Goldman-deal gamblers knew the score

Monday, April 26th, 2010 No Commented

By Bill Fleckenstein

Goldman Sachs. John Paulson. Those are hot-button words that have dominated business news lately, with many of the reports biased toward a black-and-white supposition: guilty.

This column, however, wouldn’t live up to its name if it didn’t take a contrarian view. Not surprisingly, I’m going to discuss the Goldman/Paulson flap from a slightly different perspective.

What I believe may have happened — at worst — is that Paulson, a hedge fund manager, identified various bits of mortgage flotsam he wanted to short, betting they would go down. Then he might’ve gone to Goldman Sachs (GS, news, msgs) and asked something like, “Hey, would you put a basket of this stuff together?”

It seems to me that Paulson did nothing wrong. (I myself constructed a few “put baskets” of stocks I hated back in the late 1990s. At that time, the player on the other side of my trade was a brokerage firm.)

If that’s what occurred, Goldman probably didn’t want to take the other side of that trade. So, it would’ve gone out and found some suckers — I mean, buyers. But what is most important to understand is this:

A buyer-beware market

This is not a mom-and-pop market of innocents. This is a sophisticated, buyer-beware “upstairs” market. All participants have ISDA (International Swaps and Derivatives Association) agreements — and the mountains of supporting data that go with it. Nobody unsophisticated operates in this derivatives market. Furthermore, every participant knows there is a short-seller on the other side of every purchase.

I am particularly annoyed that so many people seem to feel that Goldman should have disclosed that Paulson was somehow involved in the selection of securities in the Abacus collateralized debt obligations in question in this case, when it appears that another company, ACA, had the final say. (In a bit, I’ll spin out a scenario to bolster my point.)

Find a broker who’s right for you

Even if Paulson had complete discretion over the selection, I doubt the buyers would have cared. His reputation was not what it is now, after making a fortune shorting subprime, so his opinion on any given security was nothing special. And remember, few people believed the bears back then when they said housing was in trouble.

In fact, some very smart people were bullish on the subprime/Alt-A sector. For example: David Einhorn, who later predicted the collapse of Lehman Brothers, was the largest shareholder of now-collapsed lender New Century Financial — his fund owned more than 10% of the company — and he was also a director. I knew then that he was a very smart fellow, but for the life of me, I couldn’t figure out what he saw in the company that I didn’t.

Einhorn’s position did not stop me from being short the stock (though it might have caused others to feel better about the company than they should have), and it ultimately went almost to zero. My point: Among professionals, the fact that somebody else has a different opinion usually isn’t enough to change one’s viewpoint.

Bona fide garbage foisting

Here’s an example of what the unwashed masses think Goldman Sachs was trying to do, i.e., foist garbage on unsuspecting buyers:

In spring 2007, Goldman filed for an initial public offering for Everquest Financial (which made it through the Securities and Exchange Commission). The idea was to take some of Everquest’s mortgage products in the Bear Stearns hedge fund managed by Ralph Cioffi — which were causing it so much grief — and let the public in on the deal. Fortunately for the public (and what little might be left of Bear Stearns’ reputation), the deal never made it out the door. The markets unraveled so fast that it couldn’t be done.

By comparison, it’s quite clear how large the difference is between what Bear Stearns wanted to do and what Goldman Sachs is alleged to have done. (To learn more about Everquest, see this March 2007 BusinessWeek story.)

Continued: How the case is aided by hindsight