A Tale of Two Paulsons

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William Black

William K. Black was a federal regulator during the Savings and Loan crisis and appears in Michael Moore's 'Capitalism: A Love Story'

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April 21st, 2010 1:11 PM

By William Black

The Senate Banking Committee released the findings from its investigation of Washington Mutual – the largest S&L and largest bank failure. My research specialty is “control fraud.” These are frauds led by those that control seemingly legitimate entities and use them as a “weapon” to defraud. Financial control frauds’ “weapon of choice” is accounting. Lenders optimize accounting fraud by following a four-part recipe:

Extreme growth
Making bad loans at high interest rates
Extreme leverage
Trivial loss reserves

The Committee’s findings show that WaMu’s business operations followed this recipe. The result was what Akerlof & Romer described in their classic 1993 article – “Looting: Bankruptcy for Profit.” This is also why I titled my book: The Best Way To Rob A Bank Is to Own One.

Lehman led the parade with the recent release of the bankruptcy examiner’s report. The report shows that Lehman had scores of billions of dollars of losses on bad assets. The losses were so great that Lehman had failed. Lehman’s financial statements did not recognize the losses. In addition to this first-stage cover up of its losses, Lehman entered into huge quarter-end REPO transactions to further cover up its crippling losses. Both cover-ups could lead to criminal liability.

Now, we learn that the SEC charges that Goldman Sachs should be added to the list of elite financial frauds. It is a tale of two (unrelated) Paulsons. Hank Paulson, while Goldman’s CEO, had Goldman buy large amounts of collateralized debt obligations (CDOs) backed by largely fraudulent “liar’s loans.” He then became U.S. Treasury Secretary and launched a successful war against securities and banking regulation. His successors at Goldman realized the disaster and began to “short” CDOs. Mr. Blankfein, Goldman’s CEO, recently said Goldman was doing “God’s work.” If true, then we know that God wanted Goldman to blow up its customers.

Goldman designed a rigged trifecta: (1) it turned a massive loss into a material profit by selling deeply underwater, toxic CDOs it owned, (2) helped make John Paulson (CEO of a huge hedge fund that Goldman would love to have as an ally) a massive profit – in a “profession” where reciprocal favors are key, and (3) blew up its customers that purchased the CDOs. Paulson and Goldman were shorting because they believed that the liar’s loans were greatly overrated by the rating agencies. Goldman let John Paulson design a CDO in which he was able to pick the nonprime packages that were most badly overrated (and, therefore, overpriced). Paulson created a CDO “most likely to fail.” Goldman constructed, at John Paulson’s request, a “synthetic” CDO that had a credit default component (CDS). The CDS allowed John Paulson to bet that the CDO he had constructed (with Goldman) to be “most likely to fail” would in fact fail – in which case John Paulson would be become even wealthier because of the profit he would make on the CDS.

Now, any purchaser of the “most likely to fail” CDO would obviously consider it “material information” that the investment was structured for the sole purpose of increasing the risk of failure (and getting rid of Hank Paulson’s worst investments). The SEC complaint says that Goldman therefore defrauded its own customers by representing to them that the CDO was “selected by ACA Management.” ACA was supposed to be an independent group of experts that would “select” nonprime loans “most likely to succeed” rather than “most likely to fail.” The SEC complaint alleges that the representations about ACA were false.

The obvious question is: did John Paulson and ACA know that Goldman was making these false disclosures to the CDO purchasers? Did they “aid and abet” what the SEC alleges was Goldman’s fraud? Why have there been no criminal charges? Why did the SEC only name a relatively low-level Goldman officer in its complaint? Where are the prosecutors?

And there is the key question that we (Eliot Spitzer, Frank Partnoy and I) asked in our December 19, 2009 op ed in the New York Times – why haven’t the AIG emails and key deal documents been made public so that we can investigate the elite control frauds? Goldman used AIG to provide the CDS on these synthetic CDO deals and Hank Paulson used our money to bail out Goldman when AIG’s scams drove it to failure.

The full prepared statement of Mr. Richard Bowen, Former Senior Vice President and Business Chief Underwriter of CitiMortgage Inc. before the Financial Crisis Inquiry Commission on April 7, 2010 can be found here. Readers interested in reading the Senate Banking Committee report and the underlying documents can find them through this link.

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