The Goldman Sachs Scandal

On April 16, 2010, the Securities Exchange Commission filed fraud charges against the investment firm, Goldman Sachs. The charges caused no small amount of comment. Now, the volume of that comment has been amped up by the revelation of a few corporate emails by high-level Goldman employees, gloating about the ensuing decline of the housing market and the money they stood to make therefrom.

The gist of the negative commentary is how wrong (If not, maybe illegal?) it is to take pleasure in financial failure.

Okay, let me say, at this point that, if the fraud indictment proves to be factually true, then Goldman and the executives involved need to suffer serious consequences. In the case of the executives, that should include a lengthy all-expenses-paid sojourn in the "Graybar Hotel."

Having said that, let me iterate as strongly as I can, there is nothing wrong-and certainly nothing illegal-about being delighted with the failure of an asset to perform as others expected it to.

Even something as rudimentary as the options exchange works that way at its most conservative. For example, if you owned 100 shares of Microsoft, you could collect a premium to give the party who paid you that premium the option to buy your 100 shares at a fixed price, over a pre-determined duration. Generally speaking, the closer the "strike price" is to the current price and the longer the term of the option, the higher premium you'll collect.

If your shares of Microsoft are going for $29.50 at the time you sell your call, and you offer it at a fixed price of $45 over the next 60 days, your premium will be very small. If, on the other hand, you offer it at a price of $30 over 360 days, your premium will be quite hefty. That is because it is likely that the stock will rise enough to more than justify the premium. If that happens, your stock will be "called" away from you at the agreed-upon price, no matter how much higher it may have risen. Not only will you get less for the stock, you will have no further opportunities to collect more premiums off of it.

If such a thing might happen to your Microsoft stock, what do you, the seller of the call option want? Do you want the price of the stock to skyrocket? Hell no! You want it, at best, to stay the same and will not be too upset if it drops a bit. Is that sinful? Is it even unethical? Of course not.

For that matter, when you sell a given stock itself, you do so because you believe you have obtained the best possible price for the foreseeable future. If the stock you sold goes on to triple in price, how happy are you for the anonymous buyer-I mean, honestly?

We are even allowed to "short" stocks, which means we are proactively betting on them to go down in value. The way that works, using our same example, is that you "sell" 100 shares of Microsoft that you do NOT own and get the proceeds in cash. At some point, not necessarily of your choosing, if things go badly, you will have to buy back those 100 shares at the current market price. If the Microsoft stock went down from the time you got your sale proceeds, you will buy it back for less and make a profit. It the stock went up since then, you lose. That being the case, you are certainly happy to see the price of Microsoft fall, but you have committed no crime, by any stretch of the imagination.

Now, let us return to the Goldman Sachs matter. If all they did was to indulge in fair speculation about an asset's decline in value, then they should be entitled to gloat a little. Who doesn't like to make money? But that was far, far, far from what they did in the case involved in the indictment.

The case itself is, like most legal matters of high finance, very complex, but, basically, here is what appears to have happened. Goldman agreed to sell a package of mortgages, technically referred to as "ABACUS2007AC-1." That's fine. Such assets are sold all the time, these days. The really malodorous part is that these mortgages were hand-picked by John Paulson of the Paulson & Co. Hedge Fund as the most likely to fail, particularly in the event of a severe downturn in housing prices. Paulson deliberately went after mortgagors (borrowers) who were in over their heads, in the most speculative Real Estate markets.

Then he arranged for Goldman to get a fee of approximately 15 million dollars to market the ABACUS package to its investors as top-grade investment material. In effect, Goldman was telling its buyers that a grade ZZZ investment was actually grade AAA. Once Paulson got his desired asset to market, he naturally shorted it and made a pile at the huge expense of the investors who bought it.

Somehow, someone got the major investment rating agencies, such as Moody's and S&P, to go along with the farce and give the vehicle top ratings as well. That is another entire kettle of fish, but, if I were a member of the administration, I would send the word down that, unless those agencies come through with some VERY high-level terminations, with prejudice (i.e., no golden parachute), they will have the government on their backs like never before.

Of course, Goldman-Sachs is hotly denying the charges. At best they will admit the ABACUS package turned out to be an unwise investment that was entirely the brain-child of a 31-year-old employee named Fabrice Tourre. That strongly reminds me of the amusing fiction that the whole Iran-Contra scandal of the 1980s was completely masterminded by Lieutenant Colonel Oliver North. Let me say that again: Lieutenant Colonel Oliver North. Do you know how many people there are, military and civilian, who outrank a lieutenant colonel? Probably enough to populate a major U.S. city...um...like The Pentagon?

The point is, Goldman knew perfectly good and well what the young executive they singled out was doing. How could they not have known about a deal of that size? Of course, all the details will have to be sorted out as the SEC indictment proceeds.

You may wonder how it is that a ruinous deal, put together in 2007, is only now coming under indictment. Well, for one thing, all the best and wisest regulation in the world will do us no good if we have people in charge who are actively hostile to it, as were the Bush administration agency heads, and not just at the SEC.

For another thing, we have recently found out that a considerable number of SEC employees were too busy downloading pornography on the job to pay any attention whatsoever to what they were supposed to be doing. This is just staggering. We give federal employees a certain amount of job protection to shield them from the vicissitudes of partisan politics, not to enable them to DOWNLOAD PORN with impunity.

But that, too, is a story for another day.

Sources

Los Angeles Times

Huffington Post

Face the Nation, CBS

Wikipedia