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.

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  1. Blurtman

    Why is not Hank Paulson in Jail?

    What kind of a country has as a major cabinet official a scumbag financial felon?

    1. charles

      A view from Europe~ you are a lucky country to have even
      two more, Tim Geithner and Larry Summers, for the sake of the
      bridge playing in the can, let´s add Bob Rubin


      Hank-the-hit-man got himself that special deal while proposing TARP, remember. I think his line of BS went a little something like this….

      I’ve been trained to run towards problems, but I won’t be held legally responsible, or accountable, for any of what I proposing before this legislative body.

      Of course the jackals of that same body politic were all sitting there drooling, grinning, nodding and winking as he laid out his plans to avert disaster.

  2. attempter

    Today Krugman opened a new anti-Black front, saying the call for these e-mails is pointless, and that instead we should focus on the ratings agencies.


    While the agencies are certainly part of the problem, they’re still an epiphenomenon.

    But Obama and the Dems (Reps too, but they’re not in power) don’t want to fix the fundamental problem, the structure and entrenched practices of Wall St itself. So they and their flacks keep coming up with misdirection to distract from the core message Black, Spitzer, and (all too few) others keep trying to get through:

    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.

    Unfortunately, because the system is corrupt beyond redemption, what they call for cannot be done within the system, or while the system itself persists at this level of virulence. It’ll have to collapse of its own unsustainable criminal weight.

    1. tyaresun

      I believe that Krugman is angling for a position in the Obama admin., possibly after the Nov. election.

      1. sgt_doom

        Funny, I believe Krugman will do whatever anyone pays him to do, he’s certainly proven that to date!

        1. anarkst

          You ever watch Krugman speak? He can’t ever look anybody in the eye. Major academic sell-out.

    2. alex

      “Krugman opened a new anti-Black front, saying the call for these e-mails is pointless”

      No, Krugman was talking about GS emails that make headlines (“we made money shorting it!”) but aren’t evidence of illegal activity. Spitzer and Black are talking about emails that are evidence of illegal activity.

      Yes Krugman is sometimes too “reasonable”, perhaps for political reasons, but there is no contradiction between what Krugman, Spitzer and Black are talking about.

      1. attempter

        It’s clear that one can’t know whether or not e-mails describe “illegal” activity until they’ve been demanded and procured.

        More importantly, it’s clear that what Krugman (an over-glorified Internet thread commenter, really a mere pundit) would be willing to concede is technically illegal is far more narrow than what Black (who has a proven record as a ferocious public interest law enforcer) would call a de jure crime. (BTW, a search of K’s blog uncovered zero mentions of the PCA law, and the most recent Bill Black mention is 2007. One might think there are certain points of view Krugman doesn’t think should get wider dissemination…)

        And most importantly of all, “the law” has already abdicated. Any hack like Krugman who insists we have to stay within the bounds of “the law” rather than make an aggressive political appeal and an appeal to the true but abrogated law is simply an apologist for the racketeers and their status quo.

        And Thugman is indeed on record, many times, as saying he believes the Bailout was a good thing, that he believes the people should have to live under the thumb of these gangsters in perpetuity, and that at best we can try to crawl and grovel and lick boots to beg for some crumbs of “reform”. And as we saw with the health racket bailout he also shilled for, even those crumbs will be rescinded in the end.

        So the only question, regarding anything Krugman advocates, is how it fits into the pseudo-reform scam. If he recommends against emphasizing the more politically inflammatory e-mails, it’s highlighting his great fear of the Democrats losing their astroturf hold on people.

        For a system thug like him the apocalypse would be if a real populist movement could get rolling.

        1. backwardsevolution

          Krugman, Democrats, Republicans – all are as thick as thieves, trying to maintain the status quo, where they get paid off but we pay.

          Krugman – he had to have done something to get the Nobel. He certainly didn’t win it on his own merits.

          1. attempter

            He might have. I read that the reason the Economics pseudo-prize (not one of the original, “real” prizes; not that any of the them are real by now, c.f. the warmonger who just received the “Peace” prize – War is Peace indeed) was established in the first place was to bestow a fraudulent imprimatur and dignity on neoclassical economics and the neoclassical synthesis.

            So to whatever extent that’s still the case, Krugman’s right up their alley.

  3. AK

    I was thinking on weekend about this situation with Goldman. And I came to conclusion that in previous times Goldman\’s executives would be executed for Treason (together with John Paulson and Magnetar\’s bosses).

    Here is some analogy with what Goldman did. One can consider Goldman as an officer in some military army. That officer observed that his/her army would be trapped by an enemy. But instead of alerting his/her generals and regular soldiers as well about incoming danger he/she made a deal with some traders to sell forward arms and ammunition after his/her own army\’s defeat.

