Randall Wray, GOLDMAN SACHS VAMPIRE SQUID GETS HANDCUFFED, KC economics blog, SATURDAY, APRIL 17, 2010, http://neweconomicperspectives.blogspot.com/
In
a startling turn of events, the SEC announced a civil fraud
lawsuit
against Goldman Sachs. I use the word startling because a) the
SEC
has done virtually nothing in the way of enforcement for
years, managing to
sleep through every bubble and bust in recent
memory, and b) Government
Sachs has been presumed to be above the
law since it took over Washington
during the Clinton years. Of
course, there is nothing startling about bad
behavior at Goldman -
that is its business model. The only thing that
separates Goldman
on that score from all other Wall Street financial
institutions is
its audacity to claim that it channels God as it screws
its
customers. But when the government is your handmaiden, why not
be audacious?
The details of the SEC's case will be familiar to
anyone who
knows about Magnetar.
This hedge fund sought
the very worst subprime
mortgage backed securities (MBS) to
package as collateralized debt
obligations (CDO). The firm nearly
single-handedly kept the subprime market
afloat after investors
started to worry about Liar and NINJA loans, since
Magnetar was
offering to take the very worst tranches - making it possible to
sell
the higher-rated tranches to other more skittish buyers. And
Magnetar
was quite good at identifying trash: According to an
analysis commissioned
by ProPublica, 96% of the CDO deals arranged
by Magnetar were in default by
the end of 2008 (versus "only"
68% of comparable CDOs). The
CDOs were then
sold-on to investors, who ultimately lost big time.
Meanwhile, Magnetar used
credit default swaps (CDS) to bet that
the garbage CDOs they were selling
would go bad.
Actually, that is not a bet. If you can manage to put together
deals
that go bad 96% of the time, betting on bad is as close to a
sure
thing as a financial market will ever find. So, in reality,
it was just pick
pocketing customers - in other words, a
looting.
Well,
Magnetar was a hedge fund, and as they say, the clients of
hedge
funds are "big boys" who are supposed to be sophisticated
and
sufficiently rich that they can afford to lose. Goldman
Sachs, by contrast,
is a 140 year old firm that operates a
revolving door to keep the US
Treasury and the NY Fed well-stocked
with its alumni.
As Matt Taibi has
argued, Goldman has been behind virtually every
financial crisis the US has
experienced since the Civil War. In
John Kenneth Galbraith's "The Great
Crash", a chapter
that documents Goldman's contributions to the Great
Depression is
titled "In Goldman We Trust". As the
instigator of crises,
it
has truly earned its reputation. And it has been publicly
traded since
1999 - an unusual hedge fund, indeed. Furthermore,
Treasury Secretary Geithner
handed it a bank charter to ensure it
would have cheap access to funds
during the financial crisis. This
gave it added respectability and
profitability - one of the chosen
few anointed by government to speculate with
Treasury funds. So,
why did Goldman use its venerable reputation to loot
its
customers?
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.
That is what my colleague, Bill Black, calls control fraud.
Note
that before it went public, only 28% of Goldman's revenues
came
from trading and investing activities. That is now about 80%
of
revenue. While many think of Goldman as a bank, it
is really just a huge
hedge fund, albeit a very special one that
happens to hold a Timmy
Geithner-granted bank charter - giving it
access to the Fed's discount window
and to FDIC insurance.
That, in turn, lets it borrow at near-zero interest
rates. Indeed,
in 2009 it spent only a little over $5 billion to borrow,
versus
$26 billion in interest expenses in 2008 - a $21 billion subsidy
thanks
to Goldman's understudy, Treasury Secretary Geithner. It
was (until Friday)
also widely believed to be "backstopped"
by the government - under no
circumstances would it be allowed to
fail, nor would it be restrained or
prosecuted - keeping its stock
price up. That is now somewhat in doubt,
causing prices to
plummet. Of course, the
FDIC subsidy is only a small part
of the funding provided by
government
- we also need to include the $12.9
billion it got from the AIG
bail-out, and a government guarantee of $30
billion of its debt.
Oh, and Goldman's new $2 billion headquarters in
Manhattan?
Financed by $1.65 billion of tax free Liberty Bonds (interest
savings
of $175 million) plus $66 million of employment and energy
subsidies.
