Friday, April 30, 2010

The Goldman indictment

I waited a couple of after the indictment of Goldman to post my thoughts on it, since I have mixed feelings on the topic. If you want to take a look at the indictment, you can go here:
As most of you who have followed my work know, I have been been more negative on the products and practices of investment banks than most of my academic brethren. I think that investment bankers promise more than they can deliver and that there is far less value in most of the products that they sell than they claim in their sales pitch. On the Goldman indictment, my sympathies lies with Goldman because I feel that this it is selective prosecution, based upon 20/20 hindsight, designed to advance a larger agenda of "financial regulation and oversight" by the Federal government and Goldman happens to be (at the moment) every one's favorite bogeyman.

First, the background. The deal that has Goldman in hot water is titled Abacus and was a multi-billion dollar Collateralized Debt Obligation (CDO), a fancy terms for a bond backed up by assets, and in this case, the backing came from real estate mortgages. On the face of it, the deal looks unremarkable. In fact, Business Insider was able to get its hand on the pitchbook used by Goldman for the deal:
The pitchbook has all the hallmarks of a standard sales presentation - the obligatory disclaimer that runs 3 pages, 63 more pages that reveal less than they should, uninformative (but colorful) graphs, and tables filled with enough numbers to numb the brain (which is the objective).

So, what made this deal stand out? Here are some of the factors for its being singled out:
1. A "big loser": The securities bundled in the Abacus deal were priced at the height of the housing bubble. Like other housing backed securities it did lose money. However, it was one of the "biggest losers", with losses exceeding in the billions.
2. The John Paulson connection: The seller of the securities in the Abacus deal was the hedge fund headed by John Paulson, one of the few winners in the housing bubble. His subsequent notoriety, chronicled in a book, has made him into a sage, at least in hindsight, about the housing bubble and its implosion.
3. Goldman was the intermediary: Among investment banks, Goldman Sachs was viewed as the only one that was able to cut its losses in the mortgage backed securities debacle and escape relatively unscathed. The fact that it was the broker in this transaction has evoked suspicion that is was partnering with Paulson to take advantage of the suckers on the other side.

The indictment of Goldman seems to rest of two claims:
1. According to the SEC, Goldman Sachs claimed wrongly that Paulson was buying the securities (packaged under Abacus), when it was the seller. I checked through the sales presentation that I linked to earlier to see if there was an explicit mention of Paulson but I did not find any. It is entirely possible that Goldman left the implicit understanding that it was a buyer (I assume that the SEC has something - emails, phone calls, phone video - to back up its claim).

2. Goldman had advance knowledge of the collapse of the housing market and took advantage of their clients: Even the SEC seems to recognize that this is a much weaker legal argument, but the Senate committee investigating Goldman Sachs had no qualms about making this the center piece of its accusations. Using emails from from Fabrice Tourre, who in addition to being an employee of Goldman seems to have forgotten that emails are not erased on the server when you delete them on your computer, senators accused Goldman of knowing that the housing market was going to collapse and actively exploiting investors by selling them securities that would be destroyed by this collapse.

I know that these are legal issues subject to the legal rules on what comprises reasonable. However, if this case were subject to what the rest of us (who are not lawyers and have the benefit of common sense) think as reasonable, it just does not stand up to scrutiny:

1. What if Paulson were the seller rather than the buyer and why should the buyer of these bonds (ACA) have cared? Implicit in the SEC's argument that holding back on the identity of the seller (Paulson) was somehow a deal breaker for the buyers of the securities involved in the Abacus deal. Notwithstanding the halo that Paulson might have acquired as a soothsayer in the housing bubble, he was a voice in the wilderness in 2007 on housing prices. I seriously doubt that ACA would have not bought these securities, even if they had known that Paulson was the seller. In addition, I don't think any intermediary in this market (securities) is required to reveal to the buyer the identity and motives of the seller.

2. Goldman knew the housing market was going to collapse and took advantage of its clients: I find this argument to be beyond absurd, especially given the evidence to back it up. In fact, let's take this argument at face value. If Goldman were that prescient about the housing market in 2007, there was a dozen other ways (most of them more profitable and less work than Abacus) that they could have made money on this belief. So, why construct this convoluted way to make money? Furthermore, investment banks are not monolithic when it comes to views about markets. Having worked with investment banks for almost 30 years, I can guarantee you that at any point in time, views about whether a particular market is under or over priced (equity, bonds, real estate) diverge across an investment bank. For every strategist/analyst at the bank who is bullish, there is one who is just as strongly bearish. Thus, I find Tourre's emails (about what he thinks about the market) to be sensational but completely irrelevant to this discussion. (As an analogy, think of the following: If you were a real estate broker who believes that houses are over priced, should you stop selling houses to clients who want to buy houses?)

