Goldman Sachs: The Stupidest Trade Ever

The Securities and Exchange Commission's fraud case against Goldman Sachs (GS) involves all sorts of complicated issues regarding disclosures among sophisticated investors. But the hearings will really hinge on one simple question: Did Goldman help hedge-fund operator, John Paulson, design and create investments designed to fail that he then bet against?

Perhaps one of the best ways to gain insight on the man behind Paulson & Co. (besides reading or watching a blow-by-blow of the hearings) is to read The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History

, which came out last year. Written by Gregory Zuckerman, a reporter from the Wall Street Journal, the book details how Paulson foresaw the coming housing crisis early on and outwitted many of the most brilliant minds on Wall Street to make billions of dollars on some very risky trades.

Here's a look at at some key takeaways from Zuckerman's book:

The Real Estate Bubble
The housing crisis was a result of a variety of factors: U.S. politicians -- from both parties -- were more than willing to enact government policies to increase home ownership and, in turn, lenders followed suit with relaxed lending standards.

Smelling an opportunity, Wall Street packaged mortgage loans into esoteric securities called collateralized debt obligations (more commonly called CDOs) that offered juicy returns and sold them to hungry investors across the world. Even though CDOs often included risky subprime loans, agencies like S&P and Moody's often assigned these vehicles investment grade ratings.

Interestingly enough, the demand for CDOs was so great that Wall Street found ways to create more securities even though there were no mortgages to back them up. These newfangled instruments were called synthetic CDOs. As a result, Wall Street created $5 trillion of these instruments even though the subprime market was only $1.2 trillion.

The Man and His Investment Thesis
Paulson was a student of investment history and convinced that real estate was poised for an implosion. But he had to prove it. So he purchased every real-estate database he could find and started to crunch numbers. For example, he found that real estate prices increased 1.4% per year from 1975 to 2000 but then increased by 7% a year from 2000 to 2005. Based on prior downturns, prices would need to fall 40% to get back to normal.

What's more, as interest rates perked up, it looked like financing was starting to dry up for real estate. Basically, if many homeowners could not refinance their homes, the default rates would soar. By 2006, it became increasingly common for subprime borrowers to miss their first payments.

The Trade
Paulson had to find a creative way to make money from his nightmare scenario and this involved a complicated derivatives investment, called a credit default swap, or CDS. Think of this as an insurance policy, where you pay a premium every year for protection. So if a CDO defaults, you would get the face value of the security. Keep in mind that the premiums were often fairly low, say 1% to 2% of the face value. In other words, a default could result in a massive home run for an investor like Paulson.

Paulson found that structuring large derivatives trades was time-consuming and complex -- often involving several months of work. So why not approach Wall Street firms and help them create CDOs and CDSs? This is what happened when Paulson approached Goldman and created the ominous Abacus 2007-AC1 investment, which is at the heart of the SEC's investigation.

In Zuckerman's book, he describes this strategy as "controversial." Even Bear Stearns passed on the opportunity because of ethical concerns. Wouldn't Paulson be incentivized to make the investment highly toxic? And, while the buyers would be sophisticated investors, they were still managing money for individuals -- such as pensions. Would these investors really be doing enough due diligence on these deals or relying on third-parties like collateral agents and rating companies?

Such deals were nothing more than quick-money wagers, not long-term investments. Simply put, one party would ultimately prevail against another.

Disclosure
Even if Goldman disclosed Paulson's involvement, it's reasonable to assume that the Abacus transaction still would have been completed. Even in 2007, Paulson was considered a has-been investor who had little real estate experience or expertise with derivatives. Actually, many investors willingly bet against him when buying CDSs and thought he was simply "crazy," according to the book. Moreover, Paulson also had a hard time raising money for a subprime "bear" fund because of skepticism about his investment thesis.

The Damage

The losers in the Abacus trade, which included financial firms ACA and IKB, ultimately required government bailouts from the United Kingdom and Germany. So this wasn't just a case of "seller beware" for sophisticated investors. The harm was to society at large.

UK Prime Minister Gordon Brown referred to Goldman's actions as "moral bankruptcy" and there are calls to pull business away from the firm. The largest U.S. pension fund, CalPERS, is "disturbed" about the allegations; and companies like AIG and the defunct Lehman are thinking about filing lawsuits.

Ironically, in Zuckerman's book, Bear Stearns thought that the reputation risk of a deal with Paulson was too great. And now it looks like Goldman is paying the price.