On July 15, it was announced that Goldman had reached a settlement of the SEC's charges regarding material misrepresentations in an Abacus CDO deal, acknowledging that its materials were "incomplete". See Chan & Story, Goldman Pays $550 Million to Settle Fraud Case, NY Times (July 15, 2010).
Goldman sold the deal to buyers without informing them of the involvement of the counterparty to the deal. The counterparty was Paulson, a hedge fund manager, who had personally selected "most likely to fail" mortgages on offer and gotten Goldman to create a CDO package with those deals in it so that he could bet against the deal. The bet against the deal was a naked credit default swap. The person who bought the other side of Paulson was essentially buying a deck intentionally stacked against him, rather than a more diversified cross-section of subprime mortgages. Not surprisingly, that particular Abacus deal was particularly bad and went south within months of its creation and sale.
Now, in my view naked credit default swaps should be illegal. They are nothing but an insurance contract when the protected insurance buyer has no insurable interest in the reference property. As many have observed, such a situation presents a dangerous moral hazard-- it is like letting an arson take out an insurance contract on the most expensive house in the neighborhood and then reap the benefit of the payout after he burns the house down. Nonetheless, the financial lobby is extraordinarily powerful, and Congress did not yet bite the bullet to ban naked credit default swaps in the financial reform package. (I say "yet" because I am convinced that we must dampen the use of such derivatives or stand by to witness destruction of both financial system and economy through continuing crises fueled by rampant speculation.)
But even if naked credit default swaps aren't illegal (which is the current situation), that doesn't mean that a bank should be able to cater to one client to create a financial product stacked with the worst of the worst subprime mortgages and neglect to tell another client about that critical fact. The SEC might have had difficult proving fraud: Goldman is no dumbie, and it is adept at selecting facts to cast itself in the best life and working to obscure facts that do not. Anyone hearing Paulson's side of the story (read Michael Lewis, The Big Short) would want to know about his involvement in a deal, especially when those products were nonetheless rated AAA. (Yeah, rating agencies were in on the game too, but the banks were tailoring their synthetic CDOs to match the known rating agency procedures, sort of like stacking up a room full of people paid the average income and needing to boost it to make it look like incomes are higher, so adding a multimillionaire with just the right income to the mix to bring the average up to the desired goalpost and no more. Crapola.) And I for one suspect that the SEC could have rather easily proven material misrepresentation.
Goldman took a battering from having the suit out there and clearly wanted to settle. But Big Banks want to settle on terms that don't produce real pain. So Goldman got a deal with essentially a $550 million price tag, which, as the weekend Wall St. Journal editorial notes, is "a mere two weeks worth of recent trading profits." Goldman's Bailout Fee, Wall St. Journal, July 17-18, 2010, at A12. Too little, methinks, even with the concession not to seek a tax deduction for any part of the fine which might otherwise have been deductible. See Donmoyer, Goldman Sachs Waives Tax Deduction on SEC Settlement, Bloomberg.com (July 16, 2010). In my view, anything under 10% of Goldman's profits last year, plus no tax deduction, is de minimis. Anything smaller than that will be viewed by the financial industry as no more than a slap on the wrist. To be instructive and to spur more prudential banking from Big Banks, the penalty needs to be severe enough to be taken very seriously.