"Fraud Charge Against Goldman - The First in a Series? Was the Timing Coincidental?"

Sydney M. Williams

Thought of the Day

“Fraud Charge Against Goldman – The first in a Series? Was the Timing Coincidental?”

April 19, 2010

Whether Goldman and its executives get indicted and/or convicted of fraud remains to be seen, but there is little question in my mind that what they did – illegal or not – was certainly unethical. At the same time, the timing of the accusations was no coincidence, again, in my opinion.

The President and Democrats in the Senate are trying to push through Senator Chris Dodd’s Wall Street Reform Bill, a bill about which Main Street should have serious reservations, as it appears to do very little to prevent a repeat of what created the mess in the first place. Wall Street, it should not be forgotten, serves Democrats in two ways. First, it is an attractive target as a symbol of wealth, greed and corruption. Second, when they doff their populist hat, it is a source of substantial funding for Democratic coffers. By day, they attack the malignancy of banks and all they stand for; by night, they return, palms outstretched furtively soliciting and pocketing dollars. (To be fair, Republicans do the same, but it is the Democrats who are now in charge.)

The events that led to the fraud charges against Goldman, as I understand them, are as follows:

1) In late 2006, John Paulson, manager of the eponymous hedge fund, was looking for ways to short what he determined to be an overheated housing market.

2) Mr. Paulson approached Goldman Sachs (and likely other firms) with the idea of creating a collateralized debt obligation (CDO) comprised of residential mortgage backed securities (RMBS) that he would select based on his research, which suggested a likelihood they would be downgraded by the rating agencies.

3) Goldman agreed, for a fee, to create such a structure using the RMBS that Paulson selected.

4) Goldman named the CDO Abacus 2007-ACI, and agreed to sell it to institutional investors, allegedly without disclosing that Mr. Paulson had selected the RMBS or that he would be betting against those same securities. (Saturday’s New York Times reports that Abacus 2007-ACI was one of 25 such vehicles.)

5) Once the mortgage securities had been bought, Goldman then hired ACA Management, a well known manager of CDOs and a financial insurance provider, to manage the vehicle. A second allegation is that Goldman did not disclose to ACA Mr. Paulson’s role in selecting the RMBS, nor his intent to bet against the CDO.

6) Once the CDO had been created, Mr. Paulson then purchased through Goldman Sachs a credit default swap (CDS), betting that the mortgages, now owned by Abacus 2007-ACI, would decline in value, and some, if not all, would in fact default.

7) Goldman was paid $15 million for structuring the CDO and marketing it to their clients. (They have alleged that, in fact, they lost a total of $90 million on the whole deal, but I say, “so what”.)

8) A few months later the mortgage business imploded; Goldman’s clients purportedly lost $1 billion, while Paulson & Co., also a Goldman client, pocketed a similar amount.

No one can predict the ultimate legal outcome, but certainly the allegations do not place Goldman in a favorable light. And, while no one can predict if this is the first in a series, certainly I don’t believe it was the only such incident. Once the camel gets his nose under the tent, the rest of him generally follows and that holds true for the S.E.C. While there is an instinctive reaction among many Americans to view unfavorably anyone who bets against something as American as home and hearth, Mr. Paulson, it would appear, earned what he made by being right on an over-heated market and in his willingness to make the bet. Short sellers, often vilified, in fact serve as a governor on run-away speculators – the canary in the coal mine, if you will. (It is also important to remember that in late 2006 most investors did not believe that we were on the precipice of a residential real estate collapse.

Despite SEC spokesman, John Nester, saying (according to Saturday’s New York Times) that the timing of the charges filed against Goldman were unrelated to the finance reform under discussion, I find myself agreeing with an observation of Elie Wiesel. What he said about Jewish history, “that there are no coincidences”, also holds true for Washington politics. Whatever the coincidence, though, there is little question that the President will use the negative publicity surrounding Goldman’s behavior to push for reform. And I, for one, am in favor of reform, as I have written on numerous occasions.

While it is impossible to anticipate the next crisis – Wall Street traders and analysts are nothing if not clever – it does make sense to correct those factors that abetted the last, and that includes relegating most derivative trading to exchanges, ensuring that credit default swaps be treated as the insurance they are and that sun shines in on products such as CDOs, so that buyers have a clearer perspective of what they own, or may be considering. Off balance sheet items should be moved on to balance sheets, and leverage, for deposit taking institutions, should be limited to a more reasonable ten or twelve times. Officers and directors of banks and financial firms should be held personally and financially liable. In my opinion, certain to be opposed by many on the Street, proprietary trading desks should be spun off from desks dedicated to customer business, ala the Volker Plan. Certainly banks should be able to hedge customer orders and be able to take what remedial action may be deemed necessary to protect their assets and that of their clients, but putting their own account ahead of a client’s should be prohibited. And, if a bank is too big, it is too big. It was heartening to read, for example, that Victor Pandit of Citigroup no longer feels that his bank should be a “supermarket” within the financial industry.

The ridiculous notion, put forward by Democrats, that a $50 billion fund should be set up – paid for by banks and managed by the Federal Reserve – is akin to hiding an old hag beneath a flimsy nightgown. (Apparently, the President has nixed this recommendation of Senator Dodd’s.) Keep in mind that the recent crisis caused a commitment on the part of government for an amount measured in trillions, not billions of dollars. Senator McConnell may not be correct that such a fund would not only permit “taxpayer funded bailouts, but actually encourage them”, but he is right that such a proposal would be favored by banks and diverts attention from the more stringent recommendations of the Volcker Plan, which would separate commercial and investment banking functions from proprietary trading operations. Excluding Fannie Mae and Freddie Mac from any such bill seems absurd, given the role they played in the collapse.

The protestations of the banks against such proposals, reminds me of the story from Uncle Remus: You will remember Brer Rabbit had been caught by Brer Fox, who wanted to do him harm, “please, Brer Fox, don’t fling me in dat brier-patch.” So Brother Fox threw him into the brier-patch, which is where Brother Rabbit had been born and where he wanted to go in the first place.

I believe the President is right when it comes to demanding full disclosure on derivative instruments and the manner in which they are traded, but be wary of any bill in which the devil is in the details – and Senator Dodd’s, at 1336 pages long, has enough room to harbor a lot of details and a lot of devils. As I wrote last week, I believe there is a deliberate attempt on the part of both parties to not collaborate – they both feel it is in their best interest. That may be so, but it is not in the Country’s.

The events of last Friday may provide the catalyst the market needs to get a well-earned respite after its thirteen-month, 79% rise, but I doubt that it does much to derail the economy or the longer term market outlook.