Goldman-John Paulson CDO Scheme Stinks of Fraud
Paulson asked his investment banks [Goldman, Deutsche, Bear Stearns] to create new issues of repackaged subprime mortgage securities, known as collateralized debt obligations, or CDOs, so that they could be sold to some suckers at close to par. That way, Paulson’s hedge fund could approach some other sucker who would sell an insurance policy, or credit default swap, on the newly minted CDOs. Bear, Deutsche and Goldman knew perfectly well what Paulson’s motivation was. He made no secret of his belief that the CDOs’ subordinate claims on the mortgage collateral were close to worthless. By the time others have figured out the fatal flaws in these securities, which had been ignored by the rating agencies, Paulson could collect up to $5 billion.Incredibly, as Fiderer notes, Paulson actually handpicked mortgage bonds for inclusion in the CDOs -- that is, he picked the mortgage pools that he was going to bet against. From Zuckerman's book:
Paulson’s team would pick a hundred or so mortgage bonds for the CDOs, the bankers would keep some of the selections and replace others, and then the bankers would take the CDOs to the ratings companies to be rated…To try and protect themselves, the Paulson team made sure that at least one of the CDOs was a “triggerless” deal, or a CDO crafted to be more protective of [the] equity slices by making other pieces of the CDO [which Paulson had bet against] more likely to take early hits. Paulson’s goal was to make the equity piece at bit safer, but this step made the other parts of the triggerless CDO even more dangerous for anyone who had the gumption to buy them.Bear Stearns was actually too ethical (!!) to put these deals together for Paulson, with one trader saying "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 could sell deals that someone was shorting on the other side.”
Alan Greenspan and John Paulson.
You can say that the buyers of the CDOs should have done their due diligence. Ok, I'll grant you that. You can also say that the ratings agencies had no business granting "AAA" ratings on underlying securities with such shaky repayment prospects, and I'll agree with that too. But this leaves open the question of whether it is fair, just, or even legal to create a synthetic security that at it's core comes into existence because someone believes that the reference is going to detonate, and then sell off pieces of that security to investors without prominently disclosing the source of the funding of the cash flow, that they proffered the criteria for inclusion in the reference and that the INTENT of their funding was to profit from an EXPECTED detonation of the reference securities.If there was no disclosure of Paulson's role in crafting (and funding) these securities, I simply cannot fathom how the deals met necessary standards of disclosure. Ultimately, this is not about whether shorting the housing market was moral or not; it is about whether Paulson and Goldman's partnership was outright fraudulent. In any case, this needs to be investigated. While I understand that our government has been captured, the fact that we still can't point to a single sustained, high-profile investigation of members of this Wall Street crowd (barring the weird Ponzis) is absolutely shameful. Hopefully, Europe will do better. There is another interesting angle to this story. Paolo Pellegrini, the Paulson trader who was intimately involved in crafting these deals, used to work at the hedge fund Mariner Investment Group, which was busy constructing these kinds of CDOs in 2006. The Times described a Mariner unit as "one of the most aggressive CDO creators" in the market. It's unclear if Pellegrini was on good terms with the firm when he left, in 2004, though Mariner founder Bill Michaelcheck spoke highly of him in a recent Bloomberg profile. This raises another question: which other speculators crafted Paulson-style deals in the CDO markets? Which banks did they partner with? How did they find buyers? No one knows what is going on in Greece; my posts about another fruitful Paulson-Goldman partnership are largely speculative. But as I've written, if Paulson and Goldman's past relationship is any guide to their current behavior, whatever they are doing is probably worthy of an investigation. In this country, of course, we should probably start by getting to the bottom of what happened in the subprime CDO market.