Your Guide to the Goldman Sachs Lawsuit

As the Securities and Exchange Commission thrusts the Goldman Sachs case onto the national stage, Americans are once again getting acquainted with the most controversial members of the recession-era cast of characters: the subprime mortgage, the "too big to fail" doctrine, the Wall Street bailout, and the housing bubble, just to name a few.

[See How Goldman Sachs Might Help Democrats in November.]

But even as those themes hog the limelight, two other recurring, albeit slightly more obscure, characters—the matchmaker and the credit default swap—are also starting to peek out from behind the glamorous SEC indictment. And as they do so, they have the potential to reshape the contentious debate over Goldman's actions.

Matchmaker, matchmaker. The Goldman product that the SEC is targeting is quite complex. Known as ABACUS 2007-AC1, it is the result of years of evolution in the synthetic investment market. But the underlying theory is quite simple.

Gary Kopff, a mortgage expert and the president of Everest Management, uses the example of wheat. "Two parties get together. One says, 'I think the price of wheat is going up.' The other says, 'I think the price of wheat is going down,'" he explains. "Neither party owns any wheat."

With the Goldman case, of course, the big difference was that investors were instead betting on mortgages. And since the investment products were synthetic, investors were able to place bets on the direction of the housing market without actually owning any physical mortgage bonds.

[See How Strategic Defaults are Reshaping the Economy.]

In arranging these deals, one of Goldman's roles was that of matchmaker. In other words, it was Goldman's job to find some investors who thought that the housing market would stay healthy and others who thought it would tank. Goldman would then pair the two sides up in a transaction.

"Acting as a swaps dealer, Goldman has a commodity. And in order for it to earn a fee for that commodity going out into the marketplace, it has to put together the short side and the long side. So it has to be simultaneously in possession of the names of bona fide longs and shorts," says Kopff. Using a gambling metaphor, he says, "In that sense, [Goldman] has a duel incentive. It wants some people to go short and some people to go long because it's basically like the house. It's making money as long as it pairs up the longs and shorts."

The question then becomes: When should we blame the house? The most obvious answer is that the house could be at fault when the deck is stacked against some of the betters.

In the Goldman case, this issue is particularly relevant. Notably, the SEC is charging that Goldman let hedge fund manager John Paulson essentially hand pick mortgage bonds he thought were doomed to fail. Goldman then created a vehicle where investors could get synthetic exposure to those bonds.

Paulson, of course, effectively shorted the housing market by betting against the bonds, but there were also investors on the long side of the deal in question. The SEC is alleging that Goldman, in its role as matchmaker, never told these investors that the bonds they were getting exposure to were chosen because a prominent manager thought they were poised to implode.

In fact, they were never even made aware that Paulson was involved in the deal, according to the lawsuit. Instead, according to the SEC, they were made to believe that ACA Management, an independent third party, was behind the bond selection.

Legal issues aside, these charges raise a number of pressing questions, particularly at a time when Wall Street firms are under fire for what's perceived as a lack of corporate responsibility.

"I think there is a very large concern among American taxpayers that not only did Wall Street cause this problem and not only did the American tax payers have to bail Wall Street out, but now Wall Street is back and as profitable as ever—if not more profitable—and is going back to using the same old practices," says Michael Greenberger, a professor at the University of Maryland School of Law.