Financial Regulation

First They Came for the Criminal Investment Bankers…

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The abacus, in case you don't know what a slide rule is for.

The Securities and Exchange Commission's civil action against Goldman Sachs is a certified crowdpleaser, and based on two iron principles—that you never argue with the audience's taste and that everybody who has ever worked for Goldman Sachs needs to be executed without trial—it's probably not something we should be disputing too heavily.

But there's another, not-quite-iron principle to consider: Always be skeptical of civil suits where criminal charges seem appropriate. It's a good sign the government is venue shopping.

What seems clear is that the massive investment bank and multi-platinum TARP winner took POS mortgage debts, bundled them into CDOs, and then passed them off as AAA. Investors in the $5 billion worth of "ABACUS" instruments that have since been downgraded to junk status ended up SOL.

You can read the SEC's complaint here, with fun quotes like this one from Goldman rep Fabrice Tourre, who wrote in early 2007, "More and more leverage in the system, The whole building is about to collapse any time now… Only possible survivor, the fabulous Fab…standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all the implications of those monstruosities [sic]!!!"

That sound like a man you want to do business with? According to the SEC, a hedge fund run by John Paulson, which had large short positions in mortgage-backed securities, helped put the Abacus investments together. Thus the securities Goldman was hawking were pretty clearly set up to decline in value. Goldman not only failed to disclose Paulson's role in selecting the portfolio but specifically told investors the party doing the selection had an "alignment of economic interest" with investors. (Since the great credit unwind is a tale brimming over with villains named Paulson, it's important to note that John Paulson is not related to former Treasury Secretary Henry Paulson.)

Goldman Sachs' comments in its own defense are singularly unpersuasive. From The New York Times:

"We certainly did not know the future of the residential housing market in the first half of 2007 any more than we can predict the future of markets today," Goldman wrote. "We also did not know whether the value of the instruments we sold would increase or decrease."

The letter continued: "Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a 'bet against our clients.'" Instead, the trades were used to hedge other trading positions, the bank said.

By pleading dumb, Goldman misses one of its strongest arguments: You had to be in a coma in the first half of 2007 not to realize how dire the performance of residential mortgages had become. Goldman (which in its marketing materials did reveal that it might have either long or short positions in the Abacus portfolio) would have been foolish not to do serious hedging against the very likely event of a decline in mortgage-backed securities.

That having been said, there is plenty in the SEC complaint that indicates Goldman was at least walking right up to the line of lying to its investors. Which makes the civil action so questionable. Fraud is not a petty dispute you can get ironed out by Judge Judy. It is a crime. That should make this a matter for prosecution by the Justice Department, not a post-game effort by the SEC to define what constitutes adequate disclosure. Anybody who is in the business of building a diversified portfolio—which would necessarily include hedges against your own and your clients' long positions—should think twice about the government's using the civil courts to determine what proper disclosure is.

NEXT: Tonya Craft Trial Update: 'Mom Said I Could Get a Toy If I Talked to You'

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  1. Agreed that it should be a criminal matter. Often the problem wasn’t a lack of rules but a lack of enforcing them.

    Which is why we shouldn’t put people in power who believe in the virtue of lawlessness. Just a thought.

    1. Nor those that believe in the virtue of megalomania and possibility of omniscience.

      1. Agreed. Including belief in the omniscience of the market.

        1. So now that we have the Right People running the show, why aren’t they enforcing the rules?

          1. Ah, the Conundrum of Crony Corpratism: What to do when your team’s supporters are the ones with its hands in the cookie jar and the babysitter is making out with their partner on the couch in the the living room?

            1. Well, those cookies were getting stale anyway and who doesn’t want to boink the babysitter?

        2. How could a non-entity be omniscient?

          1. Zen!

        3. Which is more foolish: belief in the omniscience of the market, or belief in the omniscience of government? I think the market at least has the better track record.

        4. Ah, tony thinks that libertarians believe in the ideal of perfect knowledge. That may be true of Randians, depending on the misguidedness of the Randian.

          You see, Tony. The mature libertarian understands that the market is necessary precisely because perfect knowledge is NOT ATTAINABLE.

          This is something I have to battle with scientists all the time. Since you claim to be a scientist, read this:

          “Today it is almost heresy to suggest that scientific knowledge is not the sum of all knowledge. But a little reflection will show that there is beyond question a body of very important but unorganized knowledge which cannot possibly be called scientific in the sense of knowledge of general rules: the knowledge of the particular circumstances of time and place. It is with respect to this that practically every individual has some advantage over all others because he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active co?peration.”

