Goldman Sachs: Banker or Bookie?

Late last week, the Securities and Exchange Commission charged Goldman Sachs with investor fraud.  It seems that they chose not to disclose all of the terms of one of their own financial products.  After reading the analysis of the events, I have just got to ask:  Are these bankers or bookies?  Goldman Sachs, among other large Wall Street firms, appears to be running a legal bookie operation, catering to clients who wanted to place large bets on the outcome of certain financial events.  You’ve heard the expression, if it walks like a duck and talks like a duck… The real question: was the game rigged?  We’ll have to wait and see.

Last month, in a post about Greed and Delusion on Wall Street, I said

It’s difficult to appreciate the amount of backstabbing, mistrust and cynicism that is endemic at Wall Street firms. “Wall Street doesn’t care what it sells.” Investment banks exploited their institutional customers (pension funds, mutual funds, banks). The same firm that is advising them on what to invest in (the sell side) also has an in-house operation that is trading for its own account. Why is this blatant conflict of interest allowed?

Incredibly, I may have actually understated the problem!  It seems to me that it is patently impossible to be cynical enough, at least about some Wall Street firms.

Why do I say that?  Well, the suit filed by the SEC alleges that Goldman Sachs put together a package of derivatives based on subprime mortgages and did not disclose that the components were selected by the party who wanted to bet against the investment, i.e. sell short.  The claim is that the security was “designed to fail.”  Please take note of the word “alleged,” meaning that they may or may not have done something illegal.  Because it’s a civil lawsuit which may take years to adjudicate, Goldman Sachs will have ample opportunity to present its side of the story.  I have complete confidence that they will hire the best lawyers that megabucks can buy.

Even if Goldman Sachs “wins” that lawsuit, they may have lost something infinitely more valuable – their reputation.  To my mind, this is no small thing, since confidence in your advisor is (or should be) of paramount importance to investment bankers, including Goldman Sachs.  I am compelled to ask one more question, though, did these bankers aim to protect investors’ interests or were they just determined to make a profit at all costs? 

What Is the Public Value of Trading in Synthetic Securities?

But as investors and citizens, it is worth pondering whether all of this trading activity has a social purpose or is it merely gambling in a more refined form.  The topic of synthetic financial derivatives is highly complex and difficult for most ordinary mortals to understand.  But Roger Lowenstein’s column, Gambling With the Economy in the April 20^th edition of The New York Times, offers an excellent summary of the arguments:

Wall Street’s purpose, you will recall, is to raise money for industry: to finance steel mills and technology companies and, yes, even mortgages. But the collateralized debt obligations involved in the Goldman trades, like billions of dollars of similar trades sponsored by most every Wall Street firm, raised nothing for nobody. In essence, they were simply a side bet — like those in a casino — that allowed speculators to increase society’s mortgage wager without financing a single house.

The mortgage investment that is the focus of the S.E.C.’s civil lawsuit against Goldman, Abacus 2007-AC1, didn’t contain any actual mortgage bonds. Rather, it was made up of credit default swaps that “referenced” such bonds. Thus the investors weren’t truly “investing” — they were gambling on the success or failure of the bonds that actually did own mortgages. Some parties bet that the mortgage bonds would pay off; others (notably the hedge fund manager John Paulson) bet that they would fail. But no actual bonds — and no actual mortgages — were created or owned by the parties involved.

The S.E.C. suit charges that the bonds referenced in Goldman’s Abacus deal were hand-picked (by Mr. Paulson) to fail. Goldman says that Abacus merely allowed Mr. Paulson to bet one way and investors to bet the other. But either way, is this the proper function of Wall Street? Is this the sort of activity we want within regulated (and implicitly Federal Reserve-protected) banks like Goldman?

While such investments added nothing of value to the mortgage industry, they weren’t harmless. They were one reason the housing bust turned out to be more destructive than anyone predicted. Initially, remember, the Federal Reserve chairman, Ben Bernanke, and others insisted that the damage would be confined largely to subprime loans, which made up only a small part of the mortgage market. But credit default swaps greatly multiplied the subprime bet. In some cases, a single mortgage bond was referenced in dozens of synthetic securities. The net effect: investments like Abacus raised society’s risk for no productive gain.

Conclusion

I find Lowenstein’s points very convincing, and I totally agree with his recommendations.
“ …the financial bailout has demonstrated that big Wall Street banks … (have) implicit bailout protection. Protected entities should not be using (potentially) public capital to run non-productive gambling tables.
… Congress should take up the question of whether parties with no stake in the underlying instrument should be allowed to buy or sell credit default swaps. If it doesn’t ban the practice, it should at least mandate that regulators set stiff capital requirements on swaps for such parties so that they will not overleverage themselves again to society’s detriment. …”

Proposed reforms by the Obama administration will hopefully rein in the questionable activities of Wall Street bankers, although, Wall Street lobbyists will naturally attempt to defeat any such reform. As I said previously, we’ll have to wait and see, but nearly a week later, no further charges from the SEC have been forthcoming. Of note, however, several European countries have commenced the filing of similar charges against Goldman Sachs.

Apollo 13

“Houston, we have a problem” is one of the great understatements (and oft quoted lines) in movie dialogue. Those words set the stage for the amazing drama of the Apollo 13 moon exploration mission, which took place exactly 40 years ago this month. The great 1995 movie is based on the book, “Lost Moon,” which was co-authored by one of the Apollo 13 astronauts, Jim Lovell, who is played by the ever talented (and understated) Tom Hanks.

No early space mission was ever routine, certainly not in 1970. The astronauts learned their jobs through extensive and thorough training, including hours upon hours of practice in space simulators, reliance on checklists, and their previous experience as (primarily) test pilots. Even so, problems were not unusual.

But the Apollo 13 mission suffered not an ordinary problem but a catastrophic explosion in space, resulting in loss of oxygen, power and a fully functioning guidance system. The 3-man crew faced the possibility of freezing to death, suffocating and being poisoned by their own carbon dioxide exhalation. And that was before they had to manually calculate (on a slide rule, no less) and maneuver their craft into position so that they could get back to earth and land safely, without being incinerated as they passed through the earth’s atmosphere in a module that was damaged to an unknown extent.

At one point, the NASA Flight Director, Gene Kranz, as played by Ed Harris, grandly states that, ”failure is not an option.”  In truth, success was highly improbable.

The movie simultaneously covers NASA’s Mission Control’s race to save the astronauts, what was going on inside Apollo 13, and how the families of the astronauts coped, as the rest of the world watched the events unfold on live television. It is an exhilarating story of calm courage, professionalism, teamwork, perseverance, and ingenuity.

I highly recommend Apollo 13, because it is so realistic, wonderfully acted and tells a gripping story so well. For me, it also doesn’t hurt that it yields a strong dose of optimism about American know-how. Available in DVD, Apollo 13 is skillfully directed by Ron Howard, and has an excellent ensemble cast including Bill Paxton, Kevin Bacon, Gary Sinise and Kathleen Quinlan.