How the Sleazy Used-Car Salesmen at Goldman Sachs Tricked Investors into Buying Their Busted Clunkers
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As the resident finance geek in my circle of friends, I had to field several questions about Wall Street megafirm Goldman Sachs, which was sued by the Securities and Exchange Commission last week for allegedly defrauding its investors.
Of course, the danger I encountered while trying to explain what Goldman did was in getting bogged down in financial terminology. After all, a person can only hear so much about synthetic CDOs, equity tranches and credit default swaps before going insane.
I think the best way to explain these matters is to remove them from the arcane language of finance and put them into more familiar territory. For our purposes, let’s pretend that Goldman Sachs isn’t a major investment firm and is instead a small business based in rural Georgia called Honest Lloyd Blankfein’s Used Auto Emporium. And instead of selling mortgage-backed securities, let’s say that Honest Lloyd sells (you guessed it) used cars.
Our story begins with Honest Lloyd walking through his dealership lot and coming away appalled by the low quality of cars he has for sale. One truck has a nest of possums living in its engine; another has triangular wheels; yet another has sparks shooting out of its gas tank; and so on. Honest Lloyd barges into one of his salesman’s offices – let’s call him Fabrice Tourre – and pops off about the crappy stock on his lot.
“Goldurnnit, Fab, how in all tarnation are we gonna git ridda these things?” fumes Honest Lloyd. “We done got the sorriest damn cars in alla Georgia!”
Tourre, who can talk smooth with the best of them, tells Honest Lloyd to relax – he’s got a plan. Tourre has already put in a call to John Paulson, a clever local mechanic who has come up with a brilliant way to make Honest Lloyd’s car stock look better. Basically, Paulson will remove all of the worst parts from each individual car – from the possum-infested engine to the exploding gas tank – and swap them out with the working parts of another car. This means there will now be one car on the lot that has all of the horrific defects of the entire lot.
“However will we repay you for your incredible work?” asks Honest Lloyd to Paulson after he finishes up.
“How about this?” Paulson says. “Just give me the Social Security number of the dumb chump you sell the vehicle to so I can take out a life insurance policy on him. Sound like a plan?”
The two men shake hands.
This is pretty much what Goldman Sachs allegedly did when it hired hedge fund manager John Paulson to pick out the absolute worst mortgages on Goldman’s books and repackage them into a new synthetic collateralized debt obligation that would be sold to some hump investor. The government alleges that Goldman knew the new CDO was likely to blow up on whoever bought it and that it misled its investors by not telling them the assets in the CDO were handpicked by Paulson.
OK, so back to Honest Lloyd. Now that he’s put all of the worst defects into one vehicle, he still has to find some sucker who’s willing to buy it. So he calls up one of his dopiest customers – let’s call him Johnny Pension Fund – and lets him know he’s got the deal of a lifetime for him. Johnny, an affable sort who has always trusted Honest Lloyd strolls down to the lot and looks in horror at Honest Lloyd’s Frankenstein car, which has now been rebranded the Chevy Abacus.
“But Honest Lloyd! This car has triangular tires!” exclaims poor Johnny.
“Now I know what you’re thinkin’ here, Johnny,” says Honest Lloyd, putting his arm around him. “But this here car is the most innovative automotive instrument we have on the lot! Those triangular tires are designed to have the best traction in any environment! Ain’t no way you’re rollin’ down a hill or slippin’ in the snow with those puppies on!”
“Uh, OK,” says Johnny, who figures Honest Lloyd knows a lot more about cars than he does. “But wait! Did I just see a possum crawl into the engine?”
“Aw, see, that’s just a newfangled, eco-friendly technology they got,” explains Honest Lloyd. “To save gas, the possum and its kin run on a wheel in the engine and help the car go even when you’re out of fuel! Think of all the money you’ll save!”
“Well, uh, if you say so,” says Johnny. “But hold on! Why are there sparks coming out of the gas tank?!?!”
“You know what, Johnny?” says Honest Lloyd. “You can sit here and question me all you want. But I just got this puppy inspected today by ACA’s auto repair shop and they gave it a passing grade. So if you don’t think it’s safe, you can go talk to them.”
Johnny, who knows that ACA is the best auto repair shop in the county, is impressed enough with the vehicle to take it off Honest Lloyd’s hands. But Honest Lloyd isn’t quite done yet. The minute Johnny takes the Abacus off the lot, he hastily dials up Paulson and gives him all of Johnny’s personal information. Pretending to be Johnny’s wife, Paulson orders himself high-priced auto and life insurance policies that will pay him handsomely in case anything bad happens to either Johnny or the Abacus. And then when Johnny explodes on the freeway a mere forty minutes later… KA-CHING, KA-CHING, KA-CHING!
If you’ve followed the story this far, then you have a basic understanding of what Goldman Sachs allegedly did. The only difference, however, is that they didn’t have to lie in insurance companies to take out a policy on the toxic assets they were selling; rather, they simply purchased credit default swaps on the CDO and then cashed in when it inevitably went bust. And yes, it’s perfectly legal in finance to purchase insurance on assets that you’ve created but do not actually own. What could get Goldman in trouble is more that it didn’t fully inform investors of Paulson’s role in designing the CDO.
So what happens from here? Well, no one knows if the government’s suit against Goldman will hold up since it will inevitably be represented by the Johnny Cochrans of finance law. But at the very least, the case should deal a significant blow to the firm’s reputation and will hopefully make decent people think twice before investing their hard-earned cash with Honest Lloyd and the good ol’ Goldman boys.