06/20/2010 05:12 am ET | Updated May 25, 2011

The Goldman Con, and other Confidence Games

The "Pigeon Drop" is a classic con game. Typically, two con men and their mark appear to find a stash of stolen money. The grifters and the mark presume the money is unlikely to be claimed by the thief who lost it. The three confer about what to do about the loot. One of the grifters comes up with an idea: take the money to a friend who will know what to do with it. But the grifters claim they can't all go to see the friend, so only one of them should go, and they choose the mark to be the one to do it. As a show of good faith, the grifters put their own money into the pot of "found" money, and ask the mark to do the same before he or she heads off to take the money to the "friend." The mark does so, and, without the mark's knowledge, the package with all of the money is switched with a worthless pile of paper. As the three part ways, the mark follows sham directions in an effort to visit the fictitious friend, taking what is believed is the large sum of money; in reality, the mark is left holding the bag and the grifters walk off with all the cash.

The Securities and Exchange Commission (SEC) has now sued Goldman Sachs & Co., alleging that it engaged in what may amount to no more than a billion dollar pigeon drop. According to the SEC's complaint, Goldman, at the behest of hedge fund manager John Paulson, allowed Paulson to select a roster of mortgage-backed securities that he believed would perform poorly, so that he could bet on them doing just that. Goldman did Paulson's bidding, finding marks that would pour money into the investments. The investors did not know the motivating force behind the creation of the investment: that is, that an outside party had essentially created an investment it wanted to fail. Goldman hawked the investment to parties who trusted the firm to promote only solid investments. And the con was on. The investments performed exactly as planned, and Paulson and Goldman walked away richer.

Of course, Goldman has its defenses, and the SEC has a long way to go before it proves essential elements of its case. One critical issue is whether Goldman's failure to mention to investors that Paulson was not only involved in the selection of many of the securities in the investment pool but also that he intended to bet against it were "material" omissions, which would make the transaction illegal under securities laws. From a layperson's view, it is hard to see how such a key fact would not be material. Before playing a game of pickup basketball in the park, letting alone betting on one's own team to win, wouldn't one want to know whether the team was (1) made up of a bunch of short and slow players with no rebounding, dribbling or shooting skills and (2) selected by one's opponent precisely because of those qualities?

What information the SEC has secured, and what more may come out through discovery, will likely speak volumes about whether Goldman personnel knew the investments were doomed to fail, and to what extent they, even with this knowledge, pushed them on investors who were only willing to buy into them because they carried the Goldman imprimatur.

What was in it for Goldman? They stood to net fees from the transaction (up to $20 million, according to the complaint in the action), regardless of how the investment performed. In many ways, the allegations against Goldman, if they are proven true, reveal not just a lone, fraudulent transaction, but also reflect a deeper rot. Such short cons were actually part of one long con: a complex cash machine of fees for mortgage brokers, lenders, investment banks and credit ratings agencies that operated during the height of the subprime mortgage market.

During the subprime frenzy, as investors lined up to invest in securities backed by subprime mortgages, lenders, working with mortgage brokers, pursued borrowers relentlessly, despite those borrowers' inability to pay back exotic mortgages with onerous terms. In fact, the ability of the borrowers to repay their mortgages was irrelevant. Mortgage lenders knew they could sell mortgages off to investment banks, sometimes within hours of their closing. Those investment banks, in turn, looked to bundle those mortgages with other mortgages and package them into securities to feed investors who could not get enough of these securities. And credit ratings agencies were waiting in the wings to bless these securities, paid by the investment bank for their efforts. Every link in the supply chain--broker, lender, bank, ratings agency--took its fees, regardless of the viability of the borrower or the strength of the securities. "IBG/YBG" reined; the individuals putting these deals together did not need to worry about the long-term health of the transactions. Those individuals knew at the outset that when the deals went bust, "I'll Be Gone, and You'll Be Gone," and someone else would have to pick up the pieces.

Whatever the ultimate outcome of the SEC's case against Goldman, as additional information comes out about these transactions and as the SEC and state attorneys general mine other transactions for similar, potentially fraudulent conduct, we might find that such transactions, and others like them, were common. Unfortunately, it might take years before the full story of the financial collapse is aired in public, if at all. By that time, the appetite for financial reform may have waned. What is needed, then, is quick, bold and decisive action on financial reform, to rein in these and other abuses. Senator Dodd's financial reform package and the derivatives legislation recently proposed by Senator Lincoln point in the right direction. Even if not perfect (no legislation ever is), Congress should pass these bills with the understanding that more reforms may be needed once the full story of the financial crisis is told.

The only way to beat a con is to know you've been duped before the con gets away. Many of the worst subprime lenders have already closed their doors, having reaped windfall profits from fees for years. At least some of the investment banks that were a part of the long con are still around, however. The ability to rein in and seek compensation for some of the most serious abuses of the lead up to the financial crisis may hinge on the success of the SEC's case against Goldman, and the information it may yield about this and other potentially fraudulent transactions. Let's hope the SEC has the goods, and the stomach, for the fight.

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