The Goldman Sachs Swaps Shop: An Examination of Synthetic Short Selling Through Credit Default Swaps and the Implications of SEC v. Goldman Sachs & Co., et al.
Chapter Two, The Short Selling Handbook, Elsevier Publishing (2011).
3 Pages Posted: 7 Aug 2010 Last revised: 4 Jun 2011
Date Written: August 4, 2010
Credit Default Swaps (CDS) are often characterized as insurance, primarily because a buyer typically pays a premium and, in return, receives a sum of money if a negotiated event specified by contract occurs. However, unlike a genuine insurance policy, a “naked” CDS buyer can profit from events which adversely affect an asset to which the CDS buyer has no interest.
Goldman Sachs facilitated a number of controversial and complex structured finance transactions involving domestic residential mortgage instruments, many of which were of subprime credit quality at the zenith of the U.S. real estate “bubble” from 2004-2007. In at least one of these residential-mortgage-backed security (RMBS) deals, Goldman facilitated the short sale of CDS contract referencing a synthetic CDO. Goldman’s client, Paulson & Co., developed a short selling strategy against the “American Dream” in time to profit from the collapse of the domestic residential real estate market.
This article examines the prospect of civil and criminal liability for an investment bank that structured a Collateralized Debt Obligation (CDO) which referenced RMBS instruments at the behest of a client who sought to short the same instruments synthetically. The prospect of regulatory reform is also considered relative to its expected impact on a bank’s ability to maintain proprietary trading in over-the-counter (OTC) derivatives such as those used in the ABACUS 2007-AC1 CDO and related CDS transactions which prompted the filing of civil enforcement litigation by the Securities and Exchange Commission and a parallel criminal probe by the U.S. Department of Justice.
Keywords: Goldman Sachs, Credit Default Swaps, CDS, Collateralized Debt Obligations, CDO, SEC, DOJ, 10b-5, Paulson & Co., Synthetic Short Selling, TARP, Commodities Futures Modernization Act, Dodd-Frank
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