OPINIONS

Get It Right: Hindsight May Not Be 20-20

Goldman Sachs is taking the fall for Wall Street’s role in America’s economic recession, providing proponents of financial reform with the perfect platform to push their agendas. The logic goes something like this: it is possible that a Goldman employee is guilty of a fraudulent transaction; therefore Goldman is an entirely corrupt institution; therefore all such financial institutions must be corrupt (corruption is, after all, endemic to all profit-seeking establishments); therefore the administration must step in to protect the people from the horrors of the free market as represented by illegal activity by bankers on Wall Street. The timing of the fraud accusations is extremely convenient for rallying support for what was a dying attempt at financial reform. As allegations of Goldman’s misdeeds whip up public outrage against the entire financial banking system, I am hesitant to jump on the blame bandwagon. The specific instance of fraud for which Goldman currently stands accused does not necessarily implicate the financial sector of rampant wrongdoing. Disclaimer: I do not pretend to be a financial attorney nor an economic expert. These observations are those of a casual student of economics trying to keep a cool head amidst the frenzy of finger pointing.

Let’s start with a synopsis of the banking transaction in question. Goldman Sachs and other such banks create structured securities based on the needs/wants of their clients. The securities in question were collateral debt obligations (CDOs), which, on a simple level, we can think of as bundles of mortgage loans. So a homebuyer (we’ll call him Joe) goes to a mortgage originator such as Wells Fargo or Bank of America. Banks like Goldman buy these mortgages, and package them through “arranging” companies–professionals whose job is to create quality CDO products. The arranger in this case was ACA management. Arrangers look over the suggested mortgage bundle, eliminate some securities, add others and ultimately approve the CDO. CDOs were ragingly popular during the build-up of the housing bubble. As long as interest rates remained low and housing prices rose, banks and their investors raked in the dough. As we’ve seen, this pleasant situation came to an abrupt end when the housing market fell apart.

Ok, on to the fraud accusations. John Paulson, manager of a hedge fund, did independent research and decided that many of the smartest people in the financial world were wrong. The rise in housing was unsustainable and was going to fall apart relatively soon. While his peers basked in the benefits of rising prices, Paulson wagered that housing prices were going to fall, hard. When this happened, he speculated that mortgage borrowers like Joe would default on their loans, and the CDOs would become lose significant value. He asked Goldman to create a package of mortgages that he would then “short” (bet that they would fall in value). As a result, Goldman employee Fabrice Tourre met with ACA and asked the company to arrange the package. ACA reviewed the securities that Paulson wanted and decided to only include some 55 of the 123 requested. It then approved the CDO, named ABASCUS, in which German bank IKB invested $150 million. Thus, the transaction basically came down to a bet between Paulson and IKB, with Goldman acting as middleman. If the CDO had gained in value, Paulson would have suffered heavy losses. However, in the subsequent mortgage crisis (which few but Paulson predicted), he enjoyed unprecedented gains.

And where is the fraud? It seems that Fabrice Tourre did not reveal to ACA that Paulson intended to bet against the CDO when he gave ACA the list of mortgages Paulson wanted included in the package.

Well, perhaps Goldman will be found guilty of fraudulent behavior. It would seem, however, that it was incumbent on the ACA to determine if the securities were of good enough quality to be included in the CDO. All parties involved in the trade were aware of the components of the ABASCUS security. Whether or not Paulson bet against the funds that he himself selected seems largely irrelevant. The fact remains that ACA’s job was to rate and package the securities.

What concerns me more, however, is how the vilification of Goldman distracts from other relevant parties. President Obama blames the free market for the financial crisis: “a free market was never meant to be a free license to take whatever you can get, however you can get it. That is what happened too often in the years leading up to the crisis.” This defamation of the financial sector ignores the role of government in the market (the market is not and was not “free”). Many economists suggest that government sponsored agencies Fannie Mae and Freddie Mac (nationalized in 2008) incentivized risky lending practices and that past government bailouts created moral hazard. Can we say that government intervention in the market contributed less to the crisis than a misleading negotiation by a Goldman Sachs employee? The nuanced sequence of events leading to the current recession involved many parties (including individuals who purchased homes they could not afford). Dumping total responsibility on the banking industry may be convenient, but it hardly seems logical.

Want to watch the Senate hearings with me? emorgan1@stanford.edu.

  • ?

    It is not “logical” to use the bailout from 2008 as evidence that the government is responsible for what the private sector did in 2007. May the government is culpable for other reasons, but you haven’t shown anything concrete to prove this.

    You write: “The logic goes something like this: it is possible that a Goldman employee is guilty of a fraudulent transaction; therefore Goldman is an entirely corrupt institution; therefore all such financial institutions must be corrupt (corruption is, after all, endemic to all profit-seeking establishments); therefore the administration must step in to protect the people from the horrors of the free market as represented by illegal activity by bankers on Wall Street.” I don’t see how this demonstrates that the response to the financial crisis is illogical.
    Your position is the equivalent of arguing that there shouldn’t be laws against theft for all citizens because only a few people steal anyway. If the rest of the financial sector is so righteous, then why should you have any problem with creating the regulations needed to enforce responsible behavior?

  • Stan

    This girl is pretty but has a dirty mouth, a dirty dirty mouth

  • Joe

    ABACUS, not ABASCUS. You know, like the old-fashioned counting device. I know this is the opinion section, but it would still be nice if there were some journalistic standards about facts.

    “The fact remains that ACA’s job was to rate and package the securities.”

    Well, they were all rated AAA, so even if you think Goldman should be allowed to sell products that are designed to fail, it’s hard to say the buyer didn’t do due diligence. But that line of reasoning might lead one to suppose that the market is not regulated properly, so of course your article must omit such pertinent facts.

  • http://homeincomeprofit.net Home Income Profit

    I have deep stretch marks will this help to vanish them?

  • Erica

    @?: My point is that Goldman is being used to create a frenzy for reform when a) there is likely no fraud on its part and b) the senators and bureaucrats suggesting reform are obviously oblivious to the complexities of the transactions. I don’t think rash, sweeping government intervention is the solution.

    Interesting article by Stanford economist:
    http://online.wsj.com/article/SB10001424052748703871904575216633061219378.html

  • dth

    This article is pretty sloppy. First of all, you don’t seem to have much empathy for the anti-Goldman folks. Their hate of Goldman preceded any revelations of the ABACUS deal by at least a year and possibly more. This is very relevant to today’s scapegoating, as you seem to imply.

    As to the alleged fraud. You say, “Whether or not Paulson bet against the funds that he himself selected seems largely irrelevant. The fact remains that ACA’s job was to rate and package the securities.” Even Goldman Sachs isn’t making this argument, which should tip you off that it’s a very bad one. The fact is, if Goldman did conceal the facts from ACA, we don’t know what ACA would have done. Perhaps they would have exercised more scrutiny; perhaps not. The point is, ACA would have been interested to know. We don’t know whether they knew, and tt hasn’t gone to trial, so it’s likely to early to tell.

    That said, there are a number of inaccuracies in your piece. You claim that Goldman was only working as a middleman, but this can’t be true: they claim they lost money on the CDO. So one of you is wrong, and it’s probably you. You claim that Paulson would have made heavy losses had the CDO gained value. This shows a massive misunderstanding of the securities and financial instruments involved. CDOs, as an aggregate of bonds, can’t gain value above their coupon price–only lose it. The bet Paulson made, a CDS, limits your exposure by requiring a paid premium which can be cut off at any time. It’s unlikely in the extreme Paulson would have realized substantial losses. These things are the basics of the basics.

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