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.