The $2-billion Abacus 2007-AC1 fund set up by Goldman, Sachs & Co. epitomizes what Main Street hates about Wall Street: It's the financial industry's version of a high-stakes poker table, where supposed sharpies bet on the success or failure of other people's investments. And the lawsuit filed by the Securities and Exchange Commission last week only reinforced the suspicion that the tables are rigged, luring even sophisticated investors into sucker bets. In reality, "synthetic" securities such as those associated with the Abacus fund can reduce the cost of the loans that lubricate our economy — if they're sold honestly. That's where the SEC's lawsuit comes in and, in a less direct fashion, the broad financial overhaul bills being considered by Congress.
At issue is the way Goldman marketed a complex product that let investors take indirect stakes in 90 mortgage-backed securities sold by other Wall Street firms by insuring the securities against defaults. The ostensible purpose of such financial engineering is to make loans more affordable and available by enabling lenders to offload risks onto investors with an appetite for higher returns. The system breaks down, however, when investors can't tell exactly what they're buying, or they can't trust the seller. The SEC accused Goldman of secretly letting one of its customers — the Paulson & Co. hedge fund, which was betting that the housing market would collapse — help pick the mortgage-backed securities that Abacus would insure. As a result, the lawsuit alleges, Abacus investors were stuck backing a portfolio that collapsed quickly and extravagantly, enriching Paulson at their expense.
If the SEC is correct — Goldman and Paulson have denied any wrongdoing — the Abacus debacle could cost Goldman in reputation far more than the company gained from its bets against the housing bubble. But the case also underlines the need for Congress to plug dangerous gaps in the regulatory system. Derivatives trades and complex securities need to be more fully disclosed and transparent. The companies that rate securities should be given stronger incentives for independent and accurate analyses. The lenders that bundle loans for Wall Street to sell should have to keep a stake in the loans' performance, rather than allowing lenders to offload every penny of risk onto investors. And most important, banks shouldn't be allowed to originate loans that the borrower has no chance of repaying. Those reforms are included in the financial overhaul bills moving through Congress, and they should not be lost in the dispute over other, more controversial provisions of the legislation.