Goldman Sachs charged – ahem, SEC finally agrees “synthetic” CDO’s at heart of crisis

As King Harvest has said repeatedly, here and here, for example, at the heart of the credit crisis are various forms of fictitious capital, most notoriously “synthetic” securities like those at the heart of the civil charges brought by the SEC this week against Goldman Sachs.

Synthetics rely on a so-called reference portfolio of mortgage backed securities to create a trade for two counter-parties: on one side a bearish hedge fund (in the case at hand, Paulson & Co.) and on the other side clients of the intermediary investment bank who were bullish on the housing market. The bear fund buys a form of insurance called “credit default swaps” (CDS) that pay off if the underlying mortgages decline in value. In the meantime, the bullish investors collect the premium payments paid by the purchaser of the CDS and use them to pay a return to investors.

Note that in a synthetic deal no one actually makes a mortgage loan to a home buyer and no one buys an actual mortgage note from a home buyer, directly or through a securitized product. These are purely fictional securities based on the fluctuation of the so-called reference portfolio.

The reference portfolio is actually selectively built usually by a portfolio manager engaged – for a fee – for this purpose. Of course the bear investor wants a portfolio it thinks will decline in value and the bull hopes for the opposite.

These kinds of investments are roughly akin to allowing your neighbors to bet on whether or not your house will burn down – one says no it won’t and so is willing to sell the other neighbor fire insurance on your house! If your house burns down the second neighbor collects on the insurance premium but you don’t get a penny!

Of course, the bears were right and the bulls were wrong. A wild fire spread across the globe burning down houses right and left. The sellers of CDS protection to bears like Paulson had to pay up – big time.

Now Goldman Sachs is in the hot seat because they set up these kinds of trades. Allegedly they allowed one of the biggest and baddest bears around, Paulson & Co. to assist the portfolio manager, ACA, select the mortgage backed securities that would make up the portfolio. The only problem is they allegedly did not share the fact of Paulson’s participation in the creation of these trades with the other counter-party, the bulls who would buy the securities issued by the CDO and who would receive the premium payments from Paulson.

The lead Goldman trader on these deals himself found the role of Paulson “surreal” according to the SEC’s complaint. The defunct Bear Stearns – a bank not known for being shy of high risk deals – passed on these deals thinking it a little odd to be on both sides of these risky bets.

There are suggestions the SEC is looking at a range of similar deals. This could be the way to unravel the complexities of the crisis and get to the bottom of the whole mess. Stay tuned.

The SEC Complaint can be read here.