One of the things that has been striking as revelation of bad behavior in the collateralized debt market has gotten more press is that a number of commentators who had taken the “nothing to see here, move on” stance have gotten religion.
Even more dramatic has been the change in perception of Goldman. The firm has had its vocal critics (including yours truly) but they seemed an ineffective minority. Goldman’s arrogance seemed only to confirm its “Government Sachs” connections, that it could do as it pleased and thumb its nose at the rest of us to boot. It compounded the public outrage over its record 2009 bonuses through its hamhanded, narcissistic rationalizations. Lloyd Blankfein’s “We’re doing God’s work” has come to epitomize what is wrong with the financial services industry post-crisis the same way Chuck Prince’s “We’re still dancing” did for the bubble era.
So the has been more that a little bit of schadenfreude at work. The press and public sentiment against Goldman has become widespread and heightened with the SEC lawsuit over Abacus AC1 2007. Even the supposedly bipartisan Senators were on the same page in Tuesday’s marathon hearings.
Now some point out, correctly, that Goldman is being singled out. On the one hand, there was a lot of bad behavior in the industry that has yet to be scrutinized closely. On the other, collateralized debt obligations were the ground zero of the crisis, and the banks like Goldman that were particularly “innovative” are now looking to have been too clever by half. As I discuss in some detail in ECONNED, these vehicles were spectacularly leveraged. Comparatively small amounts of capital produced greatly disproportionate systemic effects. Both our own contact with structured industry experts, and other accounts of subprime short strategies make clear that DeutscheBank was at least as aggressive as Goldman as far as real-estate-related CDOs were concerned. For instance, Deutsche was also creating synthetic CDOs on behalf of subprime short John Paulson; it had its own version of Goldman’s Abacus program (Deutsche’s was called Start).
A striking point of the hearings was that Goldman kept claiming that it was a mere market-maker, while the Senators kept asserting that the firm had a duty to customers. While Goldman arguably did not have a fiduciary duty, it most certainly is required to make accurate disclosures as an underwriter, and that is the basis of the SEC’s suit. Moreover, even if Goldman’s actions were narrowly legal, markets operate on trust. What happens to capital formation if investors increasingly regard markets as a shark pool?
What is stunning is that the Wall Street Journal defends Goldman (its headline labels the hearing an “inquisition”), and chooses to ignore the applicable regulations to do so. The piece disingenuously and inaccurately asserts that the Senate was trying to apply an incorrect standard to Goldman’s conduct, a “consumer narrative”. A representative section:
On one side was a Senate committee preaching a populist narrative that’s only been boosted by the Securities and Exchange Commission’s lawsuit against Goldman. Goldman bet against its clients. It sold mortgage securities to sometimes unwitting buyers, without disclosing that the broker or important clients were betting the other way. That fueled the mortgage crisis by dumping more junk into the system. It was also disingenuous.
Senators tried to make the case that this wasn’t the fair dealing customers expect in our consumer society. In this narrative, a customer or client buys a television from Best Buy and both the seller and the manufacturer carry some responsibility that the product will do what it’s supposed to do. The consumer can return it. There are warranties.
Wall Street doesn’t work that way. That was the point made by Goldman officials including Mr. Sparks, Josh Birnbaum, Michael Swenson, Fabrice Tourre—the trader named in the SEC case against Goldman—and at the end of the day, Lloyd Blankfein, Goldman’s chief executive.
The consumer narrative isn’t the one at work at Goldman or anywhere on Wall Street. It’s a pure caveat emptor market. Buyers carry the responsibility of knowing that products carry risk. They may not work as advertised. They know that Goldman, or any broker/dealer will work to line up investors to short the deal, or take that position itself. There are no guarantees.
Yves here. This is patent rubbish. It is a sign of the lousy state of the press in America that a politically-oriented blog, FireDogLake, does a better job of describing the applicable rules than the self-styled preeminent business newspaper in America. Oh, but we forget. That paper is opposed to the idea that commerce should be subject to rules.
The staff of the Permanent Subcommittee on Investigations put together a memo explaining the basics of the transactions. After defining the terms related to securitized debt instruments, the memo explains that Wall Street firms can act as “underwriter” for the issuance of new securities.
If an investment bank agrees to act as an “underwriter” for the issuance of a new security to the public, it typically bears the risk of those securities on its books until the securities are sold. By law, securities sold to the public must be registered with the Securities and Exchange Commission (SEC). Registration statements explain the purpose of a proposed public offering, an issuer’s operations and management, key financial data, and other important facts to potential investors. Any offering document, or prospectus, given to the investing public must also be filed with the SEC. If a security is not offered to the general public, it can still be offered to investors through a “private placement.” Investment banks often act as the “placement agent,” performing intermediary services between those seeking to raise money and investors. Solicitation documents in connection with private placements are not filed with the SEC. Under the federal securities laws, investment banks that act as an underwriter or placement agent are liable for any material misrepresentations or omissions of material facts made in connection with a solicitation or sale of the securities to investors.
