Goldman in the Dock

19 April 2010 at 9:12 pm cpirrong Leave a comment

| Craig Pirrong |

I have several reactions to the SEC’s fraud complaint against Goldman.

First, some of the more sensationalist reporting emphasizes that Goldman was short the RMBS structures that it was selling to its customers. (Yeah, it’s the NYT, basing its opinion on reporting by Wretched Gretchen Morgenson, so take it for what it’s worth–meaning not much.) Well, that’s true, but Goldman was also long. After all, it was the counterparty, the protection seller, to Paulson’s CDS. It then entered into offsetting transactions. Goldman was essentially a conduit of risk between other financial firms and Paulson. Note paragraph 66 of the complaint, which indicates that Goldman paid most of the $840 million it received on short positions in the Abacus deals to Paulson. Goldman claimed in its response to the government’s Wells Notice that it was actually long because it retained a slice of the risk; the protection it sold to Paulson was for a larger portion of the potential losses than covered by the protection it bought from ACA Capital.

This means that Goldman took on substantial counterparty risk, which is also revealed in the complaint. Although the complaint does not spell out the exact transactions in detail, it appears that ACA Capital sold hedges on the Abacus deal, and that the risk that ACA Capital would not be able to perform was assumed (for 17 basis points) by ABN. In the event, ACA Cap could not perform, and ABN’s purchaser, RBS, ended paying off on the protection (to Goldman).

This is related to something I blogged about last year (which attracted Jim Chanos’s attention). Specifically, as a market maker both long and short credits, Goldman was vulnerable to default by its counterparties on its long positions. That’s why AIG’s impending demise was so threatening to Goldman. AIG owed collateral to Goldman, and Goldman owed collateral to its counterparties. If AIG had failed, Goldman likely would have failed too. That still seems to me to be the key issue that is often overlooked in discussions of the AIG bailout, and Goldman’s stake in that bailout (which it vociferously denies — too vociferously, IMO).

As to the specifics of the complaint, yes, I’m sure that ACA Management, and the ultimate buyers of the Abacus deal would have liked to know Paulson’s true role in the transaction, and his true economic interest. And it appears that Goldman was deceptive in its representations about Paulson’s role. Whether that’s enough to secure a judgment is debatable, however.

It’s worthwhile to note that it is unlikely that Paulson had material, non-public information about the mortgages at issue. He certainly had a view, based on his analysis of the market. But, according to the complaint itself, that view was based on the analysis of what is most likely public information:

In late 2006 and early 2007, Paulson performed an analysis of recent-vintage Triple B RMBS and identified over 100 bonds it expected to experience credit events in the near future. Paulson’s selection criteria favored RMBS that included a high percentage of adjustable rate mortgages, relatively low borrower FICO scores, and a high concentration of mortgages in states like Arizona, California, Florida and Nevada that had recently experienced high rates of home price appreciation.

All that information was available to ACA Management, and to the ultimate buyers.

Paulson had a view on what was going to happen in the mortgage market, and desired a structure that would pay off substantially if that view was correct. At the time others did not take the same view, even when looking at the same information. That said, one would have been wise to take pause at buying this stuff had they known that Paulson had such a strong view on the market.

One curious thing in the complaint. Typically annoying investment banker jerk Fabrice Tourre (who seems to have stepped out of a Tom Wolfe novel) is the only named defendant. Didn’t oodles of people at Goldman have to sign off on this deal? Why aren’t they named? That seems to suggest a certain weakness in the case.

The self-styled “Fab” is a natural target primarily because of his big mouth — or more precisely, his lurid emails. Emails like this are catnip to reporters — and prosecutors. But any prosecutor who makes such correspondence the keystone of his case is taking a huge risk, as the recent Bear Stearns cases illustrate clearly. The emails should be used like the cherry on the sundae — not the entire dessert. To make the case, the SEC will need more substantive evidence about Goldman’s actions — including the actions of others beyond Tourre, including any putative adults in legal. Yes, it’s hard for juries to follow. Yes, it’s boring. But that’s the hard work that must be done to secure a conviction.

One last comment. The timing of the complaint is quite interesting, coinciding with the administration’s big push for financial regulatory “reform” and its identification of this as a major winning issue. It could be just that — a coincidence. But maybe not.

Moreover, it is cases like these that build the narrative that is used to justify the need for wide-reaching regulation, most of which relates to matters far removed from the specifics of any particular case. That extrapolation is dangerous (extrapolation always is), and almost always results in bad policy.

Much of the regulation introduced in the 1930s was built on similar narratives, that were similarly removed from the specifics of the laws and regulations. The Goldman story is most resonant of the stories of bank perfidy in marketing corporate and sovereign securities in the 1920s; this narrative was an important part of the justification for Glass-Steagall. But as much recent research has shown, the empirical evidence does not support the view that banks systematically profited (and screwed their clients) by keeping good loans and palming off the bad ones through the securities markets. No doubt that happened at times, but the evidence doesn’t support the broader narrative that this was the rule, rather than the exception.

But the new narrative that parallels that of the 1930s is well established, and the Goldman complaint will only cement it in place. And this may turn out to be the most socially costly aspect of Goldman’s actions. These actions will help advance laws and regulations that pose considerable risk of doing far more harm than good.