    But what surprised me most was the position of Hank Paulson. As former Goldman\’s CEO he probably was aware (being warned by his former GS colleagues) about incoming blast of housing bubble. But he did nothing at all and only quietly observed the incoming collapse. And after collapse he orchestrated the deal, which allowed Goldman to cash out its beats on the country\’s economic disaster.

    Moreover, I think that if government wouldn\’t \”kill\” Goldman now then next time all big investment banks would be beating against their own country. I can\’t imagine the magnitude of the next financial crisis that happens then.

    1. sgt_doom

      Well, they certain would have gone to jail.

      We need only pay attention to the future husband of Chelsea Clinton, whose father, former Goldman Sachs crook, served time for financial fraud — today they only reap bonuses for the exact same thing.

      Chelsea Clinton, at McKinsey & Co., servers to the global criminal class, is marrying into a convicted felon’s family….how Very Clinton.

      Next thing you know, Hilary Clinton will be promoting the overthrow of elected democracies in the Americas (Oopsy, too late…just remembered that Honduras thingy).

      Well, at least the Clintons suddenly became $100 million richer since Bill’s been in office (they really pay alot for those speeches of his, I guess).

      And that BlackRock purchase of Quellos Asset Management right after the Clintons put all their money there…..purely COIN-CI-DENCE….don’t look behind this curtain, boys and girls…..

    2. backwardsevolution

      The lawyer who is winding up the Lehman bankruptcy has subpoenaed documents from Goldman, Citadel and a few other hedge funds re Goldman et al possibly causing the downfall of Lehman by short-selling their stock.

      If they did it, if they had insider information, then maybe Lehman’s collapse was planned. Hank Paulson let Lehman go down. He certainly didn’t bail Lehman out, yet he bailed others out. Wonder why. Could it be because Goldman was going to profit handsomely by Lehman’s demise?

      And Karl Denninger still wonders who got insider information re Bear Stearns, because somebody shorted the heck out of it just days before it went down. Who was that? Goldman again?

      This is just getting started, I hope.

  4. fresno dan

    “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”

    Uh, isn’t that still going on? (banks holding “assets” at delusional prices???)

  5. Robespierre

    If Obama was serious (and not just bread and circus) about fraud in the banking industry he will put Eliot Spitzer as an special prosecutor to look into all these banks. A new Eliot (as in Ness?) to fight what it looks more and more like organize crime…

    1. sgt_doom

      “If Obama was serious…”

      Seriously, how could you even raise such a point at this time, after Obama’s earliest appointments of Kissinger as Special Envoy to Russia, and non-economist Diana (“We need to offshore ALL American jobs”) Farrell to the economics council???

      And I won’t even go into all the rest of his Wall Street lobbyists appointments, nor pharmaceutical industry appointments, nor Monsanto lobbyist appointments…..

  6. sgt_doom

    The last paragraph of this blog post says it all — the entire system is corrupt and credit derivatives — the hallmark (along with the power to securitize everything) of the shadow banking system which allows for the rigging and manipulation of all markets by layers of leveraging allowing for layers of speculating must be altered forevermore.

  7. Cog

    Paulson was aiming the bazooka right for us.

    An interesting piece by Eric Dinallo, former NYS insurance comissioner, written a bit more than a year ago covered the “bucket rules” of 1907, which basically forbid the side-betting on exchange traded assets, like stocks/bonds, and went on to describe how it was the Commodities Futures Modernization Act that effectively repealed them, accelerating the swaps conflagration.
    Yves pulled it from the FT: http://tinyurl.com/2em7zgh

    It was a law that put in check investment synthesis. Needless to say, Phil Graham had no use for it.

    Do we have to call it THE Financial Reform bill, or will we see more helpings? Seems like only the beginning, to me.

  8. RebelEconomist

    As usual with this blog these days, I disagree with much of this post. If “‘real money’ investors have neither the analytical tools nor the institutional framework” to “avoid being hosed” on CDOs, then they have no business being involved in these investments. In my opinion, they are at least as responsible as Goldman, because they represent themselves as skilled investors to retail. As Jeremy Grantham says of fund managers in today’s FT, “we add nothing but costs”. In contrast, Goldman is a market maker and so should normally hold any positions for long. Moreover, if Goldman had been sufficiently prudent to take collateral against its exposure to AIG, it is debatable that the government bailed them out.

    1. prostratedragon

      RebelEconomist, you did note I assume that the “analytical framework” passage was written by a Paulson & Co. executive, not by either blogger, did you not?