Firms can also act as market-makers:
Investment banks sometimes take on the role of “market makers” for securities and other assets that they sell to their clients, meaning that, in order to facilitate client orders to buy or sell, an investment bank may acquire an inventory of assets and make them available for client transactions. In addition, investment banks may buy and sell assets for their own account, which is called “proprietary trading.” The largest U.S. investment banks engage in a significant amount of proprietary trading that generates substantial revenues. Investment banks generally use the same inventory of assets to carry out both their market-making and proprietary trading activities. Investment banks also typically have an inventory or portfolio of assets that they intend to keep as long term investments.
GS wants everyone to interpret the ABACUS 07-ACI transaction and similar deals as if GS were a market-maker. The fact is GS acted as an underwriter. Underwriting is the creation and sale of new securities.
Yves here. Before readers try arguing “these were not securities,” CDOs are legal entities, mini-banks with asset and liability sides. Some tranches of the Abacus deal (the liability structure) was placed in the form of notes, which most assuredly are securities.
Legal issues aside, it isn’t merely the great unwashed public that is taking an increasingly dim view of Goldman. What is striking is the change in sentiment among professionals.
Recall Goldman’s reputation: that of being the best managed firm on the Street, and its boasting about its risk management as key to its superior profits (cynics will note that Goldman nevertheless needed to be rescued along with every other major financial player). Thus Goldman cannot readily shift blame for its mortgage market misdeeds onto staff; its obsessiveness about communication makes it well nigh impossible that any of its staffers were acting without authorization. And its once-vaunted risk management, which led observers to believe that Goldman was doing a better job of managing exposures, now increasingly looks like the firm was simply more systematic and aggressive than its peers in not just shifting risks onto customers but engaging in further profit-maximizing strategies that look downright predatory.
For instance, Bruce Krasting, who has often taken issue with me over credit default swaps and is generally of the view that like love and war, all is fair in markets, took a very dim view of a revelation by Josh Birnbaum. Per a post by Tom Adams:
Senator Coburn turns to short positions that Goldman took in companies that were sensitive to mortgages, including Merrill and Bear Stearns. Senator Coburn notes that after Goldman sold Timberwolf to Bear Stearns, they took a short position in the stock of Bear Stearns. This seems pretty devastating,
Yves here. Note that these positions were NOT taken on a equity desk (based on, say, a house view that all mortgage-related credits were a short, including, say, homebuilders). They appear to have been taken within (or at least credited to) Birnbaum’s group, the Structured Products Group. Krasting elaborates:
In 2007 the SPG had gains from hedges of ~$3b and losses of ~$2b on write down of inventory. It was described that the hedges included (1) shorts on the ABX index (2) shorts on single name ABS (3) long CDS against a variety of single names and (4) they shorted common stock of companies that had a high beta to a downfall of the Sub-Prime/Alt.A market.
We know from the testimony Bear Stearns was on that “short” list. That entire list is public. I have not seen it so I will just guess that in the fall of 2007 GS was shorting the likes of New Century, WaMu, the mono lines, Countrywide, Bear Stearns, and Lehman. That list could have been broader; it might have included Fannie Mae and Freddie Mac, Citi, and BoA, even the likes of a Northern Rock or RBS.
One aspect of the collapse of 2008 was how destructive capital markets had become. The shorts pushed equities down so fast that managements and regulators lost control. The shorts were clearly predators. For me it was the shorts that destroyed the equity values. It was a near daily event.
My questions on this is (A) How much of this did Goldman do? (B) How much did the rest of the market do? (C) Did this exceptional demand for short interest in financial stocks accelerate the collapse of Bear, Lehman and all the others?
Yves here. Krasting focuses on the equity short, but the CDS single name longs were if anything even more destructive (even the Wall Street Journal described CDS as a great vehicle for bear raids). Buying CDS protection in volume pushes up yields on bonds. The rating agencies respond to market signals (this is a dirty secret). If the market yield on a bond is too far out of line with their rating, they feel pressured to downgrade. The downgrade confirms the suspicions of those who have doubts, leading to either sales of the bonds themselves or purchases of CDS by new parties, further pushing up yields. And for highly leveraged companies, rising interest rates translate pretty quickly into diminished profits, again putting pressure on ratings.
Now admittedly Lehman was beyond redemption, but had it decayed in a more gradual fashion, it might at least have filed for a long-form bankruptcy, or possibly even gone through a good bank-bad bank restructuring (the sort of deal the Fed was trying to broker that failed at the 11th hour). And had Lehman not collapsed, September and October 2008 would have looked very different.
Moreover, industry participants believe DeutscheBank was engaged in similar activity. One industry participant who had the vast misfortune to be long some of the CDOs that Deutsche pedaled recalls in 2007, when Deutsche came to his firm proposing a hedge against some of those deals, recalls his board asking point blank, “Are you short our company?” and not getting a straight answer.
Goldman is increasingly beleagured. Its lobbyists are now pariahs. More private lawsuits are coming to the fore. There are rumors it is in settlement talks with the SEC. But the once-storied firm apparently turned its well oiled machine to ruthless profit-seeking. It is an open question how much damage the firm will sustain from the well-deserved backlash, and whether it can change its conduct.