          1. You don’t have to have perfect knowledge to know that the unfettered marketplace leads inevitably to painful boom and bust cycles and massive amounts of corruption. You don’t have to know everything to appreciate the value of a market restrained by prudent regulations, in other words one that works for people rather than people working for it.

            1. IF you could provide an example of an “unfettered” marketplace, I’m all ears. The only true, free banking system is one with real competition, no federal reserve, and some sort of gold standard as a basis for the money supply. The government is the one monkeying around with the currency, creating moral hazard, and making things worse.

    2. Agreed that it should be a criminal matter. Often the problem wasn’t a lack of rules but a lack of enforcing them.

      Which is why we shouldn’t put people in power who believe in the virtue of lawlessness. Just a thought.

      Fraud being a criminal matter does not preclude it from being as civil matter as well.

  2. A civil complaint asks “how much of your money will we take?”. When you’re in the process of ‘reforming’ Wall Street, you don’t want individuals fighting against jail time, because those same individuals might be tempted to expose details that reflect poorly on the government.

    If you can tar an entire industry with a civil complaint, your ‘reform’ can be better tailored to benefit your friends.

    Yes, GS are scumbags. But the problem isn’t a lack of reform, it’s a lack of the DOJ doing its job prosecuting fraud, both by the private sector and in government.

    1. If you can tar an entire industry with a civil complaint, your ‘reform’ can be better tailored to benefit your friends.

      Does not a civil complaint, by virtue of the fact that current laws allow it, undermine the case for more regulation?

      1. Does not a civil complaint, by virtue of the fact that current laws allow it, undermine the case for more regulation?

        Logically, yes. Emotionally, no.
        Hate crime much lately?

        Regulation is now an excuse to expand the distortion of markets in favor of the current friends of those able to pass such regulation. It has nothing to do with correction of unfair practices.

        If it did, it would include J sub D’s far more complete 6PM list of the originators of the financial bubble.

  3. I have just two questions.

    1. Has anyone else filed a civil action against Goldman Sachs?

    2. If not, why not?

  4. Maybe it’s a good time to restate investment’s Prime Directive: Never invest in anything you don’t understand.

    1. That would be 99%+ of those invested in 401ks.

  5. There is no doubt in my mind that during the housing bubble fraud was committed by

    – Lenders
    – Borrowers
    – Appraisers
    – MBS originators (I’m looking at you Fannie and Freddie)
    – Derivative originators (I’m looking at you, Wall Street)
    – Bond rating agencies (probably, incompetence could explain their sleeping at the switch)

    I’d love to see the DoJ returning some indictments in all categories but I doubt it will ever happen.

    1. Did you list that in order of whom you think will most likely see an indictment, or at the very least a subpoena?

      1. Nah. Like most of my thinking, order didn’t factor into it.

        1. Fair enough. If you could only go after one group, which one would it be?

          And their punishment Judge J sub?

          1. I’d say the bond ratings agencies, just because if they get paranoid and do their damn job then it forces all the other players to fall in line.

            For justice to really be served they would have to go after everyone, but at this point that expectation isn’t realistic.

            1. I’d say the bond ratings agencies, just because if they get paranoid and do their damn job then it forces all the other players to fall in line.

              Im not sure they committed fraud at all. After the mid-70s act of government making the big 3 a de facto oligarchy, I just dont think they have tried very hard.

          2. In order
            Fannie and Freddie
            Wall Street
            Bond Rating Agencies*
            Lenders
            Appraisers
            Borrowers

            * Like I said, I’m not sure the bond rating agencies commited crimes. That what you have investigations for, no?

  6. Call me paranoid, but the fact that there hasn’t-been / isn’t-going-to-be a criminal fraud investigation points to someone taking the fall or some sort of wrist slap. The big well-connected guys walk away scott free with billions, and whatever monetary fine that is slapped on Goldman will be passed on to their customers in a small, one-time fee obscured in fine print.

  7. You had to be in a coma in the first half of 2007 not to realize how dire the performance of residential mortgages had become.

    Then tell me this, oh guru: why the hell was anyone buying em up, in any form?

    Investment banks arent there to just market products that “go up”. They provide liquidity for a variety of types of investors with different purposes. The fact that they were both selling CDOs as well as betting against them is – on the face of it – unsurprising, and unlikely to result in any proven malfeasance. Settlement without any acknowledgement, most likely. Just another pound of flesh for the government to pretend they’ve done something in the public interest.

    1. I had the same reaction, about that sentence being bullshit. If the coming crash was so obvious to Tim Cavanaugh, then he must be rich now.