      1. RebelEconomist

        I did, but it is true, whoever wrote it. And it is interesting that it was apparently written in January 2007, so it was possible to work out what was going on before the collapse. In my view, Goldman are guilty of exploiting the situation, but the fundamental cause of the financial crisis is that investors, including ordinary investors such as house buyers and mutual fund investors, were bailed out, so that they took bigger and bigger risks. But far from learning this vital lesson from the crisis, the authorities are now trying to throw the ball up in the air one more time – eg Geithner’s “air in the marks” comment.

        (Declaration: having been a highly conservative fund manager myself who was warning about the dangers of opaque and illiquid investments ten years ago and lost out to those who were more willing to play the game, I would be pleased to see those people run out of the financial industry).

    2. Blurtman

      If Goldman Sachs “have neither the analytical tools nor the institutional framework” to avoid bankruptcy as a result of their deals with AIG, then they have no business being involved in these investments.

      Somehow whenm Goldman Sachs rips off investors, the apologetic bleating from supporters is that the investors should have done better due diligence.

      But when Goldman Sachs partner in CDS fraud AIG is shown to be insolvent, Goldman’s ex-CEO goes begging to Congress to bail out AIG, and Wall Street stooges Bernanke and Geithner do just that.

      Why does it not work both ways?

      1. RebelEconomist

        Blurtman (appropriate handle) please read my comment:

        If Goldman had collateral protection against their exposure to AIG, they were not going to go bankrupt as a result of that exposure. They might well have lost more money in the turmoil if AIG had been allowed to fail, but that might well have been to their longer term advantage if it had wiped out more of their competitors.

        By the way, I think it does work both ways. As a market-maker, whose business it is to make bids and offers on investments that their customer might conceivably know more about than them, Goldman are open to being ripped off by their customers.

        1. Richard Smith

          Rebel Economist,

          I’ve been tooling along quite happily thinking that the proximate cause of the financial crisis was actually the imprudence of various banks and shadow banks (just to be clear, I include hedge funds, money market funds, broker dealers, moronolines and AIG in the category of shadow banks, so perhaps some of those players overlap with your investor class). Big assists came from various failings in oversight – private sector (the misrating agencies and, yes, ‘investors’) and public (the nonregulators).

          I certainly agree with you that “investors” haven’t exactly covered themselves with glory in all this. Their pretensions to “expertise” and “sophistication” look ludicrous; I certainly wouldn’t pay much for their assistance.

          It’s just that I don’t see how they can cause a banking crisis.

          I suspect I am just confused about your use of the term ‘investor’. But maybe you have a different hypothesis about what happened and why. Perhaps could you spell out your view of the crisis mechanism in more detail?

          1. RebelEconomist

            Glad to spell out my view, Richard. The fundamental cause of the crisis was double-sided, cumulative, cultural moral hazard generated by the authorities, especially the Fed. Whenever risk looked like being realised, from perhaps as early as 1987, but certainly including LTCM, Y2K, 9/11 and more recently, the Fed eased “to mitigate the fallout” and generated moral hazard. Double-sided because, in addition to protecting risk investors, the periods of low interest rates penalised those who stood aside and held safe fixed income assets. Cumulative because the authorities reacted to any steep fall in the market, rather than when the fall had taken the market down to a certain level. And cultural because the moral hazard permeated the whole of society, who began to feel entitled to low interest rates on almost unrestricted borrowing while expecting high returns on their investments. For example, “leverage” became a by-word for “exploit”. Ordinary people, including those bought houses that they could not afford in any adversity and those who invested in money market mutual funds while expecting to avoid any loss must share the blame with the bankers who pandered to and facilitated their expectations, but there are a lot more ordinary people than bankers.

        2. backwardsevolution

          RebelEconomist – AIG only dealt with Goldman during 2004 and 2005. After that they stopped dealing with them and Goldman was then on its own.

        3. liberal

          If Goldman had collateral protection against their exposure to AIG, they were not going to go bankrupt as a result of that exposure.

          That’s an empirical question. My impression reading around is that w/o Uncle Sam bailing out AIG, GS would have gone under.

          …but that might well have been to their longer term advantage if it had wiped out more of their competitors.

          So we’re supposed to respect them in the scenario that they make lots of money in the form of monopoly rents? LOL!

  9. Blurtman


    From: http://globaleconomicanalysis.blogspot.com/2010/04/goldman-sachs-e-mail-by-thomas-montag.html

    Thomas Montag, the former head of sales and trading in the Americas at Goldman Sachs Group Inc., called a set of mortgage-linked investments sold by his firm “one shi**y deal,” according to an excerpt from internal e-mails released today by Senate lawmakers.

