Get It Right: Hindsight May Not Be 20-20 May 5, 2010 6 Comments Share tweet Erica Morgan By: Erica Morgan 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? firstname.lastname@example.org. financial reform fraud goldman sachs senate hearings 2010-05-05 Erica Morgan May 5, 2010 6 Comments Share tweet Subscribe Click here to subscribe to our daily newsletter of top headlines.