    2. Then tell me this, oh guru: why the hell was anyone buying em up, in any form?

      Because how else was the pension fund going to hit an 8% return?

  8. On the bright side, at least the reason gear girl is now wearing a smile with her short sleeve shirt. Must be spring time!

  9. “You had to be in a coma in the first half of 2007 not to realize how dire the performance of residential mortgages had become.”

    Just for the record, even after New Century cratered in July of ’07, I think reasonable people could disagree on that point.

    As evidence, I’d point to Bear and Lehman, both of whom leveraged themselves to buy the mortgage portfolios of failed Subprime lenders like New Century. Really. That’s what did them in.

    Even after July of ’07, some really astute, smart and well intentioned investment bankers thought buying mortgages at a tiny fraction of their face value was a good idea. And it killed them.

    If we’re talking after September of ’08, well that’s another story entirely, but after July of ’07 and before September of ’08, reasonable people probably could still disagree on subprime, never mind the rest.

    “Goldman […] would have been foolish not to do serious hedging against the very likely event of a decline in mortgage-backed securities.”

    That is so true.

    There are at least three questions here that the government is conflating as it tries this in the court of public opinion.

    1) Should companies be allowed to short what they’re selling?

    2) Should companies be required to fully disclose to those who are buying what they’re selling that they’re also shorting it too?

    3) Did Goldman fully disclose to investors that they were shorting what they were selling?

    The only real question is Question #3, but I will be astounded if Goldman didn’t address that in their offering documents.

    Question #2 is an obvious “Yes”, of course, but that sort of thing is addressed in every investment I’ve ever worked on or been a party to.

    Question #1 is the one that gets the public’s “a-ha!” reflex going, but really, if hedging isn’t for betting against your own business, then what is it for?

    If all I do is farm wheat for a living, the damn government better let me hedge against wheat prices dropping, fer Christ’s sake!

    They’ve just approved a new futures market for movie box office receipts. How much easier will it be to write James Cameron, or whoever, a fat check for several hundred million dollars knowing the studio can short the project if they need to?

    Should movie studios be able to participate in the profits for movies they sell to the public, when the whole time they’re actually hedging against the movie being a flop?

    Of course they should!

    And it really is all the same thing.

    1. That the mortgage securities market was in trouble was obvious to me in September 2007. And I had no financial stake in it.

      1. There’s no reason to think the investment bankers at Lehman, Bear Stearns, et. al. weren’t as smart or well informed as you were. It is entirely possible to do the wrong thing for the right reasons.

        I suppose there’s a difference between Lehman and Bear buying failed securities at a discount and someone selling newly packaged mortgages too.

        But I hope you can see the point I’m making… I’m not speculating about what somebody might have been thinking–these two investment banks bought loads of mortgage backed securities after July of ’07, and they did it with tons of leverage.

        Because they thought it was a good idea. That’s what they did it. And they had good reasons.

        People’s personal feelings about the state of the market, actually, may have been an excellent counter-indicator…

        That’s an old Wall Street trope, you know–the time to buy is when there’s blood in the streets? You make your money on the way in to an investment, not on the way out…

        There’s another one about not catching a falling knife, but they seem to have ignored that one. A lot of fools rushed in rushed in right behind the angels actually…

        I remember the judge in the New Century bankruptcy wanting to hold up the plan, ’cause he thought New Century shareholders weren’t getting enough from the investment banks that were offering to buy the assets!

        Those were the very assets that buried those investment banks! The judge didn’t think the price was high enough! …but reasonable people couldn’t have disagreed about the value of mortgage backed securities?

        Sooner or later., I think the facts are gonna get in the government’s way. And that’ll be a great way to tell how much of a witch hunt this is. The timing with the push to get the president’s financial regulation overhaul through might just be a coincidence, but then again…?

    2. Well, you have a point. But this is not all hindsight. When I bought my white elephant in June 06, it looked to me like I was the only person in Virginia shopping for a house (not that anybody was willing to negotiate on price). Foreclosure activity almost doubled in 2007. In June Bear Stearns had to plow billions of dollars into supporting the “High-Grade Structured Credit Fund,” etc.

      Yes, it still seemed like it might turn out to be just a blip. But these people don’t get paid millions of dollars to say, “Oh I had no way of knowing.”

      Well actually, that does seem to be what they get paid millions of dollars for…

      1. “Yes, it still seemed like it might turn out to be just a blip. But these people don’t get paid millions of dollars to say, “Oh I had no way of knowing.”

