06/19/2010 05:12 am ET Updated May 25, 2011

Who is Next in the SEC's Crosshairs? Some Possible (and Heretofore Overlooked) Suspects

Both the traditional media and the blogosphere have taken an almost obsessive interest in the suit the SEC filed against Goldman last week with regard to one of its synthetic real estate related CDOs, Abacus 2007 AC1. Goldman's shares and the stock market in general traded down, presumably seeing this suit as a turn in the tide, an end of the US government's supine stance on questionable practices in the financial service sector.

Although the Wall Street Journal is reporting that the SEC is widening its investigation, so far it appears to be going only after very low hanging fruit. While the Journal notes that the SEC is looking into specific CDOs issued by Merrill, UBS, and Deutsche Bank, in all the examples mentioned, there is an existing private lawsuit against the investment bank. As we discuss in detail below, we think this initial salvo falls well short of the universe of possible miscreants.

So the big question remains: how aggressively will the SEC pursue these cases? As John Bougearel noted in an earlier post, it is too early to tell whether this suit is indeed the beginning of a concerted initiative (with the initial litigation allowing the SEC to perfect its legal arguments and uncover more information through the discovery process) or simply an effort to address (as in appease) to a public mad as hell about no-questions-asked bank bailouts and continuing subsidies to the financial services industry.

And while many commentators have focused on the quality of the SEC''s apparent case, the truth is it is far too early to tell. The claims do look strong enough to survive summary judgment, which means the SEC will be able to seek more information from Goldman, Paulson, former ACA staffers, and various counterparties. It can add claims if it wants to as the case progresses.

And as other have noted, the odds are high that even if Goldman wins (or more likely, settles), it comes out the loser. When Procter & Gamble and other large companies sued Bankers Trust over losses they sustained on derivatives trades gone bad, many observers argued they didn't have much of a case. Procter in particular had a sophisticated treasury operation; how could experienced market players claim they had been duped? The litigation appeared to be an effort to stem losses on bad bets.

But when P&G obtained access to taped conversations of BT staff discussing their and others' trades, public opinion shifted dramatically. The bank's posture was openly predatory (the most infamous quote was "Funny business, you know? Lure people into that calm and then just totally fuck 'em.''). BT never recovered from the scandal, but it took a second run-in with the authorities (failing to turn abandoned client assets over to the state) that led to the bank's sale to Deutsche Bank.

Assuming that the Goldman suit is the first step in a bigger initiative, where might the SEC and private claimants go next? There would seem to be at least three obvious channels: other John Paulson-related CDOs; non-Paulson Goldman Abacus trades; synthetic CDO programs like Abacus, apparently for the banks' own accounts (the most notable example being Deutsche Bank's Start program) and the Magnetar CDOs, which were structurally different than the Paulson program but appear to have been designed with the same intent, namely using a CDO to gain access to credit default swaps on particularly drecky subprime debt at cheap price (since the use of a CDO lured some counterparties into accepting AAA prices for at best BBB risk).

Greg Zuckerman's book The Greatest Trade Ever discusses the origin of the synthetic CDO, and depicts Paulson as the moving force behind them, attributing $5 billion of CDOs to him. According to Zuckerman, Paulson approached Goldman, Deutshce Bank, and Bear Stearns in 2006 about launching synthetic CDOs that he would sponsor in return for taking down the ENTIRE short side (as in all of the CDS used to provide the cash flow for the CDO). Bear Stearns found the idea to be unethical (!) while Goldman and Deutsche went ahead.

Various commentors, including this blog (and later in an extensively researched New York Times story) have observed that Goldman's Abacus program (25 deals, totaling over $10 billion) appeared to be designed to serve Goldman's desire to put on a short position, yet presented to customers as no different than other CDOs. Deutsche Bank's less widely discussed Start program appears to be along the same lines.

Although one of Magnetar's deals is also on the list of cases the SEC is probing, this CDO (Norma) has been in the press since 2007, when it was the focus of one of the very first stories on dodgy CDOs, this one published by the Wall Street Journal. Magnetar's program was far and away the largest of all the subprime short strategies that used synthetic or heavily synthetic CDOs as a major component. Our tally of the trades (more complete than ProPublica's) puts the total at 29 transactions with a total par value of over $37 billion.

We"ve sorted the deals by banker, since the winks and nods that might have occurred between the dealer and the hedgie sponsoring the deal could have operated across multiple transactions. The list shows that some major CDO players have not yet received much critical scrutiny for their role in working with CDO sponsors who appear likely to have designed the deals to fail, namely Calyon, Mizuho, Citigroup, Lehman, and Wachovia. We've also put Calyon and Mizhuo together on our spreadsheet, since the team at Calyon decamped to Mizhuo (while any legal action would presumably target the bank-issuer, plaintiffs might want to examine the conduct of the professionals at both firms).

In other words, there is a lot of dirt if the SEC chooses to dig. And it is far too early to tell whether they have the Administration support and the bloodymindedness to do so.

Andrew Dittmer and Richard Smith contributed to this post