Economists Do It With Models

Warning: “graphic” content…

Bookmark and Share
Follow Up: Perhaps You Like These Goldman Sachs Analogies Better Than The Tiny Town One?

April 22nd, 2010 · 8 Comments
Buyer Beware · Finance

A few days ago, I presented you with an analogy that Rachel Maddow came up with to explain the Goldman Sachs fraud mess. Aaaaaaand you didn’t like it very much, which is fair since it was a little too oversimplified. (If you’re curious, I added some more detail in the comments of that post.) But I have to admit that it’s not as bad as the analogies that some others have come up with…*cue Daily Show montage*

Oh man. First off, what on earth was Jim Cramer thinking regarding that costume? Second, apparently decent analogies to explain things like potential large-scale bank fraud are harder to come up with than I would have initially thought.

The Daily Show With Jon Stewart Mon – Thurs 11p / 10c
These F@#king Guys – Goldman Sachs
Daily Show Full Episodes Political Humor Tea Party

Dear CNN: Your attempted used-car analogy should have been a slam dunk, since the Goldman Sachs situation is a near-perfect example of the lemons problem. How did you go so wrong on this? (Sidenote: I fully expect you to tell me if any of my analogies or explanations are this bad. Seriously.)

Personally, I appreciate Jon Stewart’s recommendation: “I got an idea- why don’t you explain it like you’re news shows and your audience had *not* suffered a traumatic brain injury.” Unfortunately, I disagree with much of Stewart’s (fake) analysis from that point on…

It’s not “terrible” to sell a risky product if people in fact know that it’s risky or damaged or whatever. At the risk of making another terrible analogy, investing in these products with the proper information is like buying a pack of irregular socks- you get them at a significant discount, and they may turn out of be crap, but they could also turn out to just have the wrong color stitching on the toe or something. If the market has full information, then the prices of these products should reflect their risk, and people get what they pay for. Would you prefer the law take away your ability to buy the irregular socks at a discount because they might not work out for you?

At about 4:15 in the video, the news source said that Goldman Sachs labeled the financial product in question as a good product and said that the hedge fund had in fact invested in the product. Well, that second part, if not true, is clearly problematic. The first part is also pretty crappy, I will admit, but on a somewhat different point on the reasonableness/legality spectrum. To provide another potentially terrible analogy, I present some comments from the previous post:

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…

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???? 🙂

Basically, I’m trying my best to keep things in perspective here. Yes, Goldman didn’t let on that this hedge fund guy designed the product to be crappy, but if people could see what was in that product why should it matter? I could make sandwiches out of week-old bread and moldy cheese and they could be sold at a supermarket and the customers would balk at the idea of purchasing them as long as they could tell what they were made of, even if the supermarket went around saying how great they were. Should they have to tell their customers that I specifically made the sandwiches out of things that I wanted to get rid of in the kitchen? This doesn’t make the supermarket look good, but it also isn’t particularly problematic from a market perspective. The problem comes in if the sandwiches are wrapped such that the customers can’t examine them and then the store refuses to give a refund once the customers open them up and find them to be inedible. See the difference?

Based on the above, we’re finally honing in on where the underlying problem could be- did investors have all of the information that they needed to make an objective, informed decision? In other words, if investors knew what they were buying, knowing who constructed it becomes mostly irrelevant. I mean, no stock broker really has an obligation to tell me how Warren Buffet currently feels about the security I am about to purchase, even if he had a hand in shaping the company, right?

This all brings me to the coolest part of this that I have read about so far. Apparently these products are so complex that it might be computationally impossible to sniff out the lemons in them:

The paper (Arora et al., “Computational Complexity and Information Asymmetry in Financial Products”) argues that the complex structuring of derivatives can create “computational intractability.” In layperson terms, finding the “lemons” can become an inordinately difficult mathematical problem. Unless an investor has unlimited computational power, it may not be able to “solve” the problem and detect the lemons. It’s the same problem that occurs with trying to decode computer messages protected with a certain level of encryption. The structuring of the deal functions as a kind of encryption to camouflage the bad assets.

This means that the party that both selects the collateral and structures a complex derivative (like a synthetic CDO) has a potentially insurmountable information advantage over its counterparties. … (In an amusing twist, the paper argues that “even Goldman Sachs” wouldn’t be able to detect the lemons).