And it helps to have your
people run three successive
administrations,
of course. Unprecedented and unprecedentedly useful if one
needs
to maintain reputation in
order to run a control fraud.
In
the particular case prosecuted by the SEC, Goldman created
synthetic
CDOs that placed bets on toxic waste MBSs. A synthetic CDO does
not
actually hold any mortgage securities - it is simply a pure bet on a
bunch
of MBSs. The purchaser is betting that those MBSs will not
go bad, but there
is an embedded CDS that allows the other side to
bet that the MBSs will fall
in value, in which case the CDS
"insurance" pays off. Note that the
underlying mortgages
do not need to go into default or even fall into
delinquency. To
make sure that those who "short" the CDO (those holding
the
CDS) get paid sooner rather than later, all that is required
is a downgrade
by credit rating agencies. The trick, then, is to
find a bunch of MBSs that
appear to be over-rated and place a bet
they will be downgraded. Synergies
abound! The
propensity of credit raters to give high ratings to junk assets
is
well-known, indeed assured by paying them to do so.
Since the underlying
junk is actually, well, junk, downgrades are
also assured. Betting against
the worst junk you can find is a
good deal - if you can find a sucker to take
the bet.
The
theory behind shorting is that it
lets you hedge risky
assets in your portfolio, and it aids
in price discovery.
The first requires
that you've actually got the asset you are
shorting, the second relies on
the now thoroughly discredited
belief in the efficacy of markets. In truth,
these markets are
highly manipulated by insiders, subject to speculative
fever, and
mostly over-the-counter. That means that initial prices are set
by
sellers. Even in the case of MBSs - that actually have mortgages
as
collateral - buyers usually do not have access to essential
data on the loans
that will provide income flows. Once we get to
tranches of MBSs, to CDOs,
squared and cubed, and on to synthetic
CDOs we have leveraged and layered
those underlying mortgages to a
degree that it
is pure fantasy to believe
that markets can efficiently price
them.
Indeed, that was the reason for
credit ratings, monoline
insurance, and credit default swaps. CDSs that
allow bets on
synthetics that are themselves bets on MBSs held by others
serve
no
social purpose whatsoever
- they are neither hedges nor price
discovery mechanisms.
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.
By the way, remember the AIG bail-out, of which
$12.9 billion
was passed-through to Goldman? AIG provided the CDSs
that allowed Goldman
and Paulson to short Abacus CDOs. So AIG
was also duped, as was Uncle
Sam -
although that "sting" required the help of the New York
Fed's Timmy
Geithner. I would not take Goldman's claim that it
lost money on these deals
too seriously. It must be remembered
that when Hank
Paulson
ran Goldman, it
was bullish on real estate; through 2006 it was
accumulating MBSs and
CDOs - including early Abacus CDOs. It then
slowly dawned on Goldman that it
was horribly exposed to toxic
waste. At that point it started shorting the
market, including the
Abacus CDOs it held and was still creating. Thus,
while it might
be true that Goldman could not completely hedge its positions
so
that it got caught holding junk, that was not for lack of trying to
push
all risks onto its clients. The market crashed before Goldman
found a
sufficient supply of suckers to allow it to short
everything it held. Even
vampire squids get caught holding
garbage.
Some have argued that the SEC's case is weak. It needs to
show
not only that Goldman misled investors, but also that this
was materially
significant in creating their losses. Would they
have forgone the deals if
they had known that Paulson was shorting
their asset? We do not know - the SEC
will have to make the case.
Besides, Goldman does this to all its clients - so
the SEC will
have to make the case that clients could have been misled,
whilst
knowing that Goldman screws all its clients. After all, Goldman
hid
Greece's debt, then bet against the debt - another fairly
certain bet since
debt ratings would fall if the hidden debt was
ever discovered. Goldman took
on US states as clients (including
California and New Jersey and 9 other
states), earning fees for
placing their debts, and then encouraged other
clients to bet
against state debt - using its knowledge of the precariousness
of
state finances to market the instruments that facilitated the shorts.
Did
Goldman do anything illegal? We do not yet know.
Reprehensible? Yes. Normal
business practice.
