THE GOLDMAN SACHS CASEPart II: "The Crucible"James S. Henry

Whatever the ultimate legal merits of the SEC's case against Goldman Sachs -- and those appear to me to be questionable at best --  its most important contributions are being made right now. They are not judicial, but political. 

'Lord knows I've been about as critical as one can possibly be of Wall Street banks, as well as of unfettered free marktets. (See, for example, a, b, and c.)

However, after listing to today's  showdown hearings before  US Senator Carl M. Levin's Permanent Investigations Subcommittee,  I'm convinced that:

(1) If anyone needs the benefit of the new "financial literacy" program proposed  by S.3217, Senator Dodd's proposed financial reform bill, it is the US Senate. Many  members of the Senate -- and by extension, the House -- don't  seem to understand very basic things about  the structure and role of private capital markets, finance, and business economics, let alone global competition. In the world's largest capitalist economy, this level of ignorance  on behalf of our political elite is really mind-boggling.

(2) After 18 months of intensive investigation, the US Senate's Permanent Subcommittee on Investigations  and the SEC have not so far been able to find anything that is clearly illegal to pin on Goldman Sachs.

(3) On the other hand, on the secondary trading side of Goldman's  business, Goldman traders  clearly have "market maker" ethics, not investment adviser ethics. They've grown accustomed simply to  providing market liquidity for whatever securities clients  happen to want -- or can be persuaded to want, even if Goldman is taking opposite positions at the very same time in the very same securities. 

For example, regardless of what Goldman's own sales people  felt about the terrible quality of the synthetic CDOs they were selling in 2007  -- including many securities packaged out of  "stated income" mortgages --  they continued to sell anything for which there was a current price.  

Goldman's trader culture simply  doesn't  buy the notion that market makers  have any "duty to serve the best interests of their clients. In competitive world, this amoral culture may well be essential to being a successful "market  maker,"  and Goldman is one of the most successful secondary traders in the world  However, if we expect some higher standard of behavior toward clients, this is likely to require new rules; Goldman will never get there on its own.

Of course, in a highly competitive global market,  any such rnew ules might just cause  this entire business to move offshore, to London, Hong Kong, Singapore, or any number of other offshore financial centers.

(4) With great respect to Michael Lewis, the notion that Goldman Sachs engaged in a hugely profitable "big short" in 2007-2008, in the sense of secretly betting systematically against the same securities that it was underwriting for its clients, is easily overstated. Goldman's investment portfolio in mortgage securities turned negative in early 2007,  was net short all year long in 2007, and at times had up to $13 billion of gross shorts, the bank's net profits from all this shorting that year was $500 mllion to $1 billion. The following year, 2008, its mortgage portfolio lost $1.8 billion 

(5) There appears to be enormous pent-up rage and ressentiment in the country at large, right now, driven by the financial crisis, the slow recovery, high unemployment, and the loss of homes and pensions, on the one hand, and the widespread perception that banks not only created the crisis, but have also profited immensely from it.  Most people may not know a CDO from a dustpan, but there is a very disturbing tendency to seek scapegoats, dividing the world into villains and victims. Ironically,  the most obvious targets include companies like Goldman Sachs, one of our most successful, better-managed, if trader-ridden  companies.

(6) Compared to other major US banks, Goldman Sachs' role in the credit derivatives market, the mortgage market, and bank lending in general, as well as in the roots of the most recent crisis, was minor at best. Indeed, compared with the more than $240 billion of past due/non-performing mortgage loans now on the books of the "big four" banks,  the sums involved even in Goldman's most questionable deals were trivial. Why the US Senate and the SEC decided to focus so heavily on Goldman, as compared with Citi, Bank of America, JP Morgan, and Wells Fargo, is an interesting political-economic puzzle.  

(7) On the other hand, these other major  private banks, plus Lehman  Brothers and Bear Stearns, were by far the largest players in the private mortgage market. If they  had followed Goldman's risk management, accounting, disclosure, and leverage practices, the worst of this crisis might well have been avoided.  Indeed, it appears that one reason these generally much larger firms did not adopt such practices was because -- unlike Goldman -- they genuinely believed they were "too big to fail."  

(8) Going forward, the real problem with Goldman market was not, by and large,  illegal behavior, but an excess of perfectly legal behavior that may well be socially unproductive and way under-regulated.  Especially in a world where other countries have fallen behind in the move to  update their financial regulations, dealing with this problem will require much more than lawsuits and investigative hearings.  

IN THE DARK TRUNKS...

Today's hearings probably came as close to fireworks  as investment banking and "structured finance"  ever gets.  In one corner there was Goldman Sach's slightly shaken,  but still-unbent  CEO Lloyd C. Blankfein (Harvard '75/ HLS '78).

 

There was also Blankfein's articulate, amiable  life-time Goldman employee David Viniar  (HBS '80); the now-notorious, side-lined 31-year old Goldman VP Fabrice P. (aka "fabulous Fab") Tourre (Stanford M.S. '01),  architect of the particular "synthetic CDO" at the heart of the SEC case;  and several other  past and present stars from the "devil bank's" specialists in mortgage banking.  

Apparently not pressent was Goldman's President and COO,  Gary D. Cohn (American U, 'whenever)  (aka "Aeolus,"). Perhaps he had flown to Athens to arrange more  cosmetic "dirty debt swaps"  for Greece,   

Ring-side support for the Goldman front line  was  provided by a hand-picked team of  very high-priced trainer/coaches.  This included former Democratic House Speaker Richard Gephardt,  former Reagan Chief of Staff Ken Duberstein, and Janice O'Connell (aka "Puerta Giratoria"), a former key aid to Senator Dodd.