My nerd meter is so off the charts right now. If this is true, then investors aren’t able to fully investigate and understand what’s in the product, and they got the financial equivalent of the wrapped and unreturnable sandwich. Legal or not, this doesn’t look so good for the grocery st…er, Goldman Sachs. I will try to stop with the bad analogies now.

Tags: Buyer Beware · Finance

8 responses so far ↓

  • 1 CJB // Apr 22, 2010 at 5:42 pm

    Ehhh, I think this whole thing is a big political publicity stunt. The Street’s practice is to disclose the assets not the seller/intentions. You can make your own decisions since all of the assets are disclosed in the offering memo (this CDO was not public so its not a prospectus, its a OM). If you buy or sell stock do you care who’s on the other side of the trade? Not really, you know the asset. This is the same and the underlying 90 some bonds were all laid out to look at- if you thought they were crap, then dont invest. ACA knew what they were getting into and even had meetings with Paulson, I don’t really think they were wronged, and neither was IKB (who is currently propped up by the German govt due to a few investing mess ups of their own…not exactly careful people who did their HW). Another thing that annoys me and brings me to the conclusion this is political, is the first paragraph of the SEC filing, where they add in a completely unnecessary sentence about how assets “like” Goldman’s Abacus contributed to the downturn in the housing market. It adds nothing to the case overview and its position in the first paragraph is merely just to make Goldman look evil. That’s my 2 cents. (first time commenter!! wahoo!)

  • 2 econgirl // Apr 22, 2010 at 7:43 pm

    I’m glad I’m not the only one having a bit of a hard time getting my panties all in a twist over this. 🙂 What you are saying about the offering memo is perfectly reasonable- if investors knew what they were buying, there should be no problem, since it’s not like Paulson betting against the thing actually causes it to bust. When I buy a lottery ticket, it’s not like I feel hoodwinked when I don’t win…okay, well, maybe I do a little, but deep down I know that that isn’t reasonable.

    I really am curious to see how this computational complexity thing turns out, since that was a wrinkle in the argument that I didn’t see coming…

  • 3 B. O. Thermopylae // Apr 22, 2010 at 10:55 pm

    As for securities fraud, the SEC did not allege that the activities by Goldman were fraud.

    The SEC could care less, legally, whether Goldman used, say, Bart Simpson, to select the mortgages for the CDO…provided Goldman disclosed in the securities offering documents that it used Monsieur Simpson in said capacity. If Goldman did not materially disclose such information (it did not), or materially omitted such information (it did), then doing so is considered securities fraud in a court of law (precedents exist).

    This, apparently, is what the SEC has alleged and what Goldman must defend in a court of law.


  • 4 CJB // Apr 22, 2010 at 11:37 pm

    Ive read both the SEC filing as well as the offering memo. ACA is listed in both as selecting the securities (they did- no problems there). If the investor liked it (if they don’t trust ACA they can look up the bonds which are listed in the memo themselves and I find it hard to believe that someone investing a ton of money into this would not look them up) they can buy it. If they don’t like it, don’t buy it- or better yet buy CDS’s on it.
    Yes Paulson also selected bonds, but the bonds were agreed upon by both parties; cleared by ACA. ACA went to the meetings, knew what was going on- they are not a bunch of dummies and had a great track record- and still decided on those and agreed to put their name on it. So, why should it matter to an investor that Paulson helped pick? If ACA was not involved in this and GS did not disclose Paulson then I think there would be an issue.
    Perhaps Paulson should be named a “transaction sponsor” (paragraph 29), but that still does not mean disclosing that they helped to pick the bonds.
    I doubt it will get to court. My guess it that it will be settled out of court.

