Would you have sympathy for a professional auto mechanic who bought a lemon after given the opportunity to examine the car beforehand? Few people probably would, since if anyone should have known better, he should have. Yet, in its case (.pdf - brief synopsis here) against Goldman Sachs, the Securities and Exchange Commission needs the court to develop a very similar sort of sympathy for German IKB bank and other large sophisticated investors who purchased a synthetic collateralized debt obligation (CDO) from Goldman. Even under the circumstances of the case, it's extremely difficult not to feel that IKB should have known better.

Sophisticated Investor

Not just anyone invests in synthetic CDOs and other asset-backed securities. Buyers are limited to big, sophisticated investors. After all, IKB purchased $150 million worth of the bonds in the deal -- only a serious investor has that kind of cash to spend. This wasn't a case where Goldman cold-called a guy who works at a tire factory to trick him into buying a wacky security. IKB should have had the resources and motivation to understand what it was buying.

The Collateral Wasn't Misleading

IKB's sophistication wouldn't matter if Goldman lied to the German bank about what was in the portfolio that the bonds were based on. The SEC doesn't allege that. Instead, the complaint says that Goldman didn't disclose that a hedge fund manager, John Paulson, played a role in creating the pool of securities. While that may or may not be found to be material, it's hard to imagine how it would have made a difference to IKB. The collateral would have been the same either way, and IKB had the opportunity to perform its own analysis on the pool's potential performance. There's no input in a cash flow model for evaluating a CDO that takes into account the parties influencing the collateral pool's creation.

In a press release, Cornell law associate professor (and former associate at a firm that represented Goldman) Charles K. Whitehead makes this point:

If, instead of creating a synthetic Collateralized Debt Obligation, Paulson decided to sell the identical assets to Goldman Sachs, and Goldman Sachs had then sold the portfolio to the ABACUS investors, would Goldman Sachs have been obligated to disclose that Paulson was the seller? No - in fact, doing so would have been a breach of confidentiality. But that is, in substance, what occurred here.

This sharpens the point: investors should decide whether to buy an asset-backed bond based on how the pool will perform, not based on who put it together.

By Definition, IKB Knew a Short Existed

Finally, most news articles about the SEC case imply that if investors realized a big hedge fund had shorted the portfolio, then they would have thought twice about going long. In the case of a synthetic CDO, that's a nonsensical claim, because you can't create a synthetic CDO without also creating a short interest. The security we're talking about is derivative-like, because it references other securities. So in order to have long invertors profit if the portfolio does well, a short investor must pay up accordingly. The reverse works the same way -- so when investors like IKB lost money, Paulson profited. You need the two sides of the equation to balance.

As a result, IKB should have known a short interest existed. If it didn't, then it didn't understand a very basic fact about a synthetic CDO and really had no business investing in one. Again, it's hard to conjure up much sympathy if that's the case. This fact makes it even harder to believe that who held the short interest matters. Would be mean more if Paulson bought it instead of any of the other dozens of major hedge funds? It's hard to imagine how.

Ultimately, if Goldman is found to have misled investors, then it doesn't much matter if those investors should still have known better than to buy the security. But a sympathetic plaintiff is generally an important pre-requisite for a successful lawsuit. IKB is the SEC's de facto plaintiff here, since it's the party that lost based on Goldman's actions.

(The collateral agent, ACA, was also supposedly misled. But there's a dispute of fact here, so finding the truth regarding what really happened matters more there than what information was material.)

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