06/16/2010 05:12 am ET Updated May 25, 2011

Free Fraudin' at Goldman

The SEC sued Goldman Sachs today claiming that it intentionally created a mortgage investment that was designed to fail.

Goldman Sachs issued a press release in response, tersely dismissing the charges as "completely unfounded in law and fact."

Before considering the merits of this charge, it is important to understand the nature of Goldman's business offerings. In short, Goldman and other large financial institutions make money by putting themselves between both sides of large financial transactions. The transaction in question - an aptly ambiguously-named synthetic collateralized debt obligation (CDO) called Abacus 2007-AC1 - positioned the billionaire hedge fund manager John A. Paulson against several large pension funds, mutual funds, and other asset management companies.

Paulson hand-selected a bundle of mortgage backed securities, backed by residential mortgages of dubious credit quality, against which he wanted to bet. Specifically, he wanted to purchase insurance policies, known as credit default swaps, which would pay off handsomely if the cash flows on the underlying mortgage backed securities ceased. Paulson sought Goldman's help to structure this deal, using Goldman's franchise to find sellers of the insurance. In order to find investors willing to insure Paulson's target mortgage backed securities, Goldman told prospective investors that they would be investing in a pool of securities hand picked by an independent manager. The lawsuit alleges that Goldman misrepresented Paulson's involvement in the Abacus deal.

Time will tell if Goldman's failure to disclose Paulson as the deal's counter-party will constitute fraud. Still, there are several aspects of this transaction that get to the heart of the causes of the financial crisis. It is my central contention that suing Goldman Sachs does not address any of the following underlying causes, potentially distracting regulators from the real problems in our financial system outlined below:

1) Ratings agencies fueled moral hazard
A brief glance at the offering document prepared by Goldman for their prospective investors shows that Paulson targeted mortgage backed that received some of the highest ratings from the various ratings agencies. Such gamesmanship of the ratings agencies is well documented. Investors relied on the ratings provided by Moody's, S&P, and Fitch instead of doing their own due diligence on the mortgages in question. Investors are responsible for their own bad decisions. My own brief look into the offering document shows that investors were aware of the composition of their portfolio, as is required by law. Regardless of who chose the portfolio, investors had the same information that led Paulson to make his bearish bet on the housing market. In this sense, the SEC lawsuit ignores an age-old adage of free enterprise - caveat emptor.

2) Goldman routinely profited from the ignorance of their counter-parties
Conventional wisdom holds that Goldman Sachs left the financial crisis relatively unscathed. Indeed, they repaid their TARP warrants with interest. Such an account neglects that Goldman's various counter-parties, often rendered insolvent because of deals struck with Goldman, needed massive amounts of Federal aid to remain solvent themselves. In pursuing individual firm-level rational behavior, Goldman destabilized the entire financial system by bankrupting their business partners. Even if Goldman Sachs had enough foresight to hedge themselves against idiosyncratic credit risk, they failed to account for counter-party risk, forcing firms like AIG into the hands of government receivership. The suit in question is a case study in how Goldman readily feasted on the ignorance of their counter-parties. If Darwinian free market principles were to hold, Goldman's counter-parties would have gone bankrupt, thereby eliminating the very system from which Goldman benefited. Alas, free market principles did not hold, unconditional bailouts occurred en masse, and Goldman's counter-parties were free to fight another day.

3) Such transactions have little to do with a fully-functioning capital market
Critics of financial reform contend that any attempt to reign in the country's financial institutions will undermine the health of a fully-functioning capital market. Notice how the transaction in question was purely synthetic. There were no underlying cash instruments backing the deal. Moreover, Paulson's use of credit default swaps were not used to hedge against pre-existing exposure. Instead, these derivatives were used for speculation. As long as the everyday functions of borrowing and lending stand conflated with casino speculation, systemic actors will find ways to defy financial market stability at disastrous costs.

Ultimately, if the SEC were to apply the "Goldman Standard" of this lawsuit to other transactions of this type, numerous other financial institutions will have suit brought against them. Suing financial institutions for defrauding investors will never go out of style, especially in this hostile political environment. As an earnest believer in financial reform, I sincerely hope that lawsuits of this type will not supplant the passage of real useful reform of the financial system. In either event, Goldman will surely fight the charges. In that likely case, this lawsuit will ideally help jump-start a national dialog about what kind of financial system we want, and to what ends. It's about time.