For those who have spent years investigating fraud, it was no surprise to hear that Goldman Sachs, the (self-described) jewel of Wall Street, is the latest firm to emerge from the financial crisis with tarnished reputation. According to a lawsuit brought by the Securities and Exchange Commission, Goldman misrepresented to its customers the quality of the toxic assets underlying a complex financial derivative known as a "synthetic collateralized debt obligation (CDO)."
As you may now have heard, the story involves a pair of Paulsons. As CEO of Goldman, Hank Paulson oversaw the buying of large amounts of CDOs backed by largely fraudulent "liar's loans." When he became U.S. Treasury Secretary, he went on to launch a successful war against securities and banking regulation. Hank Paulson's successors at Goldman saw the writing on the wall and began to "short" CDOs. They realized that they had an unusual, brief window of opportunity to unload their losers on their customers. Being the very model of a modern investment banking firm, they thought that blowing up their customers would be fine sport.
John Paulson (unrelated), who controls a large hedge fund, also wanted to short CDOs and he, too, recognized that there was a narrow window for doing so. The reason there was a profit opportunity was that the "market" for toxic mortgages only appeared to be a functioning market. It was, in reality, a massive bubble in which ratings and "market" prices were grotesquely inflated. The inflated prices were continuing only because the huge players knew that the prices and races were fictional and were covering it up through the financial equivalent of "don't ask; don't tell." According to the SEC complaint:
In January 2007, a Paulson employee explained the company's view, saying that "rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while 'real money' investors have neither the analytical tools nor the institutional framework to take action."
The challenge for the Government, and for troubled firms like Lehman, was to reduce risk exposure, and the act of reducing risk by selling assets could result in "collateral damage" by demonstrating weakness and exposing "air" in the marks.
Goldman created a deal in which John Paulson played a major role in selecting the toxic paper that would underlie the investment. He picked assets "most likely to fail - quickly" and studies show that he was particularly good at picking the losers. At this juncture, there is some dispute as to whether ACA was complicit with John Paulson and Goldman in picking losers (ACA initially invested in the synthetic CDO, but then transferred the risk of loss to German and English taxpayers).
What isn't in dispute is that Goldman, ACA, and Paulson all failed to disclose to purchasers of the synthetic CDO that it was designed to be most likely to fail. The representation was the opposite: that the assets were picked by an independent entity with their interests at heart (ACA). Goldman claims it's a victim because while it intended to sell its entire position in the synthetic CDO to its customers, it was unable to sell a chunk. One feels the firm's pain. Goldman tried to blow up its customers to the tune of over $1 billion, but were unable to sell them the last $90 million in exposure.
The Goldman scandal raises several important questions: Did John Paulson and ACA know that Goldman was making these false disclosures to the CDO purchasers? Did they "aid and abet" what the SEC alleges was Goldman's fraud? Why have there been no criminal charges? Why did the SEC only name a relatively low-level Goldman officer in its complaint? Where are the prosecutors?
In a December New York Times op-ed, we, along with Frank Partnoy, asked for the public disclosure of AIG emails and key documents so that we can investigate the deceptive practices exposed by the Goldman case. Goldman used AIG to provide the CDS on most of these synthetic CDO deals (though not the particular one that is the subject of the SEC complaint), and Hank Paulson used tax payer money to secretly bail out Goldman when AIG's deceptive practices drove it to failure.
The SEC's Goldman fraud complaint points to fundamental problem in the financial sector that has been at the root of the financial crisis -- one that still exists today. The market is not transparent. It has been fraudulently manipulated to enrich managers. Investors lack clear information to make decisions about what they are buying. A continuing absence of real consumer protections makes people like those trying to obtain mortgages before the crash understand that they were, in many cases, being ripped off. According to internal Goldman Sachs e-mails, the company vice president, 31-year old Fabrice Tourre, did not really understand the complex deals he was making. And yet we note that many of these Goldman-style deals were "insured" by AIG. Without transparency, regulators cannot properly see all these kinds of deals in the aggregate. So they can neither stop the fraud nor prevent catastrophic results.
We applaud the SEC lawsuit, but it will not solve the problem. Unless our financial system is reformed to put adequate protections and checks and balances in place, we can expect this kind of fraud to continue. Financial executives will continue to take risks they do not understand. Those who control the flow of capital will continue to churn out profits with socially disastrous consequences.
Cross-posted from the Roosevelt Institute's New Deal 2.0 blog.
Tom Matlack: Did We Learn Anything?
In all this pain and suffering, stupidity and tragedy, war and natural disaster, hope and despair...in the final analysis, have we really learned anything?
intention of enforcing law. Wonder if the denizens
of D.C. know how absolutely lame "... so this will
never happen again", sounds to the heartlanders?
Are we aware of the example these "wall streeters"
and "K streeters" provide for our children?
What is our response to them when THEY say,
"Everybody's doing it"? I guess we come up with
euphemism like "Group think", "Black Swans", and
"too aggressive in rating the upside". Where's all the
Politically Correct" objectors on wall street speak?
Hog raising is the best primer for progressive
democracies,.. any other kind fails.
Basically, the way to prevent future problems is to compare U.S. laws and regulatory actions with Canada's, and whenever there's a difference, change to the Canadian way of doing things.
country with an investment gap. And that gap needs to be filled by men with money. Who’s gonna do it? You? You, Middle Class Consumer?
Goldman Sachs has a greater responsibility than you can possibly fathom.
You weep for Lehman and you curse derivatives. You have that luxury.
You have the luxury of not knowing what we know: that Lehman’s death, while tragic, probably saved the financial system. And that Goldman’s existence, while grotesque and incomprehensible to you, saves pension
funds.
You don’t want the truth. Because deep down, in places you don’t talk about at parties, you want us to fill that investment gap. You need us to fill that gap.
We use words like credit default swaps, collateralized debt obligation, and securitization… We use these words as the backbone of a life spent investing in something. You use ‘em as a punchline. We have neither the time nor the inclination to explain ourselves to a commoner who rises and sleeps under the blanket of the very credit we provide, and then questions the manner in which we provide it!
We’d rather you just said thank you and paid your taxes on time.
Otherwise, we suggest you get an account and start trading. Either way, we don’t give a damn what you think you’re entitled to!
Two of my favorite people in the same blog post. This makes me happy.
I reserve the most vile invective for the mendacious "theorists" of free and perfect markets...
Milton, Beck, Stigler, Gilder, Fama and other assorted "scientists" ( many of who won the economics Nobel prize) who cooed about the beauty of market equilibrium with security prices that embody ALL known information about companies and the macroeconomic environment while the conment took short positions - this was an academically-enforced noxious smokescreen, a compulsory narcotic to cover up the gigantic swindle.
The JUSTICE DEPARTMENT and CONGRESS have the future of America's economy in their hands. They MUST take their responsibility seriously and act swiftly and undauntingly in their efforts to investigate, prosecute and enact new legislation.
-----------------------------------------------------------------------------------------------
Interesting remark. At this point you couldn't exclude insider information, would you. From whom did they buy these losers? Did the sellers want to get rid of them, offering specific information and favourable pricint to Paulson, some kind of collusion between all of them?
It would be nice it that could be proven.