Did Goldman take advantage of "naive" clients"? Probably, but that is the nature of trading. All trading is predicated on exploiting the lack of information or good sense on the part of the the investor on the other side of the trade. I don't like what they did because it is bad business practice, in general, to take advantage of your customers. However, it is not illegal. If it were, home buyers should be suing brokers who sold them houses in 2007 and 2008 while secretly believing that these houses were overpriced, customers should be suing electronics salesmen who sold them video disc players, knowing that DVD players were the standard of the future, and voters should be suing politicians who told them that their pension and health care benefits were secure, while undercutting the basis for these benefits.

I know that a lot of people would like to see Goldman fall, and that some of them work at Goldman's competitors. While I understand the urge to bring the mighty back to earth, I think that failing to support Goldman at this time is a huge mistake. To me, this case reveals everything that is wrong with both politics and law - the use of ex-post evidence to back up a case (Paulson made money of the housing crash.. so, he must have known that the crash was coming), suspicious timing (just in time for the new law on regulating bank) and scapegoating.


Unknown said...

Excellent Note. Thanks.

Mahesh said...

Hi, This is exactly my point too. In fact ur NYU colleague, Tunku had written an article arguing quite the opposite!

But in this case, there is one thing agt GS that stands out. The deal was sold t clients saying that the CDO's were created by inhouse managers when in fact it was exactly the same portfolio that Paulson had put together. Though this cud have easily backfired for Paulson and worked in favour of investors if housing bubble continued for more time, the fact that the clients were led to believe that Abacus was put together by inhouse managers is wrong. Outside of that, no other argument made agt GS in the mainstream media makes sense.

Unknown said...

I bought a home last year. While signing the P&S my 70 year old realtor said- "my allegiance doesn't lie with you or the seller, but in being ethical. These weren't his exact words- but what, I think, he meant was if there is a high potential for roof leakage, he (or even the sellers agent) would tell me IF they knew about it. This would work other way round too i.e. he couldn't lie to the seller about my ability to get financing IF he had prior knowledge. Secondly, I was advised to not go for deals wherein the same agent represents both the buyer and seller.

As a market maker and because of reasons you so clearly explained, prosecuting GS because Paulson was on the other side of trade doesn't make sense. But, with regards to having more transparency while conducting a trade, is that the sole responsibility of rating agencies, who I'm told are paid by the investment banks? "Supposing" SEC has enough evidence to show that GS knew the house they are selling is built of straws, were they not legally obligated to mention it to the buyers? I understand your point is that this is unlikely to be the case because GS could make money through easier ways then.

I have heard a million times about the conflicts of interest in various corporate dealings (Board of Directors & management, Inv Banks & rating agencies, Inv Banks & IPOs, Corporate Acquisitions etc). Perhaps there is no reasonable solution or just a big inertia to change. Very sad indeed.

Tony Lieu said...

If a company sells a product that it knows defective, we call it fraud. I'm not well versed in the financial market, but I wasn't born yesterday either. It was clear from GS own internal email that GS knew that Abacus would be a big loser, and it positioned itself to profit handily when that thesis played out. So to claim that GS is being made a scapegoat, is hard to swallow to say the least.

donlsan04 said...

Agree on all counts

The BMOC said...

"Did Goldman take advantage of "naive" clients"? Probably, but that is the nature of trading. All trading is predicated on exploiting the lack of information or good sense on the part of the the [SIC] investor on the other side of the trade."

Goldman’s liability here isn’t because it knew the housing market was going to blow up. You are correct in saying that (i) no one could have known that, (ii) opinions probably varied within the firm, and (iii) the buyers of the securities were “sophisticated” investors who should have been aware of the risks.

No, Goldman’s liability is due to the fact that this wasn't a trading activity. Reading the pitchbook it seems clear that Goldman was the underwriter of the security. That means if Paulson helped to originate and/or structure the investment, Goldman had a duty to disclose it. This is pretty basic and standard FINRA regulation type stuff, it’s all there in the Securities Act of 1933. Goldman can argue that it was trading or market making, but these were brand new securities.

I do agree with your thoughts that the SEC's complaint is politically motivated, but that isn't a shock considering the SEC answers to the Executive Branch.

JohnLloydScharf said...

Regardless of a possible political component, you have to wonder who wen, short at 9:30AM and made over $23 a share by 10:30AM, when they announced the suit. I want them to clear the filing of tortes with me when they go after Morgan Stanley this week, but give me 24 hours notice.

Unknown said...

Hi folks,
i hav got a fundamental doubt..pls someone throw light on it... If Alliance between GS and Paulson stands true, then both of them shld be on the winning side of the trade.. right? but why Paulson &co remained unscathed in the housing bubble .. GS was a dramatic faliure .. how come ???

Unknown said...

Unlawful? Probably not. Unethical? Absolutely.

There is no gray area. It's plain and simple. Had ACA known Paulson was net short Abacus, there is no way in hell they would have given him significant influence in the products structuring.

I'm currently a finance student. 21 years old. We need people to say what needs to be said. To cut through the BS and put ethics and moral before profit. To lambaste the "greed is good" mentality that pollutes the minds of young financiers. It's not the system that's broke. It's the people.

Jonathan S.