To be fair,
Goldman is not alone - all of this appears to be
normal business
procedure. In early spring 2010 a court-appointed
investigator
issued his report on the failure of Lehman. Lehman engaged in
a
variety of "actionable" practices (potentially
prosecutable as crimes).
Interestingly, it hid debt using
practices similar to those employed by
Goldman to hide Greek debt.
The investigator also showed how the prices by
Lehman on its
assets were set - and subject to rather arbitrary procedures
that
could result in widely varying values. But most importantly, the
top
management as well as Lehman's accounting firm (Ernst&Young)
signed off on
what the investigator said was "materially
misleading" accounting.
That is a
go-to-jail crime if proven. The question is why would a
top accounting firm
as well as Lehman's CEO, Richard Fuld, risk
prison in the post-Enron era
(similar accounting fraud brought
down Enron's accounting firm, and resulted
in Sarbanes-Oxley
legislation that requires a company's CEO to sign off on
company
accounts)? There are two answers. First, it is possible that fraud
is
so wide-spread that no accounting firm could retain top clients
without
agreeing to overlook it. Second, fraud may be so pervasive
and enforcement
and prosecution thought to be so lax that CEOs and
accounting firms have no
fear. I think that both
answers are correct.
To
determine whether Goldman and other firms engaged in fraud
will
require close examination of the books, internal documents, and
emails.
Perhaps the SEC has finally fired the first shot at the
Wall Street firms
that aided and abetted the creation of the
conditions that led up to the
financial collapse. More
importantly, that first shot might have driven a
bit of fear into
the financial institutions that have been trying to
carry-on with
business as usual. And, finally, perhaps the SEC might induce
the
Obama administration to stand-up to Goldman.
It is probably not
too early for Goldman management and alumni
to begin packing bags
for extended stays in our nation's finest
penitentiaries. More
than 1000 top management at thrifts served real jail
time in the
aftermath of the Savings and Loan fiasco. This
current scandal
is many orders of magnitude greater - probably
tens of thousands of managers
and traders and government officials
were involved in fraud. We may need
dozens of new prisons to
contain them.
Meanwhile, the Obama administration
should immediately revoke
Goldman's bank charter.
Even if the firm is completely cleared of illegal
activities, it
is not a bank. There is no justification for provision of
deposit
insurance for a firm that specializes in betting against its
clients.
Its business model is at best based on deception, if not
outright
fraud. It serves no useful purpose; it
does not do God's work.
[I have looked for the quotation, in context, justifying the headline I'm doing 'God's work'. Meet Mr Goldman Sachs. I was not able to convince myself that he ever said this. But the article under the headline does indeed reveal a staggering arrogance, IMHO. References: 1, 2, -FNC]
Government
should also relieve itself of all Goldman alumni - no administration
that is
full of Goldman's people can retain the trust of the
American public.
President Obama should start his house cleaning
with the Treasury
department. Yes, Rubin
and his hired hand Summers
and protégé Geithner
(and
his hired hand Mark
Patterson,
Goldman's lobbyist who became chief of staff
of the Treasury) and
Hank
Paulson
must be banned from Washington; and
Rattner
(former NYTimes reporter who tried to bribe pensions funds when
he
worked for the Quadrangle Group - who served as Obama's "car
czar" and is now
likely to face lawsuits), and Lewis
Sachs
(senior advisor to Treasury, who
helped Tricadia to make bets
identical to those made by Magnetar and
Goldman), and Stephen
Friedman
(Goldman senior partner who served as
chairman of the NYFed), and
NY Fed president Dudley
(former chief US
economist at Goldman) must all be sent home.
Actually, anyone who ever
worked for a financial institution must
be banned from Washington until we
can reform and downsize and
drive a stake through the heart of Wall Street's
vampires.
And
why not use the powers of eminent domain to take back
Goldman's
shiny new government-subsidized headquarters to serve as the
offices
for 6000 newly hired federal government white collar
criminologists
tasked with the mission to pursue Wall Street's
fraud from the Manhattan
citadel of the mighty vampire squid? If
Obama is serious about reform, that
would be a first step.
POSTED
BY ECONOMIC PERSPECTIVES FROM KANSAS CITY AT 5:46 PM
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