Economics

Why the Goldman Sachs indictment is good news

April 28, 2010
Goldman Sachs: the Goliath of Wall Street.
Goldman Sachs: the Goliath of Wall Street.

What a difference an indictment makes. Only back in February, President Obama called Goldman Sachs CEO Lloyd Blankfein a “savvy businessman” and said he didn’t begrudge the financier his $9m bonus. Yesterday, a bipartisan senate committee joined together to beat up on the man. It seems the SEC civil suit against Goldman has become a real game changer. A few weeks ago, the chances for financial reform seemed paltry. Today, even Republican senators are turning against Wall Street. While they still maintain their opposition to the Dodd bill, they clearly fear being painted as the bankers’ lackeys. Senior New York Senator Chuck Schumer, long known as Wall Street’s man in Washington, is keeping quiet. Even he says he supports financial reform. Although the inter-party squabbling continues, it seems a real reform bill now has a decent chance of being made law.

The White House and the SEC claim the indictment on 16th April wasn’t politically motivated. Don’t believe it. First, all the Republicans on the SEC panel voted to quash it, while all the Democrats voted to go ahead. Second, the timing was impeccable. Third and most important, this case was brilliantly chosen to expose dubious financial practices in ways most of us can understand. By choosing to indict Goldman Sachs, the government picked the biggest bully in the playground and slapped him around. Goldman lost over $14bn in market capitalisation the day the suit was made public. Its reputation may take years to recover.



Here is the story, according to the SEC. In 2007 hedge fund billionaire John Paulson wanted to bet against subprime mortgages. He asked Goldman to help him create a collateralised debt obligation (CDO) he could then short. For a mere $15m fee, Goldman happily set up the CDO and then allowed Paulson to cherry pick mortgage pools he was confident would fail, and fail fast. In other words, the casino allowed one of the players to shuffle the deck in order to deal himself a straight flush.

Shockingly, this in and of itself is not illegal, nor does Goldman deny doing it. Its crime, according to the SEC, was not informing the counter parties that Paulson was stacking the deck. Goldman’s defence is that on the other side of the trade were “sophisticated investors” who should have done their own due diligence and so deserved what they got. Even if Goldman wins its case, I suspect the general public will be dismayed to find out that rigging the game is not a crime on Wall Street. And its clients certainly realise that Goldman Sachs does not have their best interests at heart.

It is worth noting that this CDO was “synthetic”—that is to say, it funded no mortgages. It was just composed of credit default swaps; so in effect it was a side bet, with absolutely no real economy benefit. Credit default swaps are supposed to provide insurance for bondholders, but these were naked because no participants owned any of the underlying debt.

The best analogy for naked CDS is buying fire insurance on the house down the street inhabited by pyromaniac squatters. Goldman and Paulson then bought them gasoline. Finance’s societal purpose is to funnel savings to the most productive investments. Even if it had been done utterly above board, this CDO would have done nothing of the sort. At best it would have been another example of the casino capitalism that has taken over our financial markets, turned it into a zero sum game, nothing more. Yet another reason for all of us to dismiss Blankfein’s claim that Goldman is “doing God’s work.”

Interestingly, the SEC brought a civil, not a criminal suit. Now AIG and others (perhaps even the British government) are thinking of suing Goldman themselves. I suspect that was the goal of the SEC. Other investors burned will be thinking of legal recourse. This could really change incentives on Wall Street—much more effectively than just throwing a banker or two in jail.

Banks have weathered the storm of the financial crisis they caused better than the rest of us. Profits are high, bonuses have returned to pre-crisis levels. But more and more, politicians and pundits are realising that our financial sector has grown too large relative to the rest of the economy.  Our economies grew faster when our financial system was more insignificant. The rise of finance has coincided with lower real investment, more crises, slower growth. A few years ago, only cranks like me thought the financial sector had grown too large. It is starting to become the conventional wisdom. I may be an optimist, but I think that this indictment is the first step in finally reining in the overgrown financial sector.