Few things excite the public as much as a financial scandal. When the scandal involves Goldman Sachs, the richest, most powerful firm on Wall Street, and the central figure is an unknown thirty-one-year-old Frenchman who refers to himself as Fabulous Fab, the result is a barrage of news stories that most people donâ??t fully understand but which create a widespread sense that some unprecedented skullduggery has been revealed and that villainous investment bankers will finally be held to account. Yet so far the facts donâ??t suggest anything that dramatic. On April 16th, the Securities and Exchange Commission filed a lawsuit against Goldman and Fabrice Tourre, a relatively junior employee, charging them with misleading investors during a 2007 deal involving subprime mortgages. Goldman has denied wrongdoing, and the suit, in any case, is a civil one. Unless the Justice Department launches a criminal investigation, neither Tourre nor his bosses will face the possibility of jail time.
Even before the S.E.C. suit, it was widely believed that Goldman had placed bets against subprime-mortgage bonds while simultaneously hawking them to some of its clients. This belief persisted despite Goldmanâ??s insistence that it neither foresaw the housing collapse nor positioned itself to benefit from it. In a calculated display of humility, David Viniar, Goldmanâ??s chief financial officer, recently told Business Week that the firm wasnâ??t that smart. But we now know that, in early 2007, John Paulson, a New York hedge-fund manager and Goldman client, was determined to sell short the subprime market in anticipation of a crash. To help him do it, he enlisted the services of Tourre, a mortgage trader who was then just twenty-eight. The case turns on whether Goldman had a legal obligation to disclose Paulsonâ??s involvement in its subsequent issuance of a complicated derivative security known as a â??synthetic collateralized debt obligation,â? whose value was tied to dozens of subprime-mortgage bonds. If the individual home loans that backed the bonds performed wellâ??if the borrowers continued to make their monthly paymentsâ??the C.D.O.â??s buyers would enjoy a decent return. But if delinquencies and foreclosures rose, they stood to lose heavily.
In such a setup, the buyers assume that someone will be betting against the bonds, so the quality of the underlying credit is key. Goldman told investors that a specialist mortgage firm called A.C.A. had compiled the portfolio. â??One thing that we need to make sure A.C.A. understands is that we want their name on this transaction,â? Tourre wrote in an e-mail, adding that it â??will be important that we can use A.C.A.â??s branding to help distributeâ? the securities. The government alleges that Goldman failed to disclose that not only was Paulson betting against the new securities but that he had helped select the mortgage assets, supplying A.C.A. with a list of individual subprime bonds to include with its own choices. (This sounds a little like a racetrack allowing a gambler to select horses and jockeys to run in a race, without informing the other bettors.) Tourre also allegedly told A.C.A.â??falsely, the government contendsâ??that Paulson invested two hundred million dollars in the new securities.
Within nine months, rising delinquencies and foreclosures had caused the investors, who included two big European banks, to incur more than a billion dollars in losses, while Paulson made almost as much in profits. Gordon Brown, the British Prime Minister, described Goldmanâ??s behavior as â??moral bankruptcy,â? but that doesnâ??t mean that the firm has no legal defense to offer: Goldman says that it lost ninety million dollars on the deal, and that in 2007 few investors knew who Paulson was, so disclosing his role wouldnâ??t necessarily have spooked them. Given the frenzy over C.D.O.s at the time, that claim may not be as ridiculous as it sounds.
Securities lawyers are divided over the S.E.C.â??s chances of proving its case, but few members of the public will mourn should Goldman lose. Long known as an investment bank that raised money for blue-chip corporations and advised rich people, Goldman now resembles a huge hedge fund that trades extensively on its own account, often betting against its own clients. Some of the firmâ??s recent actions recall its practices of the nineteen-twenties, when it famously created heavily leveraged investment funds such as Shenandoah and Blue Ridge, both of which were reduced to dust in the 1929 Crash. Still, Goldman was not alone in cooking up deals with hedge funds, or in creating toxic subprime securities. Between 2005 and 2008, the top ten issuers of synthetic C.D.O.s were Bank of America / Merrill Lynch, U.B.S., J. P. Morgan Chase, Citigroup, Morgan Stanley, Wells Fargo, Royal Bank of Scotland, Credit Suisse, Goldman, and Barclays. All these firms are now bank-holding companies, which means that their retail deposits are federally insured, and that when they get into trouble they can borrow cheaply from the Federal Reserve. If things get really serious, they may also be able to rely on taxpayers to bail them out with an infusion of capital. What we have had, in effect, is a government-guaranteed and taxpayer-subsidized casino industry piggybacked onto the legitimate banking sector. That is the real scandal. As President Obama pointed out last week, in his speech at the Cooper Union, in New York, the â??free market was never meant to be a free license to take whatever you can get, however you can get it.â?
Meanwhile, the Senate appears to be moving toward approving a financial-reform bill. The bill contains many worthwhile measures, such as setting up an agency to protect consumers from predatory financial institutions, regulating trading in many types of derivatives, and making it easier for the government to shut down a big non-bank financial company, such as G.E. Capital or A.I.G. But Wall Streetâ??s lobbyists may well succeed in blunting the billâ??s impact. Moreover, the most acute incentive problem will remain: all the banks listed above will still be â??too big to fail.â? That is why, following Paul Volckerâ??s lead, the Administration has called for a size cap on banks, and it wants to ban them from investing in hedge funds and from carrying out some forms of proprietary trading. But the cap proposed would allow giants like Citigroup and Bank of America to remain intact, and the official definition of proprietary trading remains vague. In any event, firms like Goldman and Morgan Stanley can always give up their commercial-banking licensesâ??which they took out only in 2008, to secure funding from the Fedâ??knowing that the government would almost certainly still bail them out.
As welcome as the reform bill may be, no one should think that it alone will prevent further meltdowns. It took twenty-five years of misguided economic theorizing and legislation, along with insufficient regulation, to create an outlaw financial sector. Rehabilitating it will be a mighty, multiyear endeavor.â?¦
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