John Paulson: Goldman Scandal's Real Ringmaster?

As Tuesday's hearings in Washington regarding Goldman Sachs droned on, it remained unclear who was at the bottom of the Wall Street firm's supposed skulduggery. On April 16, the SEC brought a lawsuit against Goldman Sachs alleging securities fraud for what amounted to the firm betting against the very securities it was selling to its investors, egregiously misleading them along the way.

The suit is formally against Goldman -- with its young banker Fabrice "Fabulous Fab" Tourre front and center. But it was John Paulson (pictured at left), the very smart manager and namesake of hedge fund Paulson & Co., who created the concept of the sophisticated, complex and ethically challenged "synthetic" securities that were unavailable to ordinary investors and are about to dictate historic financial reform on Wall Street and beyond.

The controversial security Paulson shaped for Goldman was called the Abacus Fund, and it was a rather elegant piece of financial engineering. The Abacus Fund--famously described in an email written by Goldman's Tourre as "all these complex, highly leveraged, exotic trades"--effectively bundled up the riskiest sub-prime mortgage loans because they offered an attractively high yield to investors. Then Paulson bet that the same securities would fail--making billions of dollars at the expense of their investors and the U.S. housing market. Ironically, Paulson, a Queens-born Harvard Business School grad, built his hedge fund over the past 15 years by investing conservatively for pension plans, banks and on other hedge funds. In the late 1990s, for example, he bet against the over-inflated tech stocks then in favor and made plenty for his clients.

To be fair, Paulson, left, was far from the only one playing this game. The Abacus Fund was designed from the blueprint of another hedge fund called Magnetar Capital. In a nutshell, Magnetar created crappy securities (like Abacus), sold them to investors, then took out insurance policies called credit default swaps that paid out many times the value of any losses incurred...effectively betting, hoping, priming the security to fail--and made a lot of amount of money when they did. Merrill Lynch, JP Morgan, Lehman Bros--everyone was doing it.

Paulson and Goldman exploited huge loopholes in the system for immense amounts of money. Both will maintain they lost money investing in securities and the housing market, but they made helluva lot more when they bet against it. In 2007, Paulson & Co. made over $15 billion by short-selling the U.S. housing market, effectively betting on its collapse, even perpetuating the magnitude of the collapse.

This is likely where the focus intensifies and public outcries for a scapegoat culminate--Wall Street, Goldman, Paulson etc. incessantly inflating the housing bubble to the severe detriment of the economy, homeowners and consumers in general. They will put faces on this mess...faces of people being foreclosed on and faces on the enablers, like Tourre and potentially Paulson. But in Paulson's case, the anger may be wholly appropriate.

So, did greed get the better of a man with a longtime conservative and successful track record? Or was he just being smart while ignoring any resemblance of ethics? Paulson's traditional investment methodologies included buying shares at a discount in companies that he knew were about to be acquired, profiting when the acquisition was complete and the shares value were fully recognized. He put in time at Bear Stearns and as a partner in a firm that specialized in mergers and acquisitions before venturing out on his own on 1994. The difference this time around was that Paulson helped devise the very securities he eventually profited from, the same ones that hasten the economic collapse.

As these hearings continue and it gets easier for the general public to wrap their heads around this picture of Paulson & Co. (and others) creating securities with designed-to-fail mortgages for unwitting consumers, those who partook are going to be painted as pariahs, whether they acted legally, unethically or otherwise.

In regard to the lawsuit, proving intent will have a lot to do with how this train moves down the tracks. If intent to deceive investors can be proven--highly doubtful, yet entirely possible if "fab Fab" Tourre, left, continues to run his mouth--then Goldman is in big trouble.

Internal emails don't play to Goldman's favor, with underlings calling these securities "s***ty" while continuing to sell them to investors. Despite some damning evidence, Goldman's defense seems to lie in simply stating they weren't to blame and acted in accordance with a longstanding policy of not being required to tell investors that they (or Paulson) were betting the other side of the securities they were selling, maintaining the investors knew what they were buying. But did they?

According to the complaint filed by the SEC:

In January 2007, a Paulson employee explained the company's view, saying that "rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while 'real money' investors have neither the analytical tools nor the institutional framework to take action." (h/t Huffington Post)

If Goldman gets nailed for fraud, one would have to assume that Paulson subsequently gets dragged through the muck, too. Second to that, his reputation will be highly questioned in front of the press and the world. And that's just not good for business, I don't care how smart you are.

To this point, Paulson is being very proactive as this news hits the street, sending out letters and having conference calls with his company's investors. Saying "trust me" or something to that effect.

He claims to be confident that public sentiment will diminish.

Maybe, maybe not. Regardless, Paulson probably won't be able to engage in such "exotic" trading practices anymore, as Washington shackles Wall Street with new restrictions on proprietary and derivative trading.
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