07/07/2010 05:12 am ET Updated May 25, 2011

Goldman: Not So Smart, But Well-Connected

The firestorm coming down on Goldman Sachs is puzzling. The firm is getting what it deserves, but for the wrong reasons. Goldman Sachs is being vilified for being smarter than everyone else. In fact, they deserve what they are getting, not because they were so smart, but because they were not so smart. But unlike most everyone else, Goldman was rescued by the government for their profound miscalculations, and that is the scandal that should upset people. Let me explain.

The SEC's case against Goldman and last week's Senate beat-down are based on the charges that Goldman failed to disclose to its clients that the derivatives their clients were buying were designed to fail. More broadly, it is alleged that Goldman had essentially concluded that the mortgage derivative market was crashing and kept that knowledge to itself. The SEC and a parade of bloviating Senators rightly pilloried Goldman for ignoring its duties to its clients. Wall Street's general defense of Goldman has been that Goldman was selling these garbage derivatives to other big boys - really big boys - who should have known better, but weren't as smart as Goldman. Goldman, the theory goes, shouldn't be punished for being smart.

Along these lines, Warren Buffett, who I usually agree with, has come to Goldman's defense. "It's very strange to say, at the end of the transaction, that if the other guy is smarter than you, that you have been defrauded," Buffett said last week. Andrew Ross Sorkin, who I usually agree with, opined that plain-spoken Warren might be right: "it does seem odd that the government, and the public, has chosen to vilify one of only a couple of firms that made fewer mistakes than the rest."

What seems to be missing here is that when you play it out, Goldman made at least one mistake that was a doozy. Goldman was using its superior intellect not only against its clients, but against those who agreed to insure the other side of Goldman's own bets against the mortgage industry, most notably AIG. The sharpies at Goldman convinced the insurers at AIG that the garbage AIG agreed to insure would never go belly up, and that AIG could take in a couple points of "premiums" and never have to worry about paying off. AIG believed the instruments were good as gold. After all, the same sharpies had already convinced the dolts at the ratings agencies to rate the garbage AAA.

So what was Goldman's doozy of a mistake? They failed to underwrite their own underwriters at AIG. It now appears that by 2007, the really smart guys in the room had already concluded that the mortgage derivative market would end badly. Yet Goldman kept creating more derivative instruments that required a counterparty to bet in favor of the market. In the past they actually bought a lot of the instruments on their own account, but by 2007 - knowing what they knew - they were buying insurance from AIG as a "hedge" against the inevitable downside. They were dumb, I would argue, because they knew or should have known that AIG had issued billions and billions of dollars of coverage on the bonds, and if (when) the market burst, AIG would never be able to satisfy its obligations.

What happens if you or I fail to underwrite our underwriters? What if we buy flood insurance from a company that's overcommitted when the flood comes? Too bad for us. Not so bad for Goldman. It appears that in the months leading up to AIG's collapse, Goldman saw where this was heading and fought daily with AIG to protect its positions. During this period, Goldman certainly wasn't telling its stockholders, or the SEC, or anyone else, that it faced a catastrophic loss if AIG was unable to meet its insurance obligations. But in September, 2008, when AIG failed, Goldman convinced its alum, Treasury Secretary Paulson, that the United States Government should honor AIG's commitment to Goldman Sachs! Not part of AIG's commitment, but all of it. One hundred cents on the dollar - a total of $16 billion. So Goldman, the group of geniuses who failed to underwrite their underwriter, was fully protected from its profound risk and folly.

It appears that Goldman successfully convinced Secretary Paulson that they were in extremis, and that Goldman's failure could bring down the entire economy. Once Goldman was saved, however, the bounce was immediately back in their step, and hubris returned. Goldman's leaders blew off a meeting at the White House. They reveled in their reputation as the smartest guys on the Street. They announced that they were never in trouble, and didn't want or need any loans from the government.

Of course, Goldman didn't offer to pay back the billions we taxpayers paid them to cover all of AIG's debt. Instead, Goldman waited a few months, and then deemed themselves worthy of nearly all that money in bonuses, the lion's share going to the Goldman principals who oversaw the failure to underwrite their underwriters. And that is the scandal no one is really talking about.