Goldman’s Response

I find Goldman’s response to Friday’s nuclear attack from the SEC instructive because it reveals just how out of touch those of us who work in the financial industry are with the average person and the politicians on both sides of the aisle now trying to court their visceral anger.  Essentially Goldman’s defense will be “this is our business and everyone in it knew what they were getting into.”  It recalls Hyman Roth’s line in The Godfather II, “So when he turned up dead, I let it go. And I said to myself, this is the business we’ve chosen; I didn’t ask who gave the order, because it had nothing to do with business!”

To which I can see the Obama administration replying “Exactly, and your way of doing business stinks.’

Whatever the lawyers at the Enforcement Division think of the merits of their case, every press release like this one makes it more and more likely that Goldman, and the rest of us, will have to drastically change our attitudes.  The game has changed and I fear the people who  matter in the financial industry continue to have their heads in the sand.

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19 Responses to “Goldman’s Response”

  1. David Fitzgerald Says:

    http://www2.goldmansachs.com/our-firm/press/press-releases/current/sec-response.html

    Sorry, I always forget you can’t link to the WSJ. Find the press release on Goldman’s website linked above.

  2. Jim Walsh Says:

    They “continue to have their heads in the sand.”

    Or somewhere.

  3. David Fitzgerald Says:

    What is staggering is they do not deny the basic factual allegation, which is that they underwrote the “long” side of the deal at the behest of a client who wanted the “short” side. Setting aside the legal arguments over whether Goldman had a duty to disclose the conflict or whether the existence of the conflict is a material fact (the elments on which the legal proceedings will hinge), Goldman’s basic defense rests squarely on the synthetic nature of the security being offered and the sophistication of the buyers. It ignores a fundamental ethical principal which is, or at least should be, at the heart of investment banking, namely that a broker dealer should not be bring to market securities which it has reason to believe are likely to decline in value.

    Change the facts. If hedge fund client X came to them and said, “We have been studying the performace of private Company Y. Management believes that Company Y is ready to go public. We however think that, although their is nothing wrong with their accounting from a GAAP perspective, their accounting policies overstate revenues and that fact has thrown off their growth projections. Please tell them you will underwrite their IPO so that we can begin to put shorts in place. Obviously you’ll take the spread on the IPO and will earn substantial commissions from us because we will place all our short orders with you.”

    I cannot imagine Goldman (or any other firm) would agree to the underwriting mandate in those circumsatnces, at least I hope not. The only difference between this scenario and the ABACUS deal currently under scrutiny by the SEC is the nature of the “long” investors. While that is not irrelevant it also should not be ethically dispositive.

    It is the “straining out of the gnat and swallowing a camel” syndrome that is destroying this country’s financial industry drip by drip.

  4. George Peacock Says:

    Once again, this is about disclosure (or lack thereof). Without the appropriate disclosure, it’s fraud. The people buying the pool (the “longs”) clearly believed that there was value of some sort and weren’t particularly worried about a housing collapse. Those “longs” lost money — and probably not just in the Goldman deal. Their willingness to buy suggests that they didn’t expect a collapse. They were plain wrong.

    Now, would they have bought if they knew that someone putting together the pool believed that the home market was going to collapse? Quite possibly, since they disagreed with that notion (or wouldn’t have gone long in the first place).

    Would they have bought the pool if they knew that the person putting together the pool was a sophisticated investor who not only believed that the housing market would collapse but was putting into the pool those investments most likely to do the worst if he was directionally right?

    Maybe, but I suspect it would have given them great pause. Even if they believed that they were right about there not being a systemic collapse, no long investor would purposefully buy the worst of the bunch of anything. I think it’s safe to say that they probably were led to believe that the pool represented the best mortgage-backed securities possible.

    But we’ll never know about the marketability of the investment to the buyers under appropriate disclosure because it appears that Goldman (a small or large subset of Goldman, anyway) knowingly lied to them.

    If the allegations are true, this is truly egregious even for the financial services industry. It ranks up there with Madoff in terms of violating the trust of and their fiduciary responsibility to their clients.

  5. Mark Esswein Says:

    “Yes, we stacked the deck. Go ahead, shoot us, but if you do, you’ll never get any of the money back.”

