Clear your mind for a moment of any preconceived notions on Goldman Sachs and hedge fund manager John Paulson, and consider how you would view this $1-billion trade.
On one side, you have a German bank that is an expert in credit markets, with 20 fixed income managers focusing on the sector, backed by another 20 IT and compliance experts. That bank is taking a position in credit derivatives as part of a $23.9-billion portfolio. The German bank has been in business for 83 years and considers itself a leading global player in credit.
On the other side of this trade is a hedge fund manager who runs a 13-year-old company that specializes in trading mergers and acquisitions. This fund manager, with a handful of employees, made its first serious foray into mortgage-backed credit derivatives less than a year ago.
Who enjoys the advantage when these two players match wits?
These thumbnail descriptions set the scene back in 2007, when Goldman Sachs built and sold a now-infamous portfolio known as Abacus 2007-AC1.
That German bank - its full name is IKB Deutsche Industriebank AG, but it is known as IKB - brought its considerable resources into play and took one side of the trade - it wagered that that Abacus portfolio, based on mortgage-backed bonds, would go up in value.
And hedge fund manager Paulson & Co. took the opposite view, working with Goldman Sachs to create Abacus, then betting that the portfolio would fall in price.
In pro sports, when a journeyman gets traded, you'll hear someone dismissively say that the player is "just a guy."
Back in 2007, in money management circles, John Paulson was just a guy. Since then, we've all found out he made a great call on U.S. mortgage markets. That wager transformed Mr. Paulson into a guru, a multi-billionaire who runs a $30-billion fund. But three short years ago, John Paulson was just another suit in a sea of Armani.
Goldman Sachs has already been convicted on Main Street for doing something very wrong in the credit crisis. Mr. Paulson is soaking up collateral damage. U.S. regulators confirmed a populist image of a Wall Street bank run amok by alleging fraud in the Abacus transaction, based on the fact that the dealer did not disclose the role played by Paulson & Co. in creating the portfolio.
But read the filings on this case, and listen to experts in this field, and it becomes hard to fault Goldman Sachs.
Warren Buffett came to the Wall Street dealer's defence over the weekend, at Berkshire Hathaway's legendary annual meeting. With a crowd of 40,000 hanging on his words, and the New York Times chronicling the event, Mr. Buffett said: "I don't have a problem with the Abacus transaction at all, and I think I understand it better than most."
The key to the U.S. government's case against Goldman Sachs is establishing that there was something amiss in Paulson & Co.'s role.
"For the life of me, I don't see whether it makes any difference whether it was John Paulson on the other side of the deal, or whether it was Goldman Sachs on the other side of the deal, or whether it was Berkshire Hathaway on the other side of the deal," Mr. Buffett said over the weekend.
Mr. Buffett's view is that institutions such as IBK simply weren't doing their homework, or using common sense, when they played credit markets at the tail end of the real estate boom. (The New York Times did point out that Mr. Buffett is not without bias, as he backed Goldman Sachs during the credit crisis.)
Goldman Sachs' first formal response to the government's charges, contained in a relatively succinct 40-page submission, works off the same themes stressed at the Berkshire Hathaway love-in.
The dealer portrayed Abacus as a relatively straightforward transaction between sophisticated investors - if anything, the odds favoured IBK - and showed the portfolio was built in a manner consistent with standard market practice.
"All participants in the transaction understood that someone had to take the other side of the portfolio risk," said Goldman Sachs' lawyers at Sullivan Cromwell.
"Offering documents clearly stated that Goldman Sachs might lay off some or all of the short exposure to the portfolio that it had taken on. A disclosure that the relatively unknown Paulson was the entity to which Goldman Sachs transferred that risk would have been immaterial to investors in April 2007," says the investment dealer in its claim.
On the issue of the SEC breaking with its own precedents to charge Goldman Sachs over the Abacus transaction, here is what Goldman Sachs' lawyers had to say: "As a broker-dealer acting as an intermediary on behalf of a client, Goldman Sachs had a duty to keep information concerning its clients' (Paulson's) trades, positions and trading strategy confidential. The [SEC] itself has recognized this obligation in other contexts, but seeks here to impose a duty to disclose the identity and market views of swap counterparties."
Warren Buffett is clearly in Goldman Sachs' corner. So are most financial professionals, when it comes to the specifics of the Abacus trade. The investment bank is likely to refute the SEC's charges when, or if, this case is tried.
But Goldman Sachs, and the rest of the Wall Street dealers, still face a daunting task in changing the verdict that's been rendered in the court of public opinion.
Andrew Willis