    The transaction was Timberwolf Ltd., a $1 billion collateralized debt obligation holding pieces of other CDOs, according to a statement today from the Permanent Subcommittee on Investigations. The CDO also included optimistic side-bets on the performance of CDOs, or derivatives, in which the firm took the opposite pessimistic side in “many” cases, the panel said.

    “Boy that timberwo[l]f was one shi**y deal,” Montag, who is now Bank of America Corp.’s president of global banking and markets, said in a June 22, 2007, e-mail to Daniel Sparks, who ran Goldman Sachs’s mortgage business at the time, according to the panel’s statement. Within five months of Timberwolf’s debut, the CDO had lost 80 percent of its value, and it was liquidated in 2008, according to the panel.

    Sparks, who left the bank in 2008, in one e-mail urged “personnel working on a potential Korean sale to ‘[g]et ‘er done,’ and sent a mass e-mail to the sales force promising “’ginormous credits’ for selling” the debt, according to Levin’s statement. “A congratulatory e-mail was sent to an employee who sold a number of the securities: ‘Great job … trading us out of our entire Timberwolf Single-A position,’ ” the panel said.

  10. steelhead23

    Black and Spitzer, the financial investigator and the prosecutor, are the dream team of the Financial Crisis – but they flat dropped the ball here. Bill, Elliot, I hope you read this blog because I am going to give you good advice.

    Many have voiced the view that reform is needed. Great, we all agree. But, is it enough? HELL NO! Justice must be served. People were hurt, lives were ruined. It would not be enough, it would not be just, for Lloyd Blankfein to say, “I’m sorry” and go on about his life. Yet anyone who witnessed his “I’m a victim” rant last week knows that admitting guilt is far from this man’s mind. Even the very lax Catholic Church requires a sinner to admit his guilt, promise to sin no more, and do penance. Penance is necessary for justice to be served.

    Yes, I am aware that Obama has cast his lot in with the likes of Blankfein and Dimon. So be it. The U.S. Dept. of Justice is not going to do a damn thing. That means that other venues, other institutions of competent authority must indict them. Eliot, with your experience in NY, perhaps you could convince the current AG to go after them. Hell, I don’t care if they start the ball rolling by going after them for unpaid parking tickets. My point is, we need folks like you two pumping the system for justice. I will remain uncomfortable with leaving my money in the hands of Wall Street until penance, real penance (like bunking with Bubba at Rikers) has been served. Sic ’em.

  11. MrAnon

    Have a question for Yves or anyone qualified to help out:

    So we’ve all seen the ACA AC1 flipbook with listed 90 RMBS on pages 56-57. http://www.scribd.com/doc/30036962/Abacus-2007-Ac1-Flipbook-20070226

    Is there any evidence available that Goldman purchased protection (shorted) any of those 90 securities? I’ve seen it mentioned via anonymous forum users that they had CDS out on at least 10 of the 90 RMBS. The reason I am asking is I question the veracity of Goldman’s PR that it lost in excess of $100MM on Abacus AC1. What is a good source to seek out what RMBS GS was short?

    Tx for any input.

  12. Smells like chapter 11

    Been thinking about how the CFMA of 2000 allows CDS’s to be treated as if they are not insurance which of course they are. There are tons of idiotic law reviews written by various sycophant lawyers jstifying this insantiy before all hell broke lose. What the CMA does specifically is make it illegal for states to make the CDS contract itself illegal. However, it might make sense to look at this a litle differently. AIG and the monolines who sold protection are all regulated by some state insurance regulator. They could easily intepret their regulations to the effect that while the CDS contract might be perfectly legal under the CMFA, insurance regulations prohibited any regulated insurer from entering into the CDS contract. This gets around the CFMA federal premeption issue by treating the regulated insurers as children, as indeed they have been, and simply incompetent to enter into such contracts.

    might be too little too late, it just a thought.

  13. Bill

    O/T, Yves I really enjoyed seeing you on PBS Newshour tonight.

    You came across to me as serious, bright and knowledgeable, and very elegant.

    Congrats, hopefully you’ll get more MSM exposure, even though it was clear even Gwenn Eifel didn’t know how to access your clearly vast store of knowledge on these topics.

    Oh, one other thing, you have great “presence”….even gravitas.

  14. JTFaraday

    “I will remain uncomfortable with leaving my money in the hands of Wall Street until penance, real penance (like bunking with Bubba at Rikers) has been served. Sic ‘em”

    The Clinton Administration is going too?! My prayers have been answered.

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