Goldman’s Fraud: Ignorance, Meet Arrogance
In sifting through the reams of damning documents and news stories that have surfaced over the past three days, it is perversely comforting to rediscover the icky truth behind financial implosions in general and the subprime debacle in particular: no one- no one- knew what the hell they were doing.
I say “comforting” because every time I try to suss out the salient details of any issue having to do with credit-default swaps, collateralized loans or subprime derivatives, I get so confused and lost I wonder if I am perpetrating my own personal fraud- moron hack journalist. So the news frenzy set ablaze last Friday by the SEC’s civil fraud case against Goldman Sachs has granted us a new opportunity to gawk at the stunning hubris of some Wall Street traders and remember that common sense has not yet been rendered irrelevant by ad networks, quant models, the iPod or Wikipedia.
To get a handle on just how much the involved parties didn’t know, a little background is helpful:
1. What’s the SEC’s suit all about?
In short, the SEC is accusing Goldman Sachs, the lionized Harvard of investment banks, of lying to investors. In finance- as in relationships- not telling the whole truth is tantamount to lying. When Goldman hawked to investors a shiny new product- a synthetic collateralized debt obligation tied to the performance of subprime residential mortgage-backed securities (sounds sexy- surely someone smart put it together) back in early 2007, they didn’t bother to tell investors that the fund’s holdings were chosen with the help of an independent hedge fund (billionaire John Paulson’s Paulson & Co.) who wanted the fund to fail. While Goldman was marketing the fund on the premise that the housing market was sound, bear Paulson was betting housing would flop and, the SEC alleges, made the portfolio pics accordingly. Spoiler alert: he was right. Paulson made $3.5 billion shorting subprime in 2007. [For more background, check out the SEC's formal complaint- it's surprisingly readable].
2. So what was in this fund, exactly?
A big pile of dodgy debt. No kidding. Investment banks nationwide binged on subprime mortgage securities back in the heyday of the housing bubble. High-risk mortgages- the kind banks were normally loathe to give out because of the high likelihood of default- were suddenly hot on Wall Street. Investors developed complex statistical models to determine borrower behavior (defaults, prepayments, etc.) driving bond value. Fancy algorithms- portfolio analytics- developed by the super-genius “quant” traders at banks showed that distributing risk over a broad “basket” of loans could turn subprime loans into safe ones. So by bundling some very risky loans in along with a heap of not-so risky loans, you had an AAA-rated product. A rock-solid way to mint money. The same way that mixing some arsenic into a pie crust recipe will make for an overall perfectly-healthy treat. Make sense? No? You’re right- it doesn’t make sense. These two Brits articulate the nonsensical-ness of it all rather nicely:
Because Paulson had a gloomy view of the future of mortgage securities, he participated in the market largely through Credit Default Swaps, insurance contracts which paid out a premium if a loan defaulted. Paulson essentially, had a lot to gain if housing went bust and (the SEC alleges) his firm influenced the Goldman fund’s portfolio picks to emphasize the dodgiest of the debt.
3. Why is this Goldman’s fault? Seems like Paulson is the bad guy.
Paulson so far hasn’t been implicated in any shenanigans though there’s a case that he should be. Goldman made the critical mistake not to be disclose to prospective investors the involvement of Paulson & Co. and their bearish view. In their response, they say ACA an “independent and experienced portfolio selection agent” and the largest investor in the fund, selected the portfolio. But how independent were they if they were the largest investor? And selected from what- a list given to them by Paulson?
The moral takeaway- and the thing that is really going to tarnish Goldman (and the stock market) in the long run is how arrogant and clueless those involved come across. “Fabulous Fab,” the named orchestrator behind the particular fund, is a straight-to-screen character. His now-famous 2007 email says it all:
“More and more leverage in the system, The whole building is about to collapse anytime now…Only potential survivor, the fabulous Fab[rice Tourre]… standing in the middle of these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!! (sic)” he wrote in an email to a friend in January 2007, according to the SEC.
Surely politics has more than its share of ignorance and arrogance and the timing of the SEC probe could not be more politically-perfect for the Dems and Obama’s financial-reform agenda. But fraud is fraud and meddling in things you don’t fully understand is always a bad idea, be it home renovation or statistical derivatives models.