Since Friday afternoon, I have been participating in a corporate off-site. On Friday night, returned home late weary and reflecting on the prospect of getting up early and returning to the off-site on Saturday morning. A cryptic email from a friend based in the US alerted me to the SEC charging Goldman Sachs. Now, it is Sunday evening in Singapore. By now, reams of analysis had been done on blogsphere. It almost feels like very old news. Such is the power and bane of a connected world. I managed to catch up with some good ones. I would refer readers to Felix Salmon’s blog over at Reuters. These two posts are recommended. I would particularly refer to the transcript of a live chat that took place as the SEC press conference unfolded. The email from Fabrice Tourre of Goldman Sachs is a gem. That captures everything that went wrong up to 2007 and is still going wrong.
I suspect that Lloyd Blankfein’s comment in an ‘interview‘ to Sunday Times claiming that bankers were doing God’s work is going to be regurgitated ad infinitum as that of Charles (Chuck) Prince who claimed that bankers had to dance as long as the music was playing. Recently, Chuck Prince and Robert Rubin were asked to testify to the Congress. They both said that they did not recognize the risks in CDOs. H..mm
One person who understood the risks actually wanted to short them. Especially Collateralized Debt Obligations created out of Residential Mortgage Backed Securities. Well, if you roll your eyes at these terms, that would be perfectly understandable. Just read the last paragraph. If they did not get it, why should you feel bad for not getting it? Of course, you should and could feel bad that you did not get paid as much as they got paid for not getting it!
This sentence from page 4 of the 22-page SEC charge-sheet is, in some ways, a good take on the rabbits that were being pulled out of hat (perhaps, it is better said as ‘pulled out of thin air) – “position Goldman to compete more aggressively in the growing market for synthetics written on structured products” [More here]. ‘Synthetics on structured product’ is clever phrasing. SEC had taken it from an internal memo in Goldman Sachs. A ‘Structured Product’ is a synthetic in itself. So, Wall Street was creating synthetics on synthetics. In other words, these financial products had taken a life of their own and were priced with no reference to the risk of the underlying securities from which they were synthesized. Those underlying securities were mortgages taken on by borrowers who had no income, no jobs and no assets.
A world of finance driven by and built on perception should not really surprise any one since the very notion of ‘fiat money’ is based on perception and nothing real. Hence, the need for ‘The Gold Standard’ 🙂
A surprising defence of Goldman Sachs comes from this blog post by Henry Blodget. I do not agree with it. I think Felix Salmon answers it well. If you read through the 22-page charge-sheet of SEC as I did, you would know why I think his defence and not the original charge of SEC is very weak.
Essentially the case is that Goldman Sachs helped John Paulson, a hedge fund manager, to structure a product that was based on the premise that defaults on sub-prime mortgages would occur on a massive scale. Hence, securities based on such mortgages (MBS) would default. Hence, it should be possible to create a CDO on such MBS that he could short by buying default insurance (Credit Default Swaps) on such a CDO. Wait. He played a role in selecting the MBS. A company called ACA Management with a decent reputation for selecting MBS was roped in, to lend credibility to the process. They were under the impression that Paulson was taking a ‘LONG’ position in the CDO. An investor with a LONG position gains if the financial asset goes up in value. The paragraph should make it clear that John Paulson was having a ‘SHORT’ position. That is, he stood to make money, if the asset (CDO) collapsed. It did. Since he had purchased insurance against those assets collapsing, he made a lot of money!
There is one missing link that astute readers would have caught. Who was on the other side? ABN-AMRO and a German State-owned bank – to name just two. They bought this CDO in good faith because, well, the credit- rating agencies had also rated them! This structure contained AAA, AA portions too!
Who wrote that insurance that John Paulson bought? ACA wrote insurance on that CDO which it had helped construct as a ‘portfolio selection agent’. They must have done so in good faith thinking that Paulson was a LONG and not a SHORT investor. The crux of the SEC complaint is that, at no stage, did Goldman Sachs communicate to ACA or to other investors who bought different tranches of that CDO that this CDO (i.e., its underlying securities) was proposed by Paulson with an interest to sell it short and not own it.
I hope I had made it clear. Now, you should be able to read the 22-pages and arrive at your own judgement as to whether SEC has a good case or not.
One thing needs to be said here. I recall reading some time ago in Baseline Scenario (a great blog on the capture of Washington, D.C. by Wall Street run by Simon Johnson and James Kwak) that the government was giving the financial industry a long rope and that it would strike at the opportune time. I could not recall that exact post but I do say that this is a good coup. It enhances the chances of passage of financial reforms in the US enormously.
[Postscript: Co-blogger Dhruva raised a legitimate question as to whether this would lead to the much-feared ‘double-dip’ in the US economy. Tangentially, it might. But, the case for that should be built on the US labour market situation. On the face of it, it is not improving. Incomes are not rising. Consumer credit data shows that consumers are not borrowing. Yet, US Commerce Department keeps reporting brisk retail sales even excluding gasoline whose price has been rising. It beats me]