Economists Do It With Models

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Goldman Sachs Fraud, Tiny Town Style…

April 17th, 2010 · 11 Comments
Buyer Beware · Finance

So this SEC suing Goldman Sachs for fraud thing is all over the news, but, like a lot of issues having to do with complicated financial products and whatnot, people are having a bit of trouble following exactly what went down that got the SEC’s panties all in a twist. For example, The New York Times reports:

According to the complaint, Goldman created Abacus 2007-AC1 in February 2007 at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst. Mr. Paulson is not named in the suit.

Goldman told investors that the bonds would be chosen by an independent manager. In the case of Abacus 2007-AC1, however, Goldman let Mr. Paulson select mortgage bonds that he believed were most likely to lose value, according to the complaint.

Goldman then sold the package to investors like foreign banks, pension funds and insurance companies, which would profit only if the bonds gained value. The European banks IKB and ABN Amro and other investors lost more than $1 billion in the deal, the commission said.

I’m obviously a huge nerd, so I don’t have a good perspective on whether this is straightforward or not. NPR’s Planet Money blog tries to shed some light on the situation, but I take it as a bad sign when other economists I follow mention on Twitter that even the “real people” explanations of the complaint against Goldman Sachs are confusing. Luckily, Rachel Maddow took a slightly different approach to the matter and housed her explanation in a cartoon analogy:

I was at the very least entertained by the bit, and I suppose that it’s roughly correct. Let me see if I can do any better at explaining what Goldman is accused of (probably not):

Hedge fund guy: I think the housing market is going to go to s**t in the next few years. More specifically, I think I know which parts of the housing market are particularly vulnerable. In order to profit off of this information, I would like to short sell a financial product that is tied to the housing market. In other words, I’m going to borrow one of these securities, sell it at the current high price, buy it back once it’s worthless and then give it back to the original owner, keeping the profit for myself. (Update: Technically the short position was achieved via a credit default swap as opposed to a regular short sale. This doesn’t affect the overall analysis, and you can see my comment below for more detail.) Now, there are a few products out there that would be appropriate for this, but it would be totally better if I could design the product myself, since then I could be extra sure that it would tank as much as possible, thus maximizing my profit. Let me call my buddies at Goldman and see what they can do for me.

Goldman Sachs, to hedge fund guy: Sure, we can do that, just tell us what you would like the crappy product to look like. But wait a second…you do realize that it’s hard to short sell something unless other people actually hold the product in their portfolios, right? And who in their right minds would buy something that you, as a smart guy, specifically picked as being the bottom of the housing market barrel? That kind of throws a monkey wrench into your plan…but wait, I think we might have a solution to this problem. So here’s the deal – you’re gonna get a call from another financial firm, and you’re gonna tell them that you are looking to create a product to invest in. Now, this is technically true, so all you’re really doing is leaving out the teeny detail that you are taking a short position rather than betting on an increase in value. No big deal, right? Just tell them what you want in the product and they will make it happen.

Goldman Sachs, to other investors: Hey look, we have this new awesome product for you. The assets in the product have been hand-picked by an outside firm who specializes in this sort of thing, so you can be confident that’s it’s going to do well. *snicker*

And then, big shock, the product tanks, the investors lose over $1 billion and the hedge fund guy makes a corresponding $1 billion. Note that the real problem here is not that Goldman Sachs purposely created and sold a crappy product. The problem is instead one of asymmetric information, which in this case is the financial equivalent of Groucho Marx’ “I don’t care to belong to a club that accepts people like me as members” quote. Simply put, if you have a really smart guy trying to sell you something that he owns, he’d better have a good reason for needing to sell it, since otherwise you’re probably getting taken for a ride. This situation is a classic example of the lemons problem- you know, where the shady dude is trying to sell you his used car and not telling you that it’s been in 5 accidents and has a faulty transmission- except that we’re talking about a financial product rather than a Honda Civic with a rolled back odometer.

