We have no idea whether Goldman Sachs did anything illegal or not. We suspect that these charges will fade away once their political usefulness has evaporated. They will pay a meaningful fine "without admitting or denying any wrongdoing" as is the common practice in these situations.
The politics behind the case, if any, remain inscrutable, but conspiracy aficionados are pointing to the odd timing at a critical juncture in the financial regulations debate and the first-time-ever, 100-percent partisan split vote by the SEC board to bring the case forward. A few days after the unrepentant Goldman executives calmly displayed their extraordinary IQs in the face of numerous profanity-laced senatorial tirades, rumors of criminal charges were leaked to the press. The unfortunate timing put a dent in the government's claim of independence from political expediency.
At this point what happens in federal court is secondary. The real action is in the court of public opinion where Goldman, a long-time supporter of the Obama administration and a serial source of Treasury secretaries for many administrations, is being tried for "betting against the American economy." More specifically, after years of facilitating government housing policy by securitizing Fannie Mae and Freddie Mac inspired subprime and Alt-A mortgages, Goldman reacted to that market backing up and began to manage its own risk aggressively. So their real crime was betting against the probability that poorly underwritten mortgage loans granted to unqualified borrowers would get repaid on schedule.
Just in case you've recently return from ski trip in Antarctica, the case revolves around a synthetic collateralized debt obligation (CDO Abacus 2007-AC1). The presentation material on Abacus 2007-AC1 contained nine pages of disclosures, disclaimers and risk factors. Goldman constructed this CDO to satisfy the requirements of two groups of investors. One group, Paulson & Co., was looking for a way to short bonds backed by subprime mortgages. The others were looking for increased exposure to the U.S. housing market.
Please note that a synthetic CDO does not actually contain any mortgages or bonds. It only references other mortgage bonds and the returns to investors reflect the performance of those referenced bonds. Think of it as playing fantasy baseball where your team of players does not actually exist. The success of your team depends on the performance of your reference players every day.
The bonds referenced in Abacus 2007-AC1 were all rated AAA by Moody's and S&P and the returns looked attractive for that risk profile. So IKB and ABN AMRO invested. ABN AMRO, a sophisticated Dutch bank, lost $841 million. IKB Deutsche Industriebank, a small regional middle-market lender in Germany, had created a subsidiary called Rhinebridge specifically to invest in U.S. subprime mortgages. They lost $150 million on Abacus 2007-AC1 and much more on other subprime plays. The bank became the subject of a ?5 billion rescue and was the first subprime-related bank failure. On the other side of this side bet, Paulson & Co. made a $1 billion profit.
And, oh yes, Goldman lost a cool $100 million of their own money on Abacus. Then they started hedging aggressively, but it was too late. Total losses for the firm during the crisis were $9.1 billion, all of which was replaced by new equity raised in the private markets before the TARP program existed. Shouldn't we be applauding the fact that Goldman was smart enough to see the emerging risks and take corrective action saving the taxpayers the obligation to breathe life into yet another zombie bank?
Under the moral construct currently in vogue in Congress, if Goldman Sachs is to be castigated as a villain for working to hedge their subprime risk once it became apparent, then what are we to think of Wachovia and Washington Mutual? After all, they lost a combined $107 billion supporting the government's program to expand homeownership for low-income families. To recall the famous admonition of House Financial Services Committee Chairman Barney Frank in September 2003, Wachovia and WaMu were "rolling the dice a little bit more in this situation towards subsidized housing." Should we think of Wachovia and WaMu as heroes for selflessly sacrificing their shareholders and bondholders to support a misguided government policy?
There are a couple conclusions we can take away from these events. First, the good senators working on reforming our financial system are struggling mightily with little apparent success to build some meaningful understanding of that system. Second, if the U.S. government had a risk management function as well developed as Goldman Sachs', they may never have "rolled the dice" in the first place.
According to estimates by former Fannie Chief Credit Officer Edward Pinto, the low-income housing policy drove Fan and Fred to promote the underwriting and acquisition of more than $2.7 trillion in dodgy mortgages. Where would we be today if Fannie and Freddie had rejected the strategy of their congressional overseers as unacceptably risky? Maybe if we could retain John Paulson of Paulson & Co. as an advisor he could give us some guidance on mitigating future systemic risk resulting from massive government intervention in the financial markets.
Finally, if Goldman is the villain for doing the smart thing are we now as a nation on the side of the incompetent — the losers?
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