  6. david fitzgerald Says:

    The vast majority of comments here in Gomorrah are in this vein, “Well, the whole point of a synthetic CDO is to put together buyers and sellers of the risk so IBK knew there was someone shorting the pool.” While this is true, it largely misses the point. The challenge the governments of the world are putting to the financial industry is more fundamental and is inherent in Paul Volker’s vision. Institutions large enough to create systemic collapse cannot simply act as neutral brokers between parties, disclosing just enough risk so that a buyer is still willing to buy while avoiding charges of outright fraud, while the “real” value comes simply in perpetuation of the market where banks earn fees on both sides of the trade. No longer can large financial institutions load up the system with risk simply because “the parties knew what they were buying.”. Obviously not because no buyer would continue to bet on a market if he reasonably thought that failure in that market would not only liquidate his particular investment but every other investmant he holds. There really are only two solutions, do not allow any institution to become so big it can create a systemic risk or regulate the positions such institutions may take and the products they can market.

    The industry hates both alternatives, but I don’t see any others.

  7. Mark Grannis Says:

    Maybe I can help, Fitz.

    Another alternative would be to let institutions of any size fail when they take excessive or imprudent risks. Large institutions tend strongly toward stupidity, so their size is a problem that tends to take care of itself — if we let it. Instead of this schizophrenic policy of pretending to watch them like hawks while simultaneously giving them special protections against lawsuits by people whom they swindle, how about if the government just keeps the courts open and makes it easy for people to get redress for actual fraud where it can be proven?

    Other, more government-driven solutions sound good if you assume they will work as designed and will not be corrupted by “industry capture” or other forms of politics as usual. But where is the empirical evidence that those conditions are met for any significant number of government regulatory programs?

    By the way, all my usual misgivings about discussion of live cases as if they were movie plot lines apply here. I don’t know what Goldman Sachs did or did not do, and I don’t have any particular confidence that the SEC does. Certainly I have learned not to take government allegations at face value.

  8. David Fitzgerald Says:

    I think you underestimate just how close we came to the abyss in September 2008. The fact is we have allowed a banking system to proliferate where failures of certain institutions will result in systemic collapse. That situation either needs to be contained or it needs to be run off in an orderly manner. We could solcve the problem of drunks owning cars by simply allowing drunks to die in car wrecks but I don’t care to contemplate the collateral damage.

    Also, I think there is much merit in Paul Krugman’s historical argument that this country did not experience a major banking crisis between 1933 and 1991 when Glass-Steagall was heavily enforced.

    Finally, I can tell you with absolute confidence that the threat of regulatory action does have an interrorem effect on stupid behavior. for example, whatever you think of the Goldman case there is one thing you can be certain of, no bank on the street is consulting the short side of a structured credit regarding the pool of reference securities that will be sold to the long side.

  9. Mark Grannis Says:

    Fitz, I don’t understand what you call “Krugman’s historical argument.” Do you have a link or other reference to it?

    For one thing, the claim that we didn’t experience a major banking crisis between 1933 and 1991 is simply false unless we’re monkeying around with what counts as “major.” I was representing the FDIC and FSLIC in the late 1980s and early 1990s. I helped close banks in California, meeting with depositors and explaining to them which of their deposits were insured and which were from that point forward mere unsecured claims in bankruptcy. It was a very big deal at the time, and people could not believe the amount of money it was going to cost the federal government. You were in college, so you can be forgiven for overlooking it, but what’s Dr. Krugman’s excuse? People who were in banking in the 1970s also seem to think that the Continental Illinois failure in the early 80s was a very big deal. Those are two counterexamples I happen to know about, but I seriously doubt they’re the only ones.

    And what does Krugman have to say about the fact that the poster children for the 2008 collapse weren’t regulated by Glass-Steagall to begin with?

    I don’t doubt that the threat of public enforcement activity affects business behavior; I see that in my business as well. But so does the threat of losing money, and that doesn’t cost the taxpayers anything, nor does it bring with it the danger that government will force someone out of business based on unjustified accusations.

    The free market doesn’t prevent all outcomes that strike us as unjust or unfortunate, but the question is whether regulation is an improvement. I fear most of the argument for increased regulation of the financial services industry skips over this comparative question, content to rest on the “something must be done” argument.

  10. Mark Esswein Says:

    Where the threat of losing money breaks down is in a case like Goldman. They were controlling both the long and short sides and doubled down against their losses.

    Back in the day, if someone set up a card game and told everyone they stacked the deck, no one would play. If they told no one, walked away with the loot and someone figured it out, they might well be tracked down and shot.

    Mark, I think you would say in the modern day, take it to Court. Certainly there will be much litigation to fall out of this mess, but what about the tertiary players? The titans at the top will battle it out in Court, but the middle class folk who lost their nestegg won’t see it help them.

    I don’t argue for increased regulation, I argue for better regulation.

