Feds Issue a “Bill of Attainder” on Wall Street?

Federal prosecutors and the SEC seem intent on criminalizing, ex post, behavior everyone thought was perfectly legal at the time. If Congress tried this it would be a “bill of attainder” and it would be unconstitutional.

This report in the WSJ notes that Wall Street created a trillion dollars of CDOs in the late stages of the housing bubble. The federal investigation is implying that investment banks did this in order to lure long investors into buying the CDOs while the banks took the short position on the other side.

The real problem the banks created for themselves was that they were too long on housing not short. If they had gone short like the few bears in the market at the time they would not have needed a bailout from the Feds. True, there were some bears like Joshua Birnbaum inside huge banks like Goldman, but he was a small part of the overall hedging operations underway at the bank.

If the Goldman Sachs’ Abacus deal is any indication, this looks like persecution not prosecution.

Goldman set up Abacus to allow investors like hedge fund Paulson & Co. to go short on housing and to enable investors like German bank IKB to go long. Goldman earned a fee for their market making services in the deal and also engaged in hedging operations to protect their investment (they initially took the short side of the deal for a brief period before laying off their risk to Paulson).

Their behavior was no different than what they do in an IPO – they buy the stock from the company as an underwriter and to do so borrow in the capital markets and engage in hedging operations to protect their risk. After all the market may turn against them and they may get stuck with unsold stock. The IPO company and its new shareholders don’t care that the underwriter hedges the risk – they welcome it. A market maker that does not carefully manage its risk is a market maker not long for this world. The history of Wall Street is haunted by their ghosts.

Now it is remotely conceivable that in fact that Goldman was lying to Congress and the SEC when asked about their hedging operations. But the SEC had the opportunity to review 8,000,000 pages of internal company documents. One presumes they took their best shot in their complaint and yet there is no evidence of this hidden conspiracy to lie to their entire long customer base.

IKB knew all along that a sophisticated player would be on the short side of the Abacus deal and have some role in the creation of the structure. In fact, Goldman took the short position initially, and IKB was glad they were willing to do so. Were they really disadvantaged because Paulson stepped in to take out Goldman as the short? Doubtful.

Remember they needed a short investor in order to make the deal in the first place, and Abacus was one of many similar deals they entered into. And that is why they wanted portfolio selection agent ACA involved – to protect their interest. Further, Goldman provided them risk factors that made clear the housing market was deteriorating, fast.

But IKB was hungry for the deal. Why?

IKB, according to the LA Times, was raising money to buy into Abacus by selling commercial paper – which is completely exempt from SEC review – to small public institutions in the State of Washington. Those entities lost millions in IKB deals and are now suing IKB. IKB thought they had found a money machine – raise millions through the commercial paper sales to unsophisticated small investors while investing it through Goldman on the other side of what they thought were dumb “shorts” who fantasized about the collapse of the housing market.

No wonder Warren Buffet has no sympathy for them, despite his long time concerns about derivatives.

Yet somehow the SEC thinks it makes sense to ride to the rescue of the IKB’s of the world!

SEC and Prosecutors Cast Wider Net in Mortgage Investigation – WSJ.com.