Goldman on Trial - Part 2

In Part I, we discussed how the lawsuit against Goldman would serve more as a distraction than a resolution to the massive loss of wealth the world experienced. To fully understand what happened, it’s important to remember a couple of lessons we learned back in the 1980s.

Do you remember at the end of the Breakfast Club, when Claire started making out with Bender? It’s easy to understand why she did it. They had been cooped up in that library all day, revealing their cigarette burned souls to each other. Plus, if you're Claire, there's no better way to piss off your parents than to make out with a guy right in front of their car, as they come to pick you up from detention. Claire was feeling good; she was breaking the rules. But come Monday, you knew it was going to be awkward. How was Claire going to explain this to her friends? She didn't need this – not in her senior year.

That’s where the rating agencies come in. Our public pools of money can often act irrationally, in a way that has consequences in the long run. For decades, our public money sat in the safest types of bonds: Federal, Provincial, State, Municipal, and certain commercial bonds. A combination of regulation and ratings created a fence around the money, so it can't chase Benders.

The rating agencies issue a rating for each bond, and pensions are permitted to invest in only those bonds that have a high "investment grade" rating. In the past, the our pensions never invested in derivatives; they were real bonds that belonged to a single business. Ultimately, it is the rating agency’s blessing that allows our large pools of public money to be invested in anything.

There is something else from the 1980s that is critical to the story: Junk Bond trading. Investment banks were making a ton of money trading Junk Bonds. Traders discovered a profitable phenomenon. Because these bonds were rated poorly by the agencies, it meant that public pools couldn't buy junk bonds. But the public pools of money were so large and they represented such enormous demand, that it created a large disparity in the bond market. The demand for investment grade bonds was inflated in value, while the market for junk bonds thinned out so as to provide ample buying opportunities. Throughout the eighties, traders would buy junk on the cheap and profit with patience. Then a man named Fred Carr did something crazy.

In 1989, Fred Carr created a Collateralized Bond Obligation