        But isn’t that what it all boils down to? What if the fact is that market tops are impossible to call in real time?

        I don’t have a problem with that. It’s a very reasonable explanation.

        —-

        The only problem I have is being put on the hook for these people’s mistakes–not that Goldman ever needed any TARP money for anything they did. They didn’t. They were forced to take the money!

        But the only problem I had with any of this was being made to pay for TARP, etc. with my future earnings. …they made a sacrifice of my future earnings for the greater good of society–again–without asking me.

        I think the whole Tea Party movement exists essentially because everyone seems to be so reluctant to put the blame for that injustice where it belongs–with the politicians who proposed TARP, etc. and who voted for it.

        I see this as another excellent example of the Obama Administration trying to misdirect responsibility for what they did and project it on to someone else. …but it isn’t Goldman’s fault that I was put on the hook for their investors’ bad investments.

        It had nothing to do with Goldman. It’s Obama’s fault. It’s Geithner’s fault. It’s George W. Bush’s fault. It’s the fault of the Republicans and the Democrats in Congress. The taxpayers didn’t lose any money because of Goldman.

        And it didn’t have anything to do with people not being able to call market tops despite how much they make either. Why make an example of Goldman? Of all the investment banks out there, they were the least culpable.

        And I buy their explanation. It’s consistent with what was going on at the time.

        If they shorted the position they were selling before it was fully subscribed, then my only question is whether their short position was disclosed in the documentation at the time. If they weren’t shorting it beforehand, was there anything in the documentation that suggested they might short such a thing in the future?

        But the bigger question I have is this–why is the government spending all of these resources on a private transaction? Is there something I’m missing? Did Goldman defraud a public institution at some point? ’cause I don’t see that…

        I see the government making a big commotion, maybe to assuage swing voters sympathetic to the Tea Party, but mostly to set up their newly proposed financial regulation scheme. Other than to make headlines, why is the government involved in this?

        1. Sure, there was no collusion between GS and Treasury and Fed to bail out AIG, right? GS didn’t steal from any of its clients, either, right?

          Take some time and read this. I’m no expert, but they make a compelling argument. If this is true, it is fraud with a capitol “F”.

          1. I’m not claiming any expertise myself, really, I just keep pointing to some facts that don’t jibe with the government’s case–and haven’t jibed with the government’s case since September of 2008, but a quick glance at the beginning of that link, and I saw a few things that gave me pause…

            “More than $70 billion worth of toxic assets were dumped into mezzanine CDOs during an eight-month period between September 2006 and April 2007, when it became obvious to Wall Street banks that the lower-rated slices, or tranches, of mortgage-backed bonds were worthless.”

            http://www.zerohedge.com/artic…..igned-fail

            There are three interesting things in that.

            1) I’ve already pointed out that already that it wasn’t universally obvious that subprime was worthless to at least two major investment banks and a bankruptcy judge after New Century cratered, so why would it be obvious to “Wall Street banks” that the lower tranches were worthless before then?

            2) These were unsecured “mezzanine CDOs”, and I’m supposed to believe qualified investors bought them thinking they were guaranteed?

            And then there’s this bit from the same link…

            “The investment portfolio, which held only two performing assets, had an average credit rating of CC.”

            3) We’re supposed to remake Wall Street in Obama’s image because investors speculated on CC rated, mezzanine CDOs and lost? That’s the bottom of the barrel!

            http://en.wikipedia.org/wiki/Bond_credit_rating

            If TARP or any other government program used taxpayer money to bail out investors in CC rated instruments, then the regulators who gave them that money should all be behind bars!

            That a good reason why regulators should be given less power an authority–not more.

      2. It’s a lot easier to double-down with someone else’s money.

    3. Should companies be allowed to short what they’re selling?

      Selling itself is basically an act of shorting.

    4. The problem is they didn’t disclose #3 in the offering document. Felix Salmon went through the prospectus pretty thoroughly. The crazy thing is that most people* don’t read the prospectus that thoroughly and they could have put in the potential conflict of interest in the fine print, no one would have noticed and they would have gotten off scot-free. This appears to be an uncharacteristically sloppy job by GS.

      * Outside of the lawyers from the offering bank.

  10. “We don’t need a criminal lawyer. We need a criminal lawyer.”

    1. I’ve become a pretty big Breaking Bad fan, but am I right in thinking it’s the most bleak thing ever put on TV? Or at least the most bleak thing since live 9/11 coverage?

