Goldman on Trial

In Criticism, Financial, Popular Posts on April 18, 2010 at 10:44 AM
Get used to Goldman being in the news for the next little while. According to this NY Times article, Goldman Sachs is being sued for knowingly packaging poor quality mortgages and other loans into a large credit derivatives bundle, and then selling it to the market. More than likely, the lawsuit is sparked by the fact that Goldman has been profitable throughout the financial crisis and it’s really pissing everyone off. News of this lawsuit has triggered banks from other nations to begin investigations to see if they have a similar case. Did Goldman sell them shitty mortgage-backed securities too?

Winning this case is going to be next to impossible. Yesterday, I pretended to be a Goldman Sachs attorney while my father, quite angry over the matter, represented the prosecution.

Dad: How is this different than selling me bad apples? You hid the rotten apples at the bottom of the basket, so I didn’t find them until later on.

Me: Let’s make it a carton of eggs. If you walk out of the store with a carton of eggs, and discover that one is broken, is it the store’s fault for selling you a broken egg or your fault for not checking? Don’t buyers have to perform their due diligence on something before buying?

Dad: No. You knowingly made it hard for me to find these bad apples. You tied bows on top and hid them in a place where I couldn’t see them until much later. And we can prove you knew this, because not only did you sell these apples to me, but after selling them, you short-sold the very same assets, fully knowing they were total shit and that they were going to drop in value. So not only did you gain from not holding them anymore, you actually profited from me losing.

Me: First, I think you have to agree with me that in a free market, you have to at least squeeze the apples before you buy them, or accept the bad ones if you didn’t bother to check.

Second, since when am I not allowed to change my opinion on how I view the markets? Initially, we were happy to hold all sorts of apples here at Goldman. We had a very optimistic view of the mortgage markets, just like everyone else. But in 2007, it became clear to us that we might be too optimistic. We had to shed our risk by selling some of our mortgage-related assets. But since we were still holding on to some, we wanted to hedge ourselves by taking further positions reflecting our new point of view, that mortgage markets were inflated. We had to protect ourselves from the risk that there was a mortgage bubble.

Dad: But you knew they were bad assets. What if I can prove that you knew that?

Me: Even if you can prove that we knew that, how can you possibly blame us for wanting to protect ourselves. Acting in our self interest is not illegal. You had access to the same information on mortgages, so did Lehman, so did AIG, yet all of you continued to take the position that housing prices would continue to rise.

If you had come to the same conclusions as us, we would not have been able to sell those assets the way we did, we would have had to sell them for much less. But in any market, a seller is supposed to get as much as he can, while a buyer is supposed to pay as little as he can. If the real estate markets continued to rise, we would have lost and you would have won. Should Goldman then be able to sue you for being right?

It was at this point that my father became aggravated with me, and I had to hold his hand and remind him that I wasn’t really a Goldman lawyer, and that I hated what was going on as much as he did.

My point was this is a very difficult thing to prove in court. There are some famous cases in derivatives law against Banker’s Trust (Proctor & Gamble and Gibson’s Greetings being the victims). In the P&G case, for example, Banker’s Trust was able to persuade the Treasurer at P&G into entering risky interest rate swaps. At the time, interest rates were low, and P&G bet that interest rates would remain low. The treasurer there was making a tidy profit each month, which of course translated into better performance results for him as the treasurer.

In the early 1990s, the Fed reserve raised interest rates by a hair, and it came to be known that P&G had made some massive bets against rising interest rates. All of a sudden, P&G found itself trying to explain to its shareholders how it had incurred massive losses that had nothing to do with operations. It was natural for P&G (and similar victims) to pursue legal action against Banker’s Trust.

P&G accused Banker’s Trust of selling them something that didn’t meet their requirements. They were sold a product that was excessively risky and complex, when really P&G just needed a simple hedge against interest rates. Their case, by itself, probably would not have held water, but as it turned out, Banker’s Trust had been sloppy.

