Goldman Sachs buys and sells securities for customers and also trades for its own book.  It’s the world’s biggest derivatives dealer.  CEO Lloyd Blankfein told a British magazine in late 2009 that they were “doing God’s work.”  Now we know what that entails.

At an April 27 Senate subcommittee hearing, Carl Levin (D-MI) quoted from Goldman e-mails that referred to securities they were selling to clients as “junk” or “crappy” or “sh-tty.”  Senator Levin added, “You are betting against the same security you’re out selling.”  On April 16, the SEC sued Goldman Sachs for civil fraud.  Could cheating be a major profit center for Goldman?  The SEC alleges that one client paid Goldman $15 million to be allowed to design a security to fail—which Goldman then sold to other Goldman clients without disclosing that the security had been designed to fail.  Within a year the security performed as it was designed: The first client made one billion dollars, and the others lost the same amount.  The major loser was Royal Bank of Scotland, which led British Prime Minister Gordon Brown to call Goldman “morally bankrupt.”

The SEC lawsuit also introduced the general public to something called a synthetic collateralized debt obligation (CDO).  The mechanical details were astonishing; the outline of the deal took 65 pages.  Before you can have a “synthetic” CDO, you have to have an actual CDO.  What’s that?  First, a poor credit risk takes out a mortgage he can’t pay.  Second, thousands of such mortgages are collected into a security—a mortgage-backed bond.  Third, those bonds are collected into another security called a collateralized debt obligation.  Then the CDOs are sold to investors.

A “synthetic” CDO refers to an actual CDO but doesn’t own any asset—it is a bet.  Like any bet it requires two sides: a “long,” who is betting housing will go up; and a “short,” who is betting housing will go down.  The short bettor, by means of a credit default swap, agrees to pay the interest payable on the referenced CDOs to the long bettor.  In return, the long agrees to pay the principal of the referenced CDOs if they default.  Goldman is the bookie who puts the bet together.  Rube Goldberg would have blanched at such a grotesque construction.

Winning or losing the bet depends on the quality of the CDOs that are referenced.  Amazingly, Wall Street had no consistent practice to outline how the bookie was to select the CDOs and what duty, if any, the bookie owed to the bettors.

The SEC complaint states that IKB, a German commercial bank, told Goldman in late 2006

that it was no longer comfortable investing in the liabilities of CDOs that did not utilize a collateral manager, meaning an independent third-party with knowledge of the U.S. housing market and expertise in analyzing RMBS.

Goldman, in marketing ABACUS 2007-ACI, represented that the “reference portfolio” was “selected by ACA Management LLC . . . , a third-party with experience analyzing credit risk in RMBS.”  Fabrice Tourre, a junior employee charged by the SEC along with Goldman, e-mailed: “One thing that we need to make sure ACA understands is that we want their name on this transaction. . . . this will be important that we can use ACA’s branding to help distribute” the securities.

Goldman did not disclose that it was paid $15 million by John Paulson’s hedge fund, which wanted to “short” the housing market, to allow him to handpick reference CDOs for the synthetic CDO.  The SEC concludes:

In sum, GS&Co arranged a transaction at Paulson’s request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors . . . Paulson’s role in the portfolio selection process or its adverse economic interests.

The European banks who took the long bet, according to the New York Times, thought they were picking up a little revenue ($7 million) without any real risk, but ended up losing $841 million.

Goldman maintains it had no obligation to tell the long bettors that the short interest had selected the reference CDOs.  It argues that the long bettors were “sophisticated investors” who should have done their own due diligence.  Goldman may have a legal defense, but selling a security that is designed to fail is appalling.  As simple wagers, the “synthetics” have no social utility.

Almost certainly, were Goldman to fail tomorrow, the government would label it “too big to fail” and bail it out.  Why is the taxpayer guaranteeing the bets at a casino?  “Can we reasonably continue with a financial system,” Paul Volcker recently asked, “that, implicitly or explicitly, relies on a firmly held expectation that major financial institutions will be protected from failure in the face of financial crisis?”