[THS] Spitzer/Black: Questions from the Goldman Scandal

[The Harder Stuff in news and commentary]

http://www.nakedcapitalism.com/2010/04/spitzerblack-questions-from-the-goldman-scandal.html

Monday, April 26, 2010
Spitzer/Black: Questions from the Goldman Scandal

By Eliot Spitzer and Bill Black, cross posted from New Deal 2.0:

For those who have spent years investigating fraud, it was no surprise to hear that
Goldman Sachs, the (self-described) jewel of Wall Street, is the latest firm to emerge
from the financial crisis with tarnished reputation. According to a lawsuit brought by
the Securities and Exchange Commission, Goldman misrepresented to its customers
the quality of the toxic assets underlying a complex financial derivative known as a
“synthetic collateralized debt obligation (CDO).”

As you may now have heard, the story involves a pair of Paulsons. As CEO of
Goldman, Hank Paulson oversaw the buying of large amounts of CDOs backed by
largely fraudulent “liar’s loans.” When he became U.S. Treasury Secretary, he went
on to launch a successful war against securities and banking regulation. Hank
Paulson’s successors at Goldman saw the writing on the wall and began to “short”
CDOs. They realized that they had an unusual, brief window of opportunity to unload
their losers on their customers. Being the very model of a modern investment
banking firm, they thought that blowing up their customers would be fine sport.

John Paulson (unrelated), who controls a large hedge fund, also wanted to short
CDOs and he, too, recognized that there was a narrow window for doing so. The
reason there was a profit opportunity was that the “market” for toxic mortgages only
appeared to be a functioning market. It was, in reality, a massive bubble in which
ratings and “market” prices were grotesquely inflated. The inflated prices were
continuing only because the huge players knew that the prices and races were
fictional and were covering it up through the financial equivalent of “don’t ask; don’t
tell.” According to the SEC complaint:

In January 2007, a Paulson employee explained the company’s view, saying that
“rating agencies, CDO managers and underwriters have all the incentives to keep the
game going, while ‘real money’ investors have neither the analytical tools nor the
institutional framework to take action.”

We know from Bankruptcy Examiner Valukas’ report on Lehman that the Federal
Reserve knew that the “market” prices were delusional and refused to require entities
like Lehman to recognize their losses on “liar’s loans” for fear that it would expose the
cover up of the losses. Valukas reports that Geithner explained to him when
interviewed (p. 1502) that:

    The challenge for the Government, and for troubled firms like Lehman, was to
reduce risk exposure, and the act of reducing risk by selling assets could result in
“collateral damage” by demonstrating weakness and exposing “air” in the marks.

Goldman and John Paulson worked together. One of the key things to understand
about shorting is that it is extremely valuable if other major players short similar
targets at the same time. By helping Paulson take advantage of Goldman’s customers
(the ones that lacked “the analytical tools” to avoid being hosed), Goldman not only
earned a substantial fee, but also aided its overall strategy of shorting the toxic
paper.

Goldman created a deal in which John Paulson played a major role in selecting the
toxic paper that would underlie the investment. He picked assets “most likely to fail –
quickly” and studies show that he was particularly good at picking the losers. At this
juncture, there is some dispute as to whether ACA was complicit with John Paulson
and Goldman in picking losers (ACA initially invested in the synthetic CDO, but then
transferred the risk of loss to German and English taxpayers).

What isn’t in dispute is that Goldman, ACA, and Paulson all failed to disclose to
purchasers of the synthetic CDO that it was designed to be most likely to fail. The
representation was the opposite: that the assets were picked by an independent
entity with their interests at heart (ACA). Goldman claims it’s a victim because while it
intended to sell its entire position in the synthetic CDO to its customers, it was unable
to sell a chunk. One feels the firm’s pain. Goldman tried to blow up its customers to
the tune of over $1 billion, but were unable to sell them the last $90 million in
exposure.

The Goldman scandal raises several important questions: Did John Paulson and ACA
know that Goldman was making these false disclosures to the CDO purchasers? Did
they “aid and abet” what the SEC alleges was Goldman’s fraud? Why have there
been no criminal charges? Why did the SEC only name a relatively low-level Goldman
officer in its complaint? Where are the prosecutors?

In a December New York Times op ed, we, along with Frank Partnoy, asked for the
public disclosure of AIG emails and key documents so that we can investigate the
deceptive practices exposed by the Goldman case. Goldman used AIG to provide the
CDS on most of these synthetic CDO deals (though not the particular one that is the
subject of the SEC complaint), and Hank Paulson used tax payer money to secretly
bail out Goldman when AIG’s deceptive practices drove it to failure.

The SEC’s Goldman fraud complaint points to fundamental problem in the financial
sector that has been at the root of the financial crisis — one that still exists today. The
market is not transparent. It has been fraudulently manipulated to enrich managers.
Investors lack clear information to make decisions about what they are buying. A
continuing absence of real consumer protections makes people like those trying to
obtain mortgages before the crash understand that they were, in many cases, being
ripped off.

According to internal Goldman Sachs e-mails, the company vice president, 31-year
old Fabrice Tourre, did not really understand the complex deals he was making. And
yet we note that many of these Goldman-style deals were “insured” by AIG. Without
transparency, regulators cannot properly see all these kinds of deals in the
aggregate. So they can neither stop the fraud nor prevent catastrophic results.

We applaud the SEC lawsuit, but it will not solve the problem. Unless our financial
system is reformed to put adequate protections and checks and balances in place,
we can expect this kind of fraud to continue. Financial executives will continue to take
risks they do not understand. Those who control the flow of capital will continue to
churn out profits with socially disastrous consequences.
More on this topic (What's this?)
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Goldman Sachs in Disastrous Position; Rampant Fraud on Wall St. (Shocked Investor,
4/16/10)
Testimony contradicts SEC’s Goldman charge (Investment Postcards from Cape
Town, 4/22/10)