One of the traders was caught on tape talking to his girlfriend on the phone about how he was passing off risk to the P&G treasurer, and that the treasurer was clueless. In addition to this, the traders were caught talking to each other about how this deal was a “wet dream.” Not only could they sell the swaps and collect a huge transaction fee, but when it came time to settling the cash involved, the traders had learned that P&G didn’t know how to determine the payment. So Banker’s Trust would call P&G and say, “so we’re going to pay out at $89,000,” and the treasurer would agree that this number sounded reasonable. Then they would hang up and giggle to each other about how they really owed ten times that amount.

Banker’s Trust ultimately settled. They had to because the behavior of the traders was not about to gather any sort of sympathy. We will see if there is evidence of Goldman acting in a similar fashion, and surely if there are phone calls to girlfriends, and emails about how stupid the rest of the world is, they too might start to scramble. Currently, their stance is to claim this entire lawsuit is completely unfounded.

When the entire financial system collapsed in 2008, when small banks were allowed to fail, we effectively destroyed trillions of dollars. That was our money. All of us. The US government should be looking for a way to permanently change the structure of the financial system instead of trying to recoup a tiny fraction of the losses.

Pursuing legal action against Goldman will not fix the problem that hit all of us in the face in the fall of 2008. I’m skeptical about their chances of success in the lawsuit, but the bigger issue is that this lawsuit isn’t suddenly going to scare those with better information from taking advantage of the weaker players in the market. Unfortunately, the pursuit of justice will only serve to distract us from the real issue, which is that the financial system has become an uncontrollable monster that very few people understand, and that nobody can control.

  1. Yeah I doubt Goldman will go down but the fact theymight go to court is at least encouraging and runs contrary to popular opinion that GS is a private subsidiary ofvthe SEC, fed, etc. Hell they've probably made money by shorting their own stock before this went public ….

  2. Oh one other thing, a lot of the media are (in my view) misrepresenting these securities that Goldman created to bet against the market. They were created for John Paulson, and a lot of reports make it sound like Paulson himself won while his investors lost. This is not true. Paulson is an independent manager, who foresaw the collapse coming. He asked GS to tailor make these securities for him. He was right, and Paulson's investors profited to the tune of several hundred percent performance over a couple years. So I don't know if GS bought into these securities, but it was Paulson & Co that requested them and saw the market collapsing, and ended up making anywhere between 3b-5b for himself.Might have been a good place to be at bonus time!

  3. Wait – what do you mean "they were created for Paulson?" You mean to say they made this total ass of a mortgage-backed product, then gave it to Paulson, who went out in the market and sold it, then bought it later and returned it to Goldman? That would mean Goldman was holding it in the end, right?

  4. "Even if you can prove that we knew that, how can you possibly blame us for wanting to protect ourselves. Acting in our self interest is not illegal."But doesn't GS owe its clients (the idiots who bought the CDO, not Paulson) a fiduciary duty? I'm not sure if intentionally selling garbage and holding material facts (ie that Paulson was behind some of the mortgage choices) meets this fiduciary duty test.

  5. This is an interesting point, John. Whether a fiduciary duty exists depends on what role you think the bank plays in all of this. If they are a seller of assets on their own behalf in a free market, they have no such duty to sell at a "fair" price or not to rip someone off by too much. Sellers should behave like sellers. I'm not even saying they aren't guilty of something, but it gets much more complex. Goldman sold these assets to a special purpose entity (SPE) that was apparently independent. Then that SPE issues shares to the public, or institutional investors, or whatever. The "fraud" is going to be proving that the SPE was not in fact independent, but the board of the SPE or whatever was highly influenced by Goldman, and that together they colluded, something like that. And sure, they might be guilty of that, but it becomes increasingly hard to prove. They need a smoking gun, which they very well might have. Otherwise it's too easy to show that the SPE has well documented valuation models that proved the price it was paying was appropriate, and although we know all those models were total shit, but that's after the fact. Anyway, my major point, which will become more evident as I post the remaining pieces, is that this is entirely the wrong way of solving the problem. It wasn't just Goldman that created not-so-independent SPEs to sell assets, good or bad. Every single bank did the same thing, it's just they are the last ones standing.

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