A few weeks ago, I did a blog post questioning whether the mega-profitable, much-hated investment bank Goldman Sachs really methodically set about putting together mortgage-backed securities that would fail. I pointed to a Michael Lewis endorsed college thesis that seemed to suggest Goldman’s mortgage CDOs had actually done better than the rest. I then asked people to vote on whether Goldman was actually a vampire squid or not. Well the Securities and Exchange Commission casts their vote today and the winner is: VAMPIRE SQUID.
The SEC is alleging Goldman committed securities fraud by colluding with a hedge fund to create bonds that were filled with home loans sure to default. Goldman then sold those bonds to invests as regular-old good investments, knowing the hedge fund that conceived the bonds planned to bet against them. Goldman may have placed some bets itself. This is from the release about the complaint:
“The product was new and complex but the deception and conflicts are old and simple,” said Robert Khuzami, Director of the Division of Enforcement. “Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third-party.”
Kenneth Lench, Chief of the SEC’s Structured and New Products Unit, added, “The SEC continues to investigate the practices of investment banks and others involved in the securitization of complex financial products tied to the U.S. housing market as it was beginning to show signs of distress.”
So there you have it. Finally, the financial crisis gets its first major fraud case. Investment banks created complex securities that increased the risks of in the financial system. Most then held on to the securities because they didn’t know what they had. Goldman instead came up with an elaborate scheme to lay off the risk on unsuspecting investors. Either way, Uncle Sam had to come in a clean up the mess. As the SEC says, in selling something they knew was worthless, Goldman was no different from the medicine man of old. It’s a fraud as old as time.
The first question was who was damaged here. The answer is all of us. First of all, the investors who bought the securities lost about $50 billion on them $1 billion. (That’s the figure for the deal in question by the SEC. But I believe if you figure in all the deals synthetic deals that Goldman set up the investor loss is much larger.) Those investors were mostly pension funds. Second, Goldman insured these purposefully useless mortgage bonds with AIG. So all of us, taxpayers that is, had to pay up for those losses when AIG had to be bailed out. So this suit is really just a case of the government trying to get its money back from Goldman. That’s something we should see more of.
Two more questions: Does this end Blankfein’s reign as head of Goldman? I think so. It’s a big deal for an investment bank to be charged with securities fraud. And it is not just a coincidence that Goldman would get hit with a fraud case when Blankfein was CEO. Even though he is not named in the complaint, Blankfein is to blame. He pushed the firm to become less of an investment bank and more of a trading behemoth. And this is the result: A brilliant trade that was so brilliant the Goldman people forgot that it also might be fraud.
Last: So are hedge funds more to blame in the financial crisis than we thought? It certainly looks that way. When the hedge funds went before Congress a year or so ago, they were praised–Paulson included. Now it looks like Paulson masterminded a trade that cost the government tens of billions of dollars. I would hope his next Congressional meeting will be less pleasant.