Paulson’s “greatest trade” may lose its luster

Apr 16, 2010 14:06 EDT/Reuters

goldman sachs | john paulson

John Paulson “greatest trade ever” may be losing some of its luster. His hedge fund made some $15 billion betting against the U.S. subprime mortgage market. But one extremely profitable deal has led to a Securities and Exchange Commission fraud suit against Goldman Sachs. Paulson & Co isn’t charged, but the SEC’s portrayal isn’t favorable to the firm and could have wider repercussions.

Washington’s main securities regulator alleges that Goldman sold collateralized debt obligation securities in a deal where it failed to disclose to investors that Paulson had been influential in selecting the underlying residential mortgage bonds. The lawsuit also says buyers weren’t told Paulson was betting against them with credit default swaps — ultimately making the firm $1 billion. Goldman said the charges are “unfounded in law and fact.” Paulson didn’t immediately have any comment.

Investors like Paulson struggled in thin markets to find ways to capitalize on their mortgage hunches. The SEC alleges that Paulson worked with Goldman to create the CDO almost solely to help the fund place its bets. Bankers wanted to help their big hedge fund clients. And Wall Street figured it could produce fresh CDO paper investors wanted to buy. With a third party involved managing the CDOs, there was a patina of appropriate independence. So far, so seemingly legitimate.

It matters, however, if such deals were conceived and influenced by hedge funds that were also betting against them. Illegal or not, bankers and funds both look disingenuous with hindsight for not being upfront about the positions.

As it stands, Paulson’s success story just looks a little more dog-eared than it once did — and that is unlikely on its own to scare investors away. Of course, if the firm gets charged too, that would turn up the heat. More broadly for the industry, it’s hard to believe the SEC’s effort won’t stretch further afield.

If nothing else, the agency’s narrative will surely add to calls for greater transparency and tighter restrictions on hedge funds’ trading. That’s good news for continental Europeans seeking tougher regulation in the face of UK and U.S. opposition. This could be part of the price paid by smart hedge fund traders and bankers for being too clever.