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Lindley Estes is a business writer for The Free Lance-Star and Fredericksburg.com. This blog is on Fredericksburg-area business. Send an e-mail to Lindley Estes.

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This week’s (4/25) investing column

THE U.S. Securities and Exchange Commission seems to have used hindsight bias in choosing its case against Goldman Sachs.

A week ago the SEC filed a $1 billion civil lawsuit against the Wall Street titan accusing it of securities fraud.

At the risk of a gross oversimplification, Goldman is accused of working with hedge fund manager John Paulson in 2007 to create an investment vehicle composed of residential mortgages. Paulson believed the U.S. housing market was about to implode, and the so-called Abacus investment allowed him to bet against the market.

On the other side of the trade were foreign banks, pension funds and insurance companies that bet on the continued success of the housing market.

Goldman is accused of failing to notify these institutions that the Abacus investment was created to fail–which it did, costing the investors more than $1 billion and making a fortune for Paulson.

Goldman has been taking a beating in the court of public opinion for some time, whether deserved or not. That’s due to a host of reasons: the fact that many of the government officials who designed the bank bailout were Goldman alum, that its bonus payments are so high and simply because it is one of the only Wall Street banks to emerge relatively unscathed.

Some of Goldman’s practices have been at the heart of the political debates on financial reform.

But up until two Fridays ago, Goldman hadn’t been charged with any specific offenses. So why did the SEC choose to center its case on the investment involving John Paulson?

It seems due in part to Paulson’s name recognition. Forbes magazine recently named him as the 45th-richest person in the world, with a net worth of $12 billion. He was the subject of Gregory Zuckerman’s book “The Greatest Trade Ever,” which shows how he made billions betting against the U.S. housing market. More recently he’s made a killing betting on a rebound in bank stocks such as Citigroup.

By bringing a case involving Paulson (who isn’t charged), the SEC might have an easier time presenting its version–that Goldman conspired with a high-powered investor and then turned around and sold the investment to a bunch of clueless saps without telling them about the mastermind who created Abacus.

Here’s the problem. When John Paulson helped create Abacus, he wasn’t yet John Paulson. In other words, as Zuckerman’s book makes clear, he was a nobody hedge fund manager.

Perhaps that doesn’t change the case. Whether it was John Paulson or John Q. Public on the one side of the trade, the SEC can allege that Goldman should have been more forthcoming to the banks to which it sold the investment (even though Goldman itself reportedly lost $90 million on the trade, and the banks it sold to were quite sophisticated).

But having the Paulson name adds to the case’s emotional appeal. One can picture an SEC lawyer telling a jury about how Goldman conspired with the mighty Paulson to dupe a bunch of hapless foreigners. The lawyer would almost certainly not mention that Paulson was an unknown at the time.

The aforementioned attorney, using backward-facing 20-20 vision, would likely talk about how everyone knew housing was about to implode, when in reality Paulson was in a small minority who saw what was coming.

Jurors put in that situation would do well to think about hindsight bias.

Permalink: http://news.fredericksburg.com/businessbrowser/2010/04/25/this-weeks-425-investing-column/