Goldman: Guilty Of Finance, Innocent On Fraud
With Morgan Stanley (NYSE: MS) and other banks now part of the plot to ruin America for homeowners, Goldman Sachs (NYSE: GS) looks likely to settle. Oh, and, surprise, surprise, not a peep has been heard about the role of Fannie and Freddie - although they need another $8 billion to cover losses no doubt completely unrelated to the shoddy mortgages they helped securitize. There is plenty of negative publicity aimed against bankers and Goldman in particular, so we're actually going to look at this issue from Goldman's side.
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Not a Charity
Apparently, they were in it for the money. The whole lot of them. Shocking, truly. A hedge fund and several investment banks out to make a buck. Whatever the point of the investigation is – and we can be forgiven for wondering because there are no regulatory guidelines for disclosures during the creation of synthetic CDOs – the points brought up in the public show trial were attacking the nature of derivatives transactions. (Learn more about the Goldman trial in The Goldman Sachs Accusation Explained.)
Selling CDOs to Orphans
Goldman makes money by helping investors bet on the market. It acted as a middleman between sophisticated investors – poor naïve souls who must, by definition, have millions of dollars, no doubt built up through years of patriotic investing in Treasury bonds – who agreed to the wager. Actually, this is not the issue. It couldn't be.
If Goldman was honor-bound to stopping investors from making poor bets a similar probe could be launched for every synthetic CDO transaction that year. The hearings spent more time focused on the nature of CDO transactions and their role in helping sophisticated investors make high-risk, high-return bets on assets – transactions that, by their nature, require one party to lose money. For the SEC, however, the investigation is about whether one of the participant's role in selecting the assets was properly disclosed.
High finance, particularly the high-risk, high-return bets worth billions of dollars that can only be made by multi-millionaires, is never going to get a lot of public sympathy. When the bet is made on mortgages just before the implosion of the market, it adds even more drama.
Watching the Goldman Sachs hearings and following the headlines since, you'd think Goldman actually bought these distressed mortgages and personally kicked families into the street when they fell behind. In truth, Goldman helped a client, John Paulson's hedge fund, bet on the performance of a pool of mortgages much like we would bet on a boxing match; there were no actual mortgages purchased or influenced by the bets, just as no matter how much you scream at the TV, you can't make a bad boxer win a fight.
Paulson had specific mortgages he wanted to bet against that he put forth. The counterparties in the bet had the right of last refusal; no gunpoint negotiations were held. The issue is whether Paulson's role in selecting mortgages should have been made explicitly clear.
Should the Regulatory Gap Be Closed?
As mentioned, and unfortunately for the SEC, there is no clear guidance on synthetic CDOs, so that case is shaky. At worst, Goldman let two counterparties enter a bet that one would lose, and the investment bank knew which one it was likely to be. However, if timing the mortgage bubble was that obvious, why did so many get caught?
The bigger issue is whether government regulation should reach into every corner of finance. Is allowing sophisticated investors to wager against each other such a bad thing? While the average person probably doesn't care if one billionaire loses a billion to another billionaire, there are two arguments for protecting this system. One function that these derivatives can play is to signal to higher-level market players that bearish sentiment is increasing. It allows smart investors to signal their beliefs to the market in a language it understands: short capital.
Although it was not a focus of the investigation, Paulson's bet might have played a part in encouraging Goldman's trading arm to begin trading against housing to hedge the risks of a housing meltdown. Whether Goldman would be morally required to hold a bad investment because it was tipped off through a transaction where it was playing a fiduciary role is a thorny enough issue that regulators took the easier route of accusing Goldman of "selling" bad goods. Losing gamblers everywhere should be eyeing up their bookies for an SEC investigation. (Learn more about the Goldman investigation, read Goldman Sachs: By The Numbers.)
A Hanging Jury
The second argument for leaving Goldman and others alone to write exotic bets for sophisticated investors is that these bets cost the taxpayer nothing. Many are confusing the financial damage surrounding the creation of mortgage-backed securities (MBSs), a huge fraud that everyone from the government to the homebuyer was in on, with helping investors bet on their performance. It's unfortunate that this main point has been so mangled by the media that the government is seen as the best hope. Regulations are going to add more bureaucracy and more costs that will be borne directly or indirectly by the taxpayer. If anyone can name an industry that has seen costs drop as a result of government regulation, please let the rest of us in on the secret.
The Bottom Line
Goldman is no angel. Many investors rightfully hold a grudge against the company for influencing analyst recommendations on IPOs during the internet boom. It is very likely that Goldman and the other banks will be found to have played a big role in the real mechanics of the mortgage meltdown, MBSs – though the same will be true of Congress, Wall Street and the general public. The CDO transaction they're trying to hang Goldman with is a separate issue. Many, myself included, wish that less capital was being leveraged in essentially non-productive derivative bets – but it is not my capital and this is still, hopefully, a free country. A skeptic can be forgiven for wondering if the Goldman case, both that of the SEC and Andrew Cuomo's inquiry, will only last as long as it's needed to stoke public anger and create support for the financial overhaul. The same skeptic might also be wondering if another expensive regulatory measure adding yet another layer of bureaucracy is the answer.
Catch up on the latest financial news in Water Cooler Finance: Crying Over Spilled Oil, And Buffett Goes To Court.