      1. Have you ever watched Intervention? It’s slightly worse.

        1. Or Millenium? Man, I loved that show.

  11. “Anybody who is in the business of building a diversified portfolio — which would necessarily include hedges against your own and your clients’ long positions — should think twice about the government’s using the civil courts to determine what proper disclosure is.”

    Hmmmmmmm. I think the moral is that anybody who is in the business of building a diversified portfolio — which would necessarily include hedges against your own and your clients’ long positions — should think twice about doing business with Goldman-Sachs.

    And what’s the deal with the iron principle that “everybody who has ever worked for Goldman Sachs needs to be executed without trial,” when the government is only launching a civil trial? Tim says that Goldman-Sach’s record is terrible–criminal!–and then says the government is somehow being too tough because they’re pursuing a civil action? Sorry, I see the Obama Administration telling Wall Street it’s too important to suffer. We’re not like Spitzer and Giuliani–we’re not going to put you in handcuffs.

    But kudos to a Reason writer actually willing to admit in print that someone in Wall Street actually did something wrong. It’s a first!

    1. Hmmm, your elements bear a striking resemblance to events in my book….a word, if you might, you cad!

    2. “And what’s the deal with the iron principle that “everybody who has ever worked for Goldman Sachs needs to be executed without trial,” when the government is only launching a civil trial?”

      I’m sorry you’re so late to the witch hunt, but this really has been going on since September of ’08, with several episodes featuring Goldman Sachs.

      Goldman Sachs has featured more prominently in recent episodes, actually, certainly with the Obama Administration, and if you take the Obama Administration at their word, it’s because of the way Goldman pays out bonuses…

      And like I said above, this really is just background for the next act, where Chris Dodd and the Obama Administration save us all from the witches’ cabal.

      Really, if you’ve been following this all along, there’s no reason not to get out ahead of the government’s storyline and talk about where this came from and where it’s going.

      They want to turn finance into an industry that’s a lot less risky and a lot more regulated, and they’re trying to turn Goldman Sachs into exhibit one…

      When the last administration wanted to do something no one had really thought about, they trotted out BS accusations about yellow-cake in Niger and they showed us phony photos of mobile weapons labs…

      Really, the story arch’s pretty predictable–there’s no reason not to jump to the last chapter. And no one’s making any of this up–they’ve already told us what they want to do.

      I don’t want to suffer an economy where people like me are granted or refused financing depending on whether government regulators deems it good or bad for society generally.

      The charges appear to be bogus anyway. And even if they’re true, the policy prescriptions the Obama Administration are drawing from this are dangerous.

  12. So your position is that can know and did or should have known the future in this case? Not knowing the future is “pleading dumb?” What?

  13. I hope they dont stop with GS. The problem is, its civil so the most they will get is a slap on the wrist and a little fine. Then its business as usual.

    Lou
    http://www.cops-r-watching.es.tc

    1. Is that a spambot?

      Even the spambots are cool with the witch hunt?

  14. There is civil fraud and criminal fraud. We prove civil fraud by clear and convincing evidence while criminal fraud requires beyond a reasonable doubt. In electing civil fraud, the burden of proof is lower than criminal fraud. Also, there is securities fraud which also requires scienter. Goldman Sachs should go down if there is justice in this world. 😉

    1. There is civil fraud and criminal fraud.
      And sometimes one leads to the other. Which may be the other ‘shoe’ waiting to drop if certain parties aren’t ‘careful’ with scope of their discovery requests.

      Don’t want to mess up any future legislation, or there may be hell to pay.

  15. You forgot to mention that as GS was selling their junk bonds they were taking out CDS’s with AIG betting against the bonds. It wasn’t just the hedge fund that was on the “it’s all going down” band wagon.

  16. That having been said, there is plenty in the SEC complaint that indicates Goldman was at least walking right up to the line of lying to its investors.

    And here is one of the major factors. There are so many federal and state regulations attempting to establish just where that line runs, nobody can keep track of where it is.

    If the rules were simpler, the instruments would be simpler.

  17. Maybe the CFTC will get off their asses, now, and go after JP Morgan and HSBC for manipulating the precious metals market.

  18. Over my dead body!

  19. A couple of points:

    (1) Market makers always take the other side of what they sell, so merely shorting what you sell isn’t necessarily bad, and can’t be outlawed.

    (2) The real complaint here is that Goldman colluded with a third party to create garbage pools, and sold the short side of those pools to the third party, without disclosing this to buyers of the garbage pools.

    Essentially, Goldman created mortgage pools that were designed to fail, and neglected tell the buyers.

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    Sometimes it is hard to tell the difference between very poor decisions and fraudulent claims.

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