The Goldman Sachs Affair

The story continues to unfold as to the role Goldman Sachs played in the huge financial mess that we recently experienced.  There are, of course, numerous parties who share culpability. 

Consumers bought houses they could not afford.  Mortgage lenders made unsound subprime loans to anyone who could fog a mirror.  Wall Street bundled these loans and sold them as fast as they could for huge fees.  Ratings agencies blessed these loans as being safer than they really were.  The federal government promoted home ownership at any cost via Fannie Mae and Freddie Mac.  The Federal Reserve kept money cheap and easy with low interest rates.  All were complicit.  

The current uproar over the actions of Goldman Sachs can be seen as turning on whether the company was dealing with clients or customers.  If Goldman was advising clients, then arguably it had a fiduciary duty to tell its clients what it thought about the particular investment that the client was making.  If Goldman was dealing with mere customers, then the company states that it only had a duty to accurately describe the product being sold, not whether it thought the product was worthy or unfit.

The Senate grilled Goldman last week, accusing the firm of peddling subprime loans that it thought to be garbage.  The Senate also claimed that Goldman was taking positions that the "garbage" it was selling would decline in value.  Goldman defended itself by claiming that it was just acting as a "market maker;" that is, bringing together willing buyers and sellers who had differing views as to the value of residential mortgages.  Goldman argued that it just facilitated these investors' desire to take certain risky positions.  Both sides have their points, although the Senate's grandstanding and Goldman's stonewalling obfuscated the situation.

The SEC recently brought a lawsuit against Goldman.  Charges of perfidy by the British and Europeans soon followed. While Goldman's actions may be distasteful, they are not necessarily illegal.

The SEC's suit against Goldman involves derivatives.  A derivative is just a fancy way of saying a contract between two parties that has a value determined by the future price of something else.  (See Wikipedia and the Washington Post for great explanations of derivatives.)  Let's say Southwest Airlines desires to protect (hedge) against rising fuel prices.  It contracts to purchase fuel 12 months from now at an agreed upon price.  If fuel prices rise over the year, then Southwest made a successful bargain since it can purchase fuel at the lower contract rate.  Conversely, the entity that made the deal with Southwest loses, since it must now sell Southwest fuel at a price lower than the market price.  A derivative sets forth the terms of this agreement.

As you can see, any such deal requires two sides to the bet.  In the case at hand, Goldman was paid a lot of money to put a deal together between a hedge fund run by John Paulson and a group of large investors, such as Germany's IKB bank.  Goldman created derivatives based upon a large pool of residential mortgages.  Paulson bet the value of the mortgages would decline; the investor group led by ACA, a boutique specializing in mortgage securities, believed the underlying mortgages to be of a higher value.

The claim by the SEC is that Goldman allowed Paulson to place "bad" mortgages into the derivative pool, increasing the likelihood that the pool would decline in value, as Paulson hoped.  The alleged wrongdoing is that Goldman failed to disclose to investors on the other side that the pool was being stacked with crummy assets.  Goldman is said to have breached its fiduciary duty to the investors.

In a fascinating article in the Washington Post, Sebastian Mallaby argues that the case against Goldman is flimsy.  "An investor [Paulson] who wants to bet against mortgages is entitled to suggest what should go into the bundle.  The buyer [ACA] is equally entitled to make counter-suggestions."  This is the nature of such transactions.

Subsequent reports indicate that Paulson and ACA engaged in detailed negotiations about which mortgages would go into the pool.  ACA rejected many of the mortgages that Paulson suggested.  It has also been reported that some of the mortgages that ACA requested to go into the pool actually were bad loans that lowered the quality of the deal, to ACA and its fellow investors' detriment.

The SEC complaint further alleges that Goldman tricked ACA into believing that Paulson was not betting against the mortgages, but thought they were sound.  Mallaby asserts that Goldman could be culpable if this were true, but he is incredulous that this happened.  There were numerous meetings between all the parties and ACA could have asked Paulson of his intentions.  "Throughout negotiations, Paulson kept proposing low-quality mortgages for the bundle and vetoing high-quality ones.  It should have been obvious to ACA that he meant to bet that they would go down." 

Meanwhile, it is worth noting that as part of the response to the financial meltdown, Goldman became a federally regulated bank.  Goldman now has access, via the Federal Reserve, to money at very favorable terms to fund its business.  The New Yorker suggests that, with respect to the big banks, "What we've had, in effect, is a government-guaranteed and tax-payer subsidized casino industry piggybacked back onto the legitimate banking sector."

We have much to be upset about with respect to our large financial institutions.  Unfortunately, the government may have picked the wrong fight with Goldman.

A real world postscript:  The Wall Street Journal looked at some of the underlying mortgages that faltered in this ill-fated investment pool.  One defaulting borrower with a pre-tax income of $9,000 per month struggled to make $5,000 monthly payments on a $688,000 mortgage with an initial interest rate of 9.05%.  Nonetheless, she was allowed to take out an even bigger loan for $786,250 at an initial rate of 7.55% that would float to as high as 13.55% in two years.

Words of Wisdom

Behind every great fortune lies a great crime.
-- Balzac (French novelist and playwright)