Sunday, April 18, 2010

John Paulson Needs A Good Lawyer

Original posted on the Baseline Scenario by Simon Johnson:

Of all the reactions so far to various dimensions of Goldman fraudulent securities “Fab” scandal, one stands out. On Bill Maher’s show, Friday night, I argued that John Paulson – the investor who helped design the CDO at the heart of the affair – should face serious legal consequences.

On the show, David Remnick of the New Yorker pointed out that Paulson has not been indicted. And since then numerous people have argued that Paulson did nothing wrong – rather that the fault purely lies with Goldman for not disclosing fully to investors who had designed the CDO.

But this is to mistake the nature of the crime here – and also to misread the legal strategy of the SEC.

The obvious targets are Goldman’s top executives, whom we know were deeply engaged with the housing side of their business in early 2007 – because it was an important part of their book and they were well aware that the market was in general going bad.

Either Goldman’s executives were well aware of the “Fab” and its implications – in which case they face serious potential criminal and civil penalties – or they did not have effective control over transactions that posed significant operational and financial risk to their organization.

They will undoubtedly pursue the “we did not know” defense – which of course debunks entirely the position taken by Gerry Corrigan (of Goldman and formerly head of the NY Fed) when I pressed him before the Senate Banking Committee in February. Corrigan claimed that Goldman’s risk management system is the best in the business and simply superb; the former may be true, but the latter claim will be blown up by Lloyd Blankfein’s own lawyers – they must, in order to keep him out of jail. (Aside to Mr. Blankfein’s lawyers: the people you are up against have already read 13 Bankers and may put it to good use; you might want to get a copy.)

And don’t be misled by the purely civil nature of the charges so far – and the fact that the announced target is only one transaction. This is a good strategy to uncover more information – for broader charges on related dimensions – and it allows congressional enquiries to pile on more freely.

As for John Paulson, the issue will of course be the “paper trail” – including emails and phone conversations. A great deal of pressure will be brought to bear on the people who have worked with him, many of whom now faced permanently broken careers in any case.

Here’s the legal theory to keep in mind. Mr. Paulson only stood to gain on a massive scale (or at all) if the securities in question were mispriced, i.e., because their true nature (that they had been picked by Mr. Paulson) was not disclosed. In other words, the Paulson transactions at this stage of the game only made sense if they involved fraud. The principals involved (Paulson and top Goldman people) are all super smart, with unmatched practical experience in this area; they get this totally.

John Paulson was not the trigger man – it was Goldman and its executives who withheld adverse material information from their customers. But if the entire scheme was Mr. Paulson’s idea – if he was in any legal sense the mastermind (obviously he was, but can you prove it beyond a reasonable doubt?) – then we are looking at potential conspiracy to commit fraud. And if he had conversations of any kind and at any time during this period with top Goldman executives, this will become even more interesting - so of course all relevant phone records will now be subpoenaed.

Mr. Paulson should be banned from securities markets for life. If that is not possible under current rules and regulations, those should be changed so they can apply. If that change requires an Act of Congress, so be it.

There is fraud at the heart of Wall Street. It is time to end that.

1 comment:

Lawrence J. Kramer said...

Dropped by via Blogger's "Next Blog" thingy. Interesting post.

I have to disagree with the claim that Paulson had to commit fraud to do his deals. I don't disagree that he did commit fraud, only that he had to do so. He just got greedy.

Every day, I can buy stock that I believe is undervalued from someone who thinks it's overvalued. Paulson could have shorted any pool of subprime mortgages and made money. (He also could've shorted WAMU and Countrywide stock.) Designing his own pool was just adding an unnecessary layer of gain.

Paulson's gain required that the underlying assets be mispriced, but the mispricing could as easily arise from the buyers' mistaken view of the American housing market as from Paulson's selection of the particular bonds. He just chose not to risk ACA picking "good" sub-prime bonds, e.g., the Wells-Fargo bonds that he rejected from the pool. That was dumb and corrupt, and he deserves to lose as much as he made, and then some.

Meanwhile, the real idiots here are the very smart Rubin and Summers, two guys who allowed Paulson to buy a credit default swap on debt he did not hold. That's just like fire insurance on a house you don't own. In Paulson's case, he even got to build the house with faulty gas pipes, sell it to someone else, insure it anyway, and then wait for it to burn down. The temptation to commit fraud arose from the opportunity to profit from a loss that could be caused by fraud. No CDS, no fraud, no meltdown.