  11. Mark Grannis Says:

    Mark, I’m going to have to whistle you for a foul on the “better regulation” argument. If that’s allowed, then I am also allowed to argue that we can safely repeal all the laws on the books because we’ll just all agree to behave better. Whether it’s private action (in the market or in court) or public action, we’re working with the same crooked timber of humanity. There will be loopholes. They will be found. The clever will take advantage of the credulous. To suppose that we can somehow avoid that merely by aspiring to be “better” is to leave the field of policy debate and enter the world of fantasy.

    I’ve already said I know absolutely nothing about this case and don’t want to comment on what the press and the SEC would like us to assume are the actual facts. I will say, however, that I am increasingly hard pressed to distinguish between the upper echelons of Wall Street and the sports book at Caesar’s Palace. The stock market is supposed to connect people who have extra money with people who have unfunded ideas for putting that money to use. If the capital isn’t actually flowing to some new productive activity, this is just rich guys making bets, and I really couldn’t care less which of them win and which of them lose. I have a little sympathy for your “tertiary players,” Mark — but not as much as I have for the unemployed people whose jobs are never created because of an over-regulatory environment, or even for the taxpayers who have to pay to clean up the mess. The tertiary players were free to gamble with rich guys, or not. They made their choice. The rest of us didn’t get a choice; we just got a bill.

    This New Yorker cartoon is, unfortunately, absolutely and indisputably true.

  12. Mark Esswein Says:

    “The stock market is supposed to connect people who have extra money with people who have unfunded ideas for putting that money to use. If the capital isn’t actually flowing to some new productive activity, this is just rich guys making bets, and I really couldn’t care less which of them win and which of them lose.”

    Exactly, except that the latter part seems to be the norm and that a good deal of the stake comes from the poor schmuck whose retirement is invested at the casino. Note the passive.

    On better regulation, I misspoke. What I really meant was more agile. “Hah! Agile government!” you say, but I don’t think it really has to be that way. More thoughts on that thread to come…

  13. David Fitzgerald Says:

    Paul Volcker’s principal seems reasonable to me:

    Deposit taking instiututions (including insurance companies) that benefit from public insurance plans may not engage in speculative trading other than to facilitate client transactions. These firms have an artificially low cost of capital that inflates trading results and provides a “cookie jar” for them to raid in order to pump up results. An added benefit is that it keeps traders out of the board rooms of systemically important institutions. That’s the real disaster.

  14. David Fitzgerald Says:

    You know, he kinda looks like Grannis. At a minimum they shop in the same stores. has anyone ever seen them in a room together?

    http://www.nytimes.com/2010/04/27/opinion/27brooks.html?hp

  15. Mark Grannis Says:

    And here’s yet more wisdom on the subject from a man who wears bow-ties:

    http://www.washingtonpost.com/wp-dyn/content/article/2010/04/22/AR2010042204208.html

  16. David Fitzgerald Says:

    While in principal I would applaud anything that sobers up senior management, this solution does have a dirty downside that will need to be managed.

    His Brazil reference is apt for me as I am about to sign up a deal there this very morning. While it is true that officers of financial institutions have personal liability for their stewardship, the net effect is to drive tremendous amounts of wealth offshore.

    It also fails to deal with the fact that risk, even excessive risk, isn’t necessarily a bad thing While things were quite nice in 1908 I am sure, the capital markets and, by extension, the ability to finance wealth creation, were constrained in both size and extent. Few people could employ lreasonablel everage (that is not an oxymoron, despite what people in bow ties seem to think) to obtain a middle class lifetsyle. It also fails to address the historical fact that pre New Deal financial legislation financial panics were both widespread and frequent and economic recessions were deeper and lasted longer than in more modern times.

    The fatal flaw that the 2008 financial crisis revealed in our regulatory structure was the proliferation of institutions which each, individually, posed a risk to the viability of the fianancial system as a whole (i.e. AIG). The only way to deal with that problem is through sensible, nonpartisan and rational regulation. Not sure we can get that, but don’t we have an obligation to try? Otherwise, what is the point of politics?

    • Mark Grannis Says:

      We only have an obligation to try something if we have good reason to believe that something is better than nothing. Otherwise, we have an obligation to try nothing.