 Senator Dodd, the retiring Chair of the Senate Banking Committee, has been working since November on  S.3217, an epic 1600-page bill that Senate Republicans (with perhaps a little help from Fed staffers who opposed the bill) have  just prevented from coming to a vote. 

Of course Goldman has also hired Obama's own former chief counsel Gregory Craig as a key member of its defense team.

Once taken seriously as a "liberal" Democratic Presidential candidate, Gephardt has gone the way of all flesh, and is now  completely preoccupied with serving such worthy clients as Peabody Energy, the world's largest private coal company; NAPEO, an association of "professional employer organizations" that is trying to dis-intermediate what little remains of labor rights for outsourced workers; UnitedHealthCare, a stalwart opponent of the "public option" in health care reform; and of course, Goldman Sachs, which has also employed the  prosaic Missourian to pitch the (really insidious) idea of "infrastructure privatization"  all over the country to cash-strapped state and local governments.

IN THE WHITE TRUNKS.. 

In the other corner is the aging  heavyweight champion from Michigan. Senator Levin (Harvard Law '59), is a low-key but tenacious warrior, with a mean-right hook; Goldman would do well not to underestimate him.   He's a  veteran critic, investigator, and opponent  of  global financial chicanery, dirty banks, and tax havens -- except perhaps when it comes to GM's captive leasing shells and re-insurance companies in the Cayman Islands and Bermuda (Heh, even a Dem's  gotta eat!)  

Sen. Levin is backed up by several knowledgeable, tough cross-examiners, especially Democratic Sen. Kaufman of Delaware and Republican Senator Collins of Maine. On the other hand, Republican Senators McCain and Sen Tom Coburn  were a bit more  "understanding" of Goldman's basic amoral attitude toward market-making. 

FIRST ROUND

In handicapping this contest, some observers predicted that the best and brightest from our nation's leading  investment bank  would basically roll over the "old folks" from the Senate.

In the first few hours, however, it quickly became clear that the bankers were a little under-prepared for the Senators' often-times impatient, hard-nosed tone, especially from former Prosecutor Levin, Collins, and Kaufman.

Nor were they prepared for the widespread, if perhaps naive and even "Midwestern" view  that there was just something fundamentally wrong with the lines Goldman drew between pure "market-making" and providing investment advice.

LEVIN DOG

For example, Sen. Levin  was a real rat terrier  on the question  of whether it was ethical for Goldman market-makers in 2007 to  be aggressively pushing clients like Bear Stearns  to buy a CDO security called "Timberwolf" that Goldman's own internal analysts had called  "shitty."  Meanwhile, Goldman's ABS group was shorting Bear by buying puts.  The panel of five present or former Goldman executives had trouble recognizing that there was any problem at all -- given the fact that, from a legal standpoint, Goldman had fully informed these clients about the risks they were taking.

For another $2 billion "Hudson" CDO deal that Goldman sold from its inventory, the firm's own sales people characterized the product as "junk," and indicated that more sophisticated customers might not buy it.  Yet, according to Senator Levin,  Goldman's selling documents for a portion of the sale characterized  the deal as one where Goldman's interests and the client's interests were "aligned" because Goldman retained an equity interest in the Hudson package. In Senator Levin's view, this  "retention" was misleading, simply because Goldman took time to sell down its position.

On the question of the Abacus transaction at the core of the SEC law suit,  Sen. Levin was able to establish that the  Goldman's  Tourre never told the German bank that invested in the deal that  John Paulson, the hedge fund manager who helped choose the portfolio, although he claimed to have told portfolio selection manager ACA.  Oddly enough, from what we heard about other "raw deals" today for the first time, this now appears to have been perhaps the weakest deal for SEC to attack.

Similarly, Senator Collins pressed a group of Goldman securities "market-makers"  very hard about whether  or not they felt they had a "duty" to work in the "best interests of their clients." The responses she received indicated that these Goldman executives, while insisting on the organization's high ethical standards, also simply "did not get" the point that there might be some higher ethical, let alone legal,  duties to clients, for pure market makers, beyond just providing them with legally-required disclosure.

CONTEXT

Senator Levin claimed that these hearings have been in the works for more than a year. He says that it is just sheer coincidence that they are occurring soon after the SEC decided to file its case by a narrow 3-2 party lines vote, and right when Senator Dodd's reform bill just happens to be on the verge of being introduced. 

Other sources indicate that Levin's investigation had been scheduled to continue through May, and that it was abruptly rescheduled after the SEC vote.

Furthermore, for someone who is supposedly holding hearings to gather facts and find out what was really went on,  Senator Levin had already formed quite a few strong opinions prior to hearing from any witnesses -- as shown in his latest press release.  

 But so what?  Even if  he's was a little simplistic, filled with anti-bank animus, and eager to portray the financial crisis as a kind of morality play,  and even if there's no big payoff other than the theatrics, it was definitely kind of fun to  watch the "show trial" -- finally  see someone  asking  big bankers tough questions under oath.  After all,  regardless of what  "caused" the financial crisis and its interminable aftermath,  it is pretty clear who is paying for it -- and it is certainly  was neither these Senators nor the bankers in the dock. 

( Stay tuned for Part III, which takes a closer look the Goldman Sachs case in light of these hearings, and consider the broader question of other "big bank" roles in the crisis.)

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(c) JSHenry, SubmergingMarkets (2010)