Fantasy football on trial

The trial of the year for finance nerds isn't Zimmerman, it's the SEC vs. Fabrice Tourre, the young ex-Goldman Sachs rising star who had the misfortune to have used metaphors in emails to his girlfriend that were as vivid and comprehensible as the subject matter of his financial work was dull and impenetrable.

Before the Great Crash, Goldman not only traded in mortgage-backed securities but in investment vehicles called "synthetic" securities.  The securities were called "collateralized debt obligations" or CDOs, an unhelpful name that actually refers to nothing more complicated than a grab-bag of jillions of ordinary mortgages.  Packaging mortgages together like this is called "securitization," and it has the advantage of converting a pile of unique, individual, hard-to-trade mortgages into something homogeneous that can be split into standardized pieces that are more easily priced and sold.  As this helpful site explains, it's like turning irregular piles of meat and mystery bits into standardized link sausages.

So what's a "synthetic" CDO?  It bears the same relationship to an actual CDO that fantasy football bears to actual football players.  It's a bet on the performance of a list of real CDOs.   The gamblers don't buy the CDOs themselves; they simply bet on whether the whole list will increase or decrease in value.  Like every bet, it requires matching up two willing participants:  one to bet on one result, and one to bet on the opposite.

Tourre's alleged crime (actual a civil violation, which exposes him to fines and sanctions but not jail time) was to ask a hedge-fund trader to participate in the selection of the mortgage securities on which the synthetic-CDO participants would place their bets, and then fail to disclose the trader's role in the prospectus given to potential bettors.  To make matters worse, the trader then placed his own bet on the synthetic CDO--gambling that they would decrease in value--and won big time.  (Goldman itself bet on an increase in value and lost.)

It's never a good idea to fail to disclose the role of anyone involved in a deal, but I'm having real difficulty with the harm-causation theory here.  I think the idea is that the trader was particularly good at spotting which mortgages were most likely to fail, which gave him an unfair advantage; other bettors might have been unwilling to place their own bets--or might have insisted on betting the opposite way--if they had known of his involvement and his bearish stance.  On the other hand, to use the fantasy-football analogy, this was like asking a skillful scout or industry analyst to choose fantasy league players, and then allowing him to bet that the team would end up in the cellar.  Is that unfair to other bettors?  Should the other bettors be told who chose the players to include in the league, and that he intended to bet that those players would blow their season?  It's not as though he has any power to affect their games.  It's only a question of whether he's better than most at guessing how they'll play.  Perhaps to be more precise, it's a worry that he has inside knowledge of which players have been hiding an incipient knee injury or drug problem.

If you're having trouble following this scenario, you're not alone.  Apparently the judge, jury, lawyers, and witnesses are confused, too.  The SEC started out with a reasonably helpful analogy to a ship that takes on water and then sinks.  The equity investors are in the bilges.  Mezzanine investors are in steerage.  First-class passengers have the nice cabins with portholes.  When the water pours in, equity is submerged first, but if things get bad enough they are soon joined in their misery by mezzanine investors and even the masters of the universe sunning in their deck chairs.  Eventually the whole ship plunges to Davy Jones's Locker.  But then the judge, trying to be helpful, butted in with the opposite aquatic metaphor, a "waterfall."  In complex financial deals, the "waterfall" or "cascade" refers to the detailed directions for the application of income streams.  Favored investors get the first dollars, followed by junior debt, and equity gets whatever is left over.  This, of course, is the exact reverse of the doomed-ship scenario.  In the midst of this confusion, the judge reportedly asked why the prosecution's first witness had to go over the 90 minutes originally slated for his testimony, especially in view of the pole-axed expressions of the jurors.

I'm no litigation ace--much more of a back-office toiler--but even I know it's a bad idea to bore the beans out of the trier of fact.  One way or another, the prosecution and the defense had better find a way to connect all this law and evidence to something the jurors can evaluate in their guts.  The prosecution starts with an advantage, of course:  they can just keep repeating "rich people bad."  I'm guessing that the defense's best hope is for the presence of some sophisticated gamblers in the jury box.

H/t Rhymes with Cars & Girls