      People who have studied pre-1913 banking crises have made a powerful case that our problems in this country were caused in large part by the unit banking rule, which prohibited or severely restricted the operation of networks of branch banks in different communities. This rule, which prevailed precisely because of the politics you want to try (pressure from the small banking lobby so that they would not face competition from large out-of-state banks) prevented banks from diversifying their loan portfolios across branches. Thus, a drought or a flood in one community, or a shutdown or major accident at a local factory, would very predictably cause a big problem for a small local bank’s loan portfolio, not to mention a systematic drawdown of deposits. This made bank runs frequent. And when they occurred, the poor little bank was unable to draw on reserves from its operations in distant towns that might have been unaffected, because it wasn’t allowed to have any operations in distant towns that might have been unaffected. Canada, which did not have the unit banking rule but was otherwise comparable in everything but size (and in particular, had no central bank), had almost none of the banking panics that characterized the U.S. in the second half of the 19th century.

  17. George Peacock Says:

    I pretty much agree with Mark throughout. I am sure that most people proposing one regulation or another that it would work as intended and was “better.” There are often significant unintended consequences, however, and there is always a clever, self-interested mass able to work around regulation in unseen and sometimes perilous ways.

    I don’t know where to begin with the idea of an “agile” government, so I’ll leave that alone.

    I would like to prevent anything from being “too big to fail.” But my brain tells me, rather, to make it very very clear that we will let things fail (and have systems in place to allow an orderly cleanup) and then all the players will have to adjust, distrust, and monitor their counterparties to avoid being caught in a contagion. Let knowing people police themselves or be pulled down by failure. Further, in addition to being ousted for failure, management ought to suffer significant fines, including even a clawback of all compensation received for the last, what, 3-5 years. There would be some mighty careful steppin’ going on. Compensation incents and fear prevents.

    People took risk because the upside could be made manifest in the short term even if the long term was possible failure of the entire enterprise.

    If I were to point to one thing that allowed this to happen I would say it was the complacency of the bondholders. They didn’t provide their usual market signal and due diligence. Why? There may be many reasons but I suspect the main culprit is that they weren’t worried about their investments. They should live in fear; it’s the market mechanism that keeps the market in check.

    Look at how spreads have reacted in Greece as things appear to be more or less hopeful. It wasn’t the credit agencies or any government regulators or Councils that ratted out Greece, it was the bondholders.

    Finally, he rambled, Mark makes a very good point about Canadian and American banks, especially the point about how political and presumably well-intended regulation often leads to bad outcomes. The irony is that though regulation led to the bank crises of old, all we remember is a failure of the banks — a market failure. Regulation escapes largely unscathed. Tie the hands of the market and then blame it for a failure. Again, why is that?

  18. David Fitzgerald Says:

    A bit confused with how to deal with your comments, George, so I’ll start with the bondholders.

    I believe the source of the “complacency” you site was, unlike the situation in Greece, that it was not bank liabilities that were called into question in the fall of 2008 but bank assets. Bondholders tend to get nervous first when they see more and more people with a claim on the pie. It takes a little more prescience to see that the pie itself is shrinking or rotten. The situation then was exacerbated by two factors: (1) supposedly independent rating agencies (largely unregulated) had passed on the quality of the assets being held by the banks and (2) banks had hedged their exposure to fluctuations in the value of those assets by buying insurance, principally through AIG, whose regulated insurance subsidiaries (who, even now, are quite profitable and well capitalized, thank you) provided their finance subsidiary with a AAA rating and a rotten license to print money in the form of worthless credit protection.

    I suppose one could argue, and no doubt you would, that any fool who relies on a third party to evaluate the quality of their investments deserves what he gets and doesn’t need regulation to protect them. Of course that argument proves too much in that we all rely on precisely that to one degree or another in almost every investment we make. if we did not there would be no need for house inspectors, real estate appraisers, financial planners (there’s always your stand up act, George) and even Consumer Reports would be out of business.

    You could I suppose further argue that it is one thing for Joe Six Pack to rely on such help but that one should expect more from highly sophisticated financial institutions with regard to their proprietary investments. Alas, would that it were so. But, even if it were so, there would be only one way to stop the financial institutions from “outsourcing” some of this due diligence and that would be to put in place a regulatory regime to stop it. It is not as if the government mandated the ratings industry. The rating agencies were a creation of the market, sought out by investors and used by the banks to sell more and more product, more and more efficiently. The market loved the rating agencies, judging purely by their profitability. Was that not a “market failure?”

    Further, your “creative destruction” argument presupposes a condition, “systems…to allow an orderly clean up”. That sure sounds like a euphemism for regulation to me, unless one imagines that bankruptcy and work out regimes spring ex nihilo from the market. Isn’t such a regulatory regime, modeled after the highly successful FDIC, what is precisely at the heart of the current financial reform bill? It seems we are no longer arguing about whether we should have regulation but about what regulation we shall have. That to my mind is a far more sensible and necessary argument.


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