I try to generally be as objective as possible (and have in fact defended Goldman’s business practices in the past), so I want to stay way more out of the discussion of whether this is a sign that more financial regulation is necessary than Rachel Maddow does in the video above. I will, however, point out that what Goldman Sachs is accused of is already illegal under current law, so I’m not sure how new regulations in and of themselves would prevent this behavior. Cue the oversight conversation…

Tags: Buyer Beware · Finance

11 responses so far ↓

  • 1 econgirl // Apr 17, 2010 at 7:00 pm

    Also, I can’t resist pointing out that the Goldman VP charged in all of this refers to himself in emails as “Fabulous Fab.” That should be a crime in and of itself.

  • 2 ArL // Apr 17, 2010 at 9:38 pm

    So, from what I’ve heard on the news, it was a synthetic CDO of subprime mortgages. By definition someone has to take a short position for this to be created. It’s hard to see how it could have been misrepresented otherwise. The only hitch is if Abacus management was paid to pick the bonds and didn’t. Anyone who bought a synthetic CDO of subprime mortgages got what they deserved. That stuff was ridiculous to begin with, and it’s not like it was sold to widow’s and orphans, it was sold to people managing millions and billions that were supposed to know what they were doing.

  • 3 Kevin Greer // Apr 18, 2010 at 4:07 am

    Jodi,

    I’ll spare you the specifics of Paulson’s trade (short version: Rachel Maddow should probably find a line of work that doesn’t involve analysis of financial transactions–this is not a short sale, but a more generic application of “short,” which in this case means buying credit default swaps against a portfolio of debt obligations) or the legal viability of the SEC’s challenge to Goldman’s structuring and marketing of the underlying CDOs (a weak case–even by SEC standards–likely brought to distract the public from the other SEC story that broke the same day).

    That said, I do agree that the issue that goes to the sweet spot of your expertise it the that of asymmetric information. However, the real problem here, as will be revealed as this case plays out, is that the bonds underlying the CDOs were rated AAA or AA by the leading rating agencies. This is not a problem Goldman created so much as it was a market maker responding to a demand for a given trading opportunity. If there is someone to blame here, it’s the due diligence arms of the CDO buyers (primary fools) and the rating agencies (secondary fools, but everyone on Wall Street has known of their incompetence for decades).

    So ArL’s comments are on the money. And while I’m certainly no Goldman apologist, this particularly story has far moving parts than the Maddow analysis might suggest.

  • 4 Dr. Goose // Apr 18, 2010 at 2:48 pm

    Said John Paulson, “Subprime will tank,
    And I’d like to take that to the bank.”
    Said Goldman, “We’ll fashion
    A short you can cash in
    From the Kool-Aid our dumb clients drank.”

  • 5 Warren // Apr 18, 2010 at 5:20 pm

    “Simply put, if you have a really smart guy trying to sell you something that he owns, he’d better have a good reason for needing to sell it, since otherwise you’re probably getting taken for a ride.”

    Hmmm. Sounds a lot like the reason I won’t by gold from people telling me what a great investment it is…

  • 6 econgirl // Apr 18, 2010 at 6:15 pm

    @ Dr. Goose: LOVE 🙂

    @ ArL and Kevin: Well, yes…sort of. What Kevin says about Paulson not actually short selling appears to be correct upon further research. The NYT says the following:

    “Goldman joined in Paulson’s bet by writing the credit default swap used to take a position that the mortgage securities would decline in value. Thus, Goldman was creating a C.D.O. that it marketed to investors while helping a client take a position that the C.D.O. would decline in value — playing both sides of the street without telling the purchasers.”

    (from http://dealbook.blogs.nytimes.com/2010/04/16/goldman-fraud-case-holds-risks-for-both-sides/ Also, it’s worth noting that banks play both sides of the street a lot, since that’s basically what being a market maker entails.)

    It’s statements like these in the media that led me astray a little:

    “They’re going to have to show…that [Goldman] knew that Paulson was not only shortselling it but he had a big role in collecting weakest possible mortgages to bet against it,” said Bradley Simon, a white collar criminal defense lawyer and partner at Simon & Partners LLP.

    (From http://online.wsj.com/article/SB10001424052748704508904575191882961621478.html)

    I naively assumed that when the Wall Street Journal quotes a lawyer talking about short selling and doesn’t mention the problem with the statement that the lawyer is actually describing the situation accurately. Silly me. Luckily, the particular implementation of the short position doesn’t affect the overall argument, but I will put in an update in the interest of not sounding like an idiot.

    That said, it’s only sort of the case that someone has to take a short position in the CDO itself in order for it to exist. I acknowledge that someone has to own the underlying mortgages that back the product and provide the payouts, so technically the owners of the mortgages are shorting in a way by trading the future income streams for an up front payment that it views to be favorable. But it’s important to note that this is not what Paulson was doing. He was making a side bet on the CDO that paid off if the CDO lost value, and I see no evidence of him having a corresponding long position in the CDO.

    From an editorial standpoint, I am torn. I don’t think it’s okay to write off the severity of losses to people and organizations just because they happen to be wealthy…but I do think that if investors could see what the security was made of then they were able to make objective decisions about the position, and the fact that some other finance guy thought it was a bad bet should be more or less a non issue from a practical perspective (though not necessarily from a legal one). If you wanted to play devil’s advocate versus the SEC, you could make the analogy that it’s not like brokers are obligated to make statements to the clients of the form “you know, Warren Buffet thinks that that stock is crap.”

    Furthermore, I don’t think that the “got what they deserved” comment is fair, since there is a proper price for everything. The investors could have been making a perfectly reasonable bet based on the available information, even though that bet did not end up in their favor. In that way, I don’t really feel bad for them save for the fact that some of them likely wouldn’t have taken the position if they had had access to full information.

  • 7 econgirl // Apr 18, 2010 at 6:20 pm

    @ Warren: YES! If you think that gold is such a good investment, why are you spending money on this commercial as opposed to using that money to, oh, I don’t know, BUY GOLD???? 🙂

  • 8 EconomyBeat.org - user-generated content about the economy » Blog Archive » The Goldman Sachs fraud case explained // Apr 19, 2010 at 12:37 pm

    […] Economists Do It With Models tries to explain this in a little more detail and in layman’s terms: Hedge fund guy: I think the housing market is going to go to s**t in the next few years. More specifically, I think I know which parts of the housing market are particularly vulnerable. In order to profit off of this information, I would like to short sell a financial product that is tied to the housing market. In other words, I’m going to borrow one of these securities, sell it at the current high price, buy it back once it’s worthless and then give it back to the original owner, keeping the profit for myself. (Update: Technically the short position was achieved via a credit default swap as opposed to a regular short sale. This doesn’t affect the overall analysis, and you can see my comment below for more detail.) Now, there are a few products out there that would be appropriate for this, but it would be totally better if I could design the product myself, since then I could be extra sure that it would tank as much as possible, thus maximizing my profit. Let me call my buddies at Goldman and see what they can do for me. […]

  • 9 dWj // Apr 19, 2010 at 12:46 pm

    The bigger issue for Goldman than the SEC per se is its clients’ potential reaction. From that standpoint, the big question here is what exactly Goldman’s fiduciary duties to its clients are, and, more to the point, what its clients think Goldman’s duties to them are. Certainly for a synthetic CDO, in which short positions balance long positions, any belief that creating the structure entails an endorsement of the side being offered to clients isn’t workable. So this has to focus on how much of what kind of information Goldman is obligated to disclose.

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  • 11 Kevin // Mar 22, 2015 at 6:12 pm

    There is always a fraud happening if we don’t pay attention so we need to be really careful in not trying to do anything else or else we might end up losing badly. I am very careful when it comes to investment and that’s why I only go with OctaFX, it’s an regulated brokerage company with winning 9 award for their amazing service and also have payment system which is completely instant without even charging any fees at all withdrawal or deposit.

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