Goldman Sachs – “the other side” told persuasively

“Goldman Sachs” is not a term of endearment at my favorite websites, such as Front Porch Republic. And I have reflected my own ill-ease with such too big to fail concerns in recent weeks, as well as passing along some counter-arguments.

Wall Street Journal columnist Gordon Crovitz today defends Goldman Sachs in his own way: short selling a derivative signals the market that a sector may be ready to collapse. I certainly agree with that – just as short selling a stock signals that a particular stock may be ready to tank.

The most telling point for me in Crovitz’s column – apropos of why the SEC may lose its case against Goldman Sachs rather than why derivatives are good – is simply that once you accept the premises that (1) shorting a derivative is beneficial because it signals the market of a possible sector collapse, and (2) long buyers in these specially created securities knew someone else was selling short, it seems to follow that “it would be hard to prove that it mattered who [the short seller] was.” That John Paulson was selling short and that Goldman Sachs bundled the derivative for him seems to be what SEC thinks GS should have disclosed.

All this, of course, ignores John Médaille’s, invocation of Aristotle and Aquina to distinguish natural from unnatural market exchanges, but Distributist economics are, for the time being at least, so far out of the mainstream as to be easily ignored. Considering the repeated failures of mainstream economics, that may be ripe for change.

The Democrats have a bright if peurile idea: “Hey, guys! I’ve got a great idea! Regulation utterly failed to prevent the economic collapse, and voters are mad at Wall Street, so lets grab this chance to make Washington bigger with even more regulation! Whaddya think, guys?!” (I’m not sure the Republicans have a counter-plan. They’re just in denial that a market could fail.)

Pretending to regulate something as complex as derivatives is destined again to fail, so I would be remiss were I to pass up, before Congress passes “the most sweeping overhaul of the financial regulatory system since the aftermath of the Great Depression,” not to sing another rousing chorus of “if they’re too big to fail, bust ’em up!”

Is it possible better to distill Goldman Sachs than this?

J. Bradford DeLong, an economist at Berkeley, distills the Goldman Sachs allegations so thoroughly that it would be foolish for me to try to excerpt it. This is, maybe, a 5 minute read — if you’ve never cracked an economics textbook in your life.

UPDATE:

Here’s a half-hearted defense of Goldman Sachs, not surprisingly from the Wall Street Journal.

After 18 months of investigation, the best the government can come up with is an allegation that Goldman misled some of the world’s most sophisticated investors about a single 2007 “synthetic” collateralized debt obligation (CDO)? Far from being the smoking gun of the financial crisis, this case looks more like a water pistol.

The column suggests that the SEC overlooked, or is trying in its Complaint to ignore, “the difference between a cash CDO—which contains slices of mortgage-backed securities—and a synthetic CDO containing bets against these securities … The existence of a short bet wasn’t Goldman’s dark secret. It was the very premise of the transaction.”

Did Goldman have an obligation to tell everyone that Mr. Paulson was the one shorting subprime? Goldman insists it is “normal business practice” for a market maker like itself not to disclose the parties to a transaction, and one question is why it would have made any difference. Mr. Paulson has since become famous for this mortgage gamble, from which he made $1 billion. But at the time of the trade he was just another hedge-fund trader, and no long-side investor would have felt this was like betting against Warren Buffett.

Not that there are any innocent widows and orphans in this story. Goldman is being portrayed as Mr. Potter in “It’s a Wonderful Life,” exploiting the good people of Bedford Falls. But a more appropriate movie analogy is “Alien vs. Predator,” with Goldman serving as the referee. Mr. Paulson bet against German bank IKB and America’s ACA, neither of which fell off a turnip truck at the corner of Wall and Broad Streets.

Goldman Sachs

I feel sorry for some of the people – astonishingly few – who realized what a house of cards we were living in financially two years ago and who put their money where their mouth was by short-selling.

Why should I feel sorry for them? Because they called it exactly right, but lost money anyway because the government bailed out some of the companies they were shorting.

Not so John A. Paulson. Although the New York Times re-tells his story today – under a headline that sounds like a lament (Investor Who Made Billions Not Targeted in Suit) – he got exactly what he deserved: richly rewarded for an audacious big-time bet that was spot on accurate. (It was more complicated than regular short-selling, but the concept was the same: he foresaw the collapse of collateralized debt obligations in mortgages and sought a way to profit if he was correct.)

Why should anyone think for a minute that he would be targeted in a lawsuit?

Has it come to that? Anyone who gets rich gets sued by some ambitious prosecutor playing to the rubes in the peanut gallery?

Yeah, in New York state it did come to that under the corrupt Eliot Spitzer, whose disgrace from whoring around is fading waaay too fast. Before he was governor, he was Attorney General, and made his political fortune filing extortionate suits against people who had committed no recognized crime but had made out well enough to incite envy – or to be susceptible of inciting populist envy if Spitzer played it right. This, for just one instance (suscription may be required).

Kudos to prosecutors who targeted double-dealing Goldman Sachs (I’m not prejudging the criminality of this particular case – though it seem likely to me) and left Paulson alone. May their tribe increase.

UPDATE:

It’s worse than I thought for Goldman. Here:

Among other things, the commission alleges that, starting in early 2007, Fabrice Tourre, a vice president working in Goldman’s New York headquarters at the time, structured and marketed Abacus 2007-AC1 — a syntheticcollateralized debt obligation tied to the performance of a bunch of residential mortgage-backed securities. The problem was that he did this without telling Abacus investors that John Paulson, a prominent hedge fund manager who made billions of dollars by famously betting against the mortgage market, had selected the mortgage-securities that went into Abacus specifically because they were so lousy.

And then, the S.E.C. alleges, Paulson bet against Abacus and made $1 billion, while the investors — among them, ABN Amro and IKB, two big European banks — lost $1 billion when the real-estate market collapsed.

So Goldman helped Paulson package bad mortgage-backed securities so that when the unwitting bought them, Paulson could borrow them and short them? I think so. And then Goldman sold them to the unwitting without mentioning that “this package was specifically bundled to be especially crappy”? So says the complaint! And here:

A number of journalists and commentators (yours truly included) have taken issue with the fact that some dealers (most notably Goldman and DeutscheBank) had programs of heavily subprime synthetic collateralized debt obligations which they used to take short positions. Needless to say, the firms have been presumed to have designed these CDOs so that their short would pay off, meaning that they designed the CDOs to fail. The reason this is problematic is that most investors would assume that a dealer selling a product it had underwritten was acting as a middleman, intermediating between the views of short and long investors. Having the firm act to design the deal to serve its own interests doesn’t pass the smell test (one benchmark: Bear Stearns refused to sell synthetic CDOs on behalf of John Paulson, who similarly wanted to use them to establish a short position. How often does trading oriented firm turn down a potentially profitable trade because they don’t like the ethics?)

Yet the author of that block quote continues:

Strange as it may seem, structured credit-related litigation is a new area of law, with few precedents. Until the credit crisis, unhappy investors seldom sued dealers and other key transaction participants.

This may be why the commission is pursuing this as a civil case rather than criminal. What Goldman did was not clearly a crime.

But it sure smell bad.