19 April 2010

Awaiting Our Pecora Moment (II)

My friend Marshall Auerback (bio) wrote this stunning synopsis of the nefatious motivations of Goldman Sachs (and others) which adds to Simon Johnson's discussion of the SEC's recent allegation of fraud by Goldman Sachs (which I posted yesterday).  

Chuck Spinney

Goldman Sachs' Motivations
Marshall Auerback

Whether what they did was "legal" or not is a side issue.  The whole purpose of the deregulation of the last 25 years was to make what was once illegal, legal.  Read JK Galbraith on the Great Depression; you'll appreciate the historical echoes here.  Before 1999, Goldman (like the other investment banks) was a partnership—run by future Treasury Secretary Hank Paulson. The trouble with that arrangement is that it is impossible to directly benefit from a run-up of the stock market. Sure, Goldman could earn fees by arranging initial public offerings for Pets-Dot-Com start-ups, and it could trade stocks for others or for its own account. This did offer the opportunity to exploit inside information, or to monkey around with the timing of trades, or to push the dogs onto clients. But in the euphoric irrational exuberance of the late 1990s that looked like chump change. How could Goldman's management get a bigger share of the action?

Flashback to the 1929 stock market boom, when Goldman faced the same dilemma. Since the famous firms like Goldman Sachs were partnerships, they did not issue stock; hence they put together investment trusts that would purport to hold valuable equities in other firms (often in other affiliates, which sometimes held no stocks other than those in Wall Street trusts) and then sell shares in these trusts to a gullible public. Effectively, trusts were an early form of mutual fund, with the "mother" investment house investing a small amount of capital in their offspring, highly leveraged using other people's money. Goldman and others would then whip up a speculative fever in shares, reaping capital gains through the magic of leverage. However, trust investments amounted to little more than pyramid schemes—there was very little in the way of real production or income associated with all this trading in paper. Indeed, the "real" economy was already long past its peak—there were no "fundamentals" to drive the Wall Street boom. It was just a Charles Ponzi-Bernie Madoff scam. Inevitably, Goldman's gambit collapsed and a "debt deflation" began as everyone tried to sell out of their positions in stocks—causing prices to collapse. Spending on the "real economy" suffered and we were off to the Great Depression. Sound familiar?

So in 1999 Goldman and the other partnerships went public to enjoy the advantages of stock issue in a boom. Top management was rewarded with stocks—leading to the same pump-and-dump incentives that drove the 1929 boom. To be sure, traders like Robert Rubin (another Treasury secretary) had already come to dominate firms like Goldman. Traders necessarily take a short view—you are only as good as your last trade. More importantly, traders take a zero-sum view of deals: there will be a winner and a loser, with Goldman pocketing fees for bringing the two sides together. Better yet, Goldman would take one of the two sides—the winning side, of course--and pocket the fees and collect the winnings. You might wonder why anyone would voluntarily become Goldman's client, knowing that the deal was ultimately zero-sum and that Goldman would have the winning hand? No doubt there were some clients with an outsized view of their own competence or luck; but most customers were wrongly swayed by Goldman's reputation that was being exploited by hired management. The purpose of a good reputation is to exploit it.

The most famous shorter of MBSs is John Paulson, who approached Goldman to see if the firm could create some toxic synthetic CDOs that he could bet against. Of course, that would require that Goldman could find chump clients willing to buy junk CDOs—a task for which Goldman was well-placed. According to the SEC, Goldman allowed Paulson to increase the probability of success by allowing him to suggest particularly trashy securities to include in the CDOs. Goldman arranged 25 such deals, named Abacus, totaling about $11 billion. Out of 500 CDOs analyzed by UBS, only two did worse than Goldman's Abacus. Just how toxic were these CDOs? Only 5 months after creating one of these Abacus CDOs, the ratings of 84% of the underlying mortgages had been downgraded. By betting against them, Goldman and Paulson won—Paulson pocketed $1 billion on the Abacus deals; he made a total of $5.7 billion shorting mortgage-based instruments in a span of two years. This is not genius work—84% to 96% of CDOs that are designed to fail will fail.

Paulson has not been accused of fraud—while he is accused of helping to select the toxic waste, he has not been accused of misleading investors in the CDOs he bet against. Goldman, on the other hand, never told investors that the firm was creating these CDOs specifically to meet the demands of Paulson for an instrument to allow him to bet them. The truly surprising thing is that Goldman's patsies actually met with Paulson as the deals were assembled—but Goldman never informed them that Paulson was the shorter of the CDOs they were buying! The contempt that Goldman shows for clients truly knows no bounds. Goldman's defense so far amounts to little more than the argument that a) these were big boys; and b) Goldman also lost money on the deals because it held a lot of the Abacus CDOs. In other words, Goldman is not only dishonest, but it is also incompetent. If that is not exploitation of reputation by Goldman's management, I do not know what would qualify.