The mess at Goldman Sachs

It seems appropriate in these harsh and uncertain economic times to observe Congressional hearings on the business practices of what were once widely admired executives of American business. When things don’t work out well in their industries, CEOs can expect to be summoned to Capitol Hill to appear at hearings, often for many hours. They may have crimes to hide from the public and business practices which are shameful, unethical or even illegal — but the ritual is to appear before the elected officials, who sometimes don’t seem to even understand the issues.

Austin Jaffe, Ph.D.

Goldman Sachs was — before the financial crisis and even more so now — the finest investment bank on Wall Street based on its market capitalization, earning capacity, historical performance and reputation.  It drew an enormous amount of attention when it appeared that Goldman soured on the mortgage-backed securities market and liquidated its holdings long before anyone else did. Firms failed (e.g., Lehman Brothers) or were taken over (e.g., Merrill Lynch) due to their large respective positions in the housing and mortgage markets (which are clearly tied together).  At Goldman they decided that what proved to be the biggest housing bubble in history could not last and they would avoid going where others had been investing. But as money-hungry Wall Street firms often do, Goldman continued to create trading instruments and helped make a market for institutional investors who are also hungry to make big money.

Here’s where the story gets technical.

In December 2006, Goldman began selling mortgage-backed security products even though they believed the market was overheated and headed downward. Yet the federal government’s lawsuit claims it was not until September 2007 that the bank failed to disclose what it was doing — “shorting” (betting against) the market it was helping to create. A Goldman spokesman was quoted in the Centre Daily Times as saying last month, “We are not required to disclose individual trading positions.  Rather, we disclose the financial performance of the firm. In this regard, net revenues from the residential mortgage business represented around 1 percent of the firm’s total net revenues in 2007.”

Perhaps. But the Securities and Exchange Commission (SEC) claims that Goldman violated disclosure rules that information “material” to a company’s performance should be announced. No doubt Goldman was quiet about its revised strategy against the housing market and the sustained house price appreciation. Therein lies the legal issue: Is this a securities law violation and if so, how can it be proven?

The case is further complicated by the choice of investment vehicle. In the 1990s, mortgage-backed securities (MBSs) were “plain vanilla” — pools of first mortgages where the cash flows from repayment of borrowers’ loans were passed through to institutional investors. Then came CMOs (collateralized mortgage obligations) where the pools were sliced into different “tranches” and sold throughout the world.  By the mid 2000s, Goldman and others created even more complex instruments, now called CDOs (collateralized debt obligations) since other debts such as credit cards and even delinquent property tax bills could be included in the pools. The number of pieces of individual mortgages or other obligations in any investment pool could be in the tens of thousands.

The next development would expand the possibilities even further with synthetic CDOs.  In this security, a new derivative was used — the infamous credit default swap from AIG — to make bets on whether, in this case, mortgage pools would keep producing cash flow as borrowers continued to repay their mortgages. Credit default swaps were pure bets on the future of MBSs (based on prepayment risk) and every transaction required a buyer and a seller. In the government’s complaint against Goldman it is argued that the bank failed to warn investors that the hedge fund Paulson & Co. was betting against the securities. Yet as commentators reported at the time of the government’s charges, by definition both sides of the market must be in play for the bet to be made using credit default swaps. The use of credit default swaps in the Goldman synthetic CDOs is the core of the lawsuit.

None of us on the outside can tell whether securities law violations occurred, however, it’s apparent that there were billions at stake. Beware: this market is not one for novice investors. The millions made annually in salary and bonuses at Goldman and elsewhere for hundreds of employees, not only executives, are not simply because they have signed on with the firm!

One other thing: CNNMoney.com ran a story (“Always Bet on Blankfein”) on April 28, 2010.  Apparently, a British firm called Intrade is making a market inviting bets for a fee on whether Goldman CEO Lloyd Blankfein will survive the SEC lawsuit and its fallout. That’s right: people can place bets on virtually anything in the UK, in this case whether Blankfein will be fired or will resign. Interestingly, such wagers allow Goldman shareholders to hedge their positions against the decline in Goldman stock. Ironically, this strategy is not different than what Goldman did against the housing market.

It’s very difficult to say what will happen to Goldman. This type of securities law violation is very difficult to prove. There is recent talk of a financial settlement. In the meantime, I think The Economist put it best on April 24^th when it ran this headline: “Greedy Until Proven Guilty.”

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Tags: economy, goldman, sachs

This entry was posted on Wednesday, June 16th, 2010 at 6:00 am and is filed under Economics. You can follow any responses to this entry through the RSS 2.0 feed.