  • 5 Charles Dolci // Apr 23, 2010 at 1:54 am

    I will admit that I am a bit perplexed by this, but I would tend to agree with CJB .
    Also, it seems to me there are certain similarities between the current situation and futures contracts and trading. This also brings up the issue of asymmetrical information.
    In reality, doesn’t EVERY transaction have two elements – asymmetrical information and enough information. I may not have as much (or the same kind of) information as the other party AND vice versa – but I have enough information for my purposes, or at least enough that I am willing to take the risk and go forward with the deal. I don’t know much about the complex innards of this computer I am using – but I thought I had “enough” information to buy it anyway. Isn’t “symmetrical information” just one of those textbook theories that sounds goood in the classroom, but, like unicorns, doesn’t exist and never can exist in the real world?
    Regarding futures contracts – if the “investor” has spent a lot of time studying the weather patterns and thinks that this year will be an El Nino year – which means droughts in Australia and a worldwide shortage of wheat, must he advise the domestic wheat farmer, with whom he wants to enter into a futures contract, about his weather prediction? There is an asymmetry of information – the farmer doesn’t know about El Nino and the investor doesn’t know about growing wheat. But with that imperfect information each is willing to take certain risks and enter into the contract.
    Everybody was gambling here. Paulson thought, based upon his research (but still imperfect and incomplete knowledge), that they underlyng obligations would crap out. He had no guarantee, but he was willing to take the risk. The buyers had access to the same information, if they had wanted to look. But they were willing to go ahead based on their imperfect and incomplete information. They felt they had enough information. And Paulson could have been wrong. All parties were gambling (taking calculated risks) based on imperfect information.
    But isn’t that the nature of all transactions, particularly in that industry?
    I see bare knuckles politics at work here and a lot of after the fact finger pointing and blame shifting.

  • 6 Doc Merlin // Apr 23, 2010 at 6:11 am

    My lawyer friends tell me that the SEC doesn’t have much of a case.

  • 7 Mitch // Apr 23, 2010 at 8:16 am

    What if the sandwiches you sold at the supermarket were only contingently moldy?

    I like the complexity point. It’s like a cognitive externality that financial engineering has imposed on all the participants in certain markets.

  • 8 greg // Apr 24, 2010 at 9:01 pm

    I am presently in litigation with Fremont Reorganizing, Goldman Sachs dba Litton Loan Servicing, et al., (2 different cases) for about 2 years now. The main issue with the complaint is a fraudulent loan originated by Fremont in June 2006. This in turn produced an array of other
    issues: unsigned deed of trust, over billing issues, lost payments, excessive balloon payment, back dated assignments, illegal non-judicial foreclosure documentation, missing documentation, illegally reporting to my credit, falsifying declarations, 6 week TRO’s, court procedures not followed, judges wait until the courtroom is cleared to rule against a TRO (both times); retired (78 year old) judge ruled against a seated judges TRO where the retired judge took 30 minutes to read a 300 page brief. The whole time they have been ignoring my request and failing to give me the required documentation so that I can rescind the loan. Goldman Sachs dba Litton Loan Servicing has been aggressively trying to foreclose on my property. I believe to cash out for insurance reasons. (It’s over a million dollar loan) I have invested over $400,000 into this property for the past 5 years and if I had known about this mortgage meltdown game played by Wall Street I would have never proceeded with this Real Estate transaction. The Media and the Government has not once addressed or helped the borrower, namely me, who also has been damaged by these defaulted CDO’s.

    A Time line of what’s going on with Goldman Sachs to show how they are scheming to pursue foreclosures for the insurance by acquiring distressed, shelled fraudulent companies which will eventually or haven’t already gone BK…

     Oct 26, 2005 Litton Loan Servicing Class Action – mishandling loans, servicing over 400,000 borrowers – case settled Feb 17, 2009 for $537 (limited due to class status)
     Feb 27, 2007 FDIC Cease and Desist – Fremont Reorganizing for illegal loan practices, et al., (largest predatory lenders who heavily solicited brokers for their schemes)
     Oct 16, 2007 Massachusetts Lawsuit vs Fremont and Goldman Sachs – Predatory Lending Practices – settled May 11, 2009 for $60 mil
     Dec 11, 2007 – Goldman Sachs Acquires Litton Loan Servicing
     June 2, 2008 Litton (Goldman Sachs) Acquires Fremont Reorganizing Servicing Rights
     June 19, 2008 Fremont Reorganizing files BK
     Apr 16, 2010 – SEC vs Goldman Sachs – Securities Fraud

    Here is the link to my blog if you want to download court documents pertaining to my case.

    Note: My wife is pursuing individuals who are interested in joining her in a class action lawsuit with regards to violation of her community property rights in a wrongful foreclosure. If you are in a community property state and a spouse is not on title you may have grounds for legal action.

Leave a Comment