Your Guide to the Goldman Sachs Lawsuit

Old themes get new attention in the Goldman case.

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At the moment, one thing is clear: Goldman's own investors accurately predicted that the housing market would crash, and they placed their bets accordingly. But what remains to be seen is to what extent the investment bank encouraged some of its clients to take the opposite position.

As a result, at least in the court of public opinion, the Goldman case will be a key test of the matchmaker defense. Put another way, was Goldman merely allowing clients who had a bullish outlook toward the housing market to put money on that view? After all, in order for markets to function, intelligent investors need to disagree from time to time.

"In some ways, this is Wall Street 101 in that there needs to be somebody on both sides of every deal. So clearly you have a world full of smart financial firms, but still with those firms often taking bets opposite of each other," says Kevin McPartland, a senior analyst with the TABB Group, a financial-sector research and advisory firm. "There's always going to be somebody that's looking in the opposite direction."

But another possibility, some say, is that Goldman was knowingly giving its clients bad advice by actively prodding them into taking long positions rather than merely presenting them with the option. "[Goldman is] cynically saying, 'We're not making a recommendation on whether to buy or sell this.' But clearly they are. They're creating the instrument and they're sending their salesmen across the world to meet with institutional players," says Kopff. "To say they're not taking on point of view on that almost belies reality."

From a legal standpoint, the more pertinent question is: Did Goldman conceal the role of Paulson? And if so, would the long investors in the deal in question still have taken the same position had they known that Paulson picked the bonds with the goal of effectively shorting them?

In answering the latter question, the SEC points to the example of the German bank IKB Deutsche Industriebank, a Goldman client that took a long position in the Abacus deal that's the subject of the lawsuit. "IKB would not have invested in the transaction had it known that Paulson played a significant role in the collateral selection process while intending to take a short position in ABACUS 2007-AC1," the SEC says in the suit.

The 'naked' truth. Another issue that could take center stage in the fallout from the Goldman case is the validity of credit default swaps, the complex deals that are often likened to insurance policies.

With most forms of insurance, people take out policies on items, such as houses and cars, that they own. In some cases, credit default swaps work the same way. In other words, investors can own mortgage bonds in the belief that they will appreciate in value, but at the same time they can hold an insurance policy—through these swaps—that will pay out in the event that borrowers default. Used that way, these swaps allow investors to hedge their bets.

But there are also naked swaps, which let people short investments without ever having to own them directly. Using the insurance example, it would be the rough equivalent of a person taking out an insurance policy on his neighbor's house under the belief that the house would be struck by lightning.

That's what happened in the Goldman deal, which was created using a package comprised of various credit default swaps. Investors like Paulson were then able to take the short side of the deal by buying insurance on the bonds referenced in the deal.

In turn, the long investors were the insurers. They received regular payments, much in the same way insurance providers do, from policyholders like Paulson. These payments were much like the interest they would accumulate had they actually owned the bonds outright. In exchange, they agreed to make large payouts to the short investors should the bonds fail, which is exactly what happened.

During the downturn, Goldman was hardly the only firm that allowed investors to employ these naked credit default swaps. In fact, naked shorts are viewed by many as one of the prime reasons why the housing collapse was so painful. "The naked CDS … wreaked havoc on the market," says Greenberger.


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