophisticated investors who knew that the banks might take the other side of their bet.
The Securities and Exchange Commission and FINRA, however, are reportedly investigating the situation. One focus of the investigation is whether the banks purposely selected especially risky mortgage-linked assets that would be most likely to crater, thereby setting themselves up to receive even larger windfalls and setting their clients up to lose billions of dollars when the housing market imploded, as they firmly believed it would. Some securities packaged by the banks soured within months of being created.
Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in representing investors who lost significant sums in CDOs and other structured investments.. For further information, please contact us.