The Giant Vampire Squid and Leviathan

Goldman Sachs, colloquially known as the Giant Vampire Squid, may meet the fate that our sages of antiquity predicted for the sea-monster Leviathan:

Raba said in the name of R. Yochanan: The Holy One will make a feast for the righteous out of the flesh of Leviathan, and what is left will be portioned out and made available as merchandise in the marketplaces of Jerusalem. (Bava Batra 75a)

Fried calamari isn’t kosher, to be sure, but neither is the Giant Vampire Squid, according to the SEC. As I just blogged over at Asia Times:

This is on the scale of the Enron case. Except that it could affect every firm involved in subprime securitization.

I haven’t read anything in years as racy as the SEC’s complaint against Goldman Sachs for collusion with the Paulson hedge fund to cheat subprime investors out of $1 billion. A billion-dollar fraud is not a small matter. I’m no lawyer, but the granularity of detail and documentation that the SEC has assembled appears extremely impressive. They have nailed a 32-year-old Goldman vice president who cobbled together the tainted structure, and he appears to be singing. Investment banks aren’t like the mafia. No-one takes twenty-year sentences and keeps their mouth shut. This case very well might open up others.

The issue, as the press has reported, is the selection of collateral in a Goldman Sachs synthetic CDO deal. As the SEC reports:

In late 2006 and early 2007, Paulson performed an analysis of recent-vintage Triple B RMBS and identified over 100 bonds it expected to experience credit events in the near future. Paulson’s selection criteria favored RMBS that included a high percentage of adjustable rate mortgages, relatively low borrower FICO scores, and a high concentration of mortgages in states like Arizona, California, Florida and Nevada that had recently experienced high rates of home price appreciation.  Paulson informed GS&Co that it wanted the reference portfolio for the contemplated transaction to include the RMBS it identified or bonds with similar characteristics.

GS then allegedly packaged Paulson’s picked time bombs into a CDO that it sold to investors while selling protection on the portfolio to Paulson. He pocketed $1 billion, and the investors lost $1 billion.

This opens Pandora’s Box. Investors who lost a trillion dollars in subprime CDO’s now will descend like Harpies upon the banks that packaged them, with subpoenas for every email and internal memorandum involved. The civil suits that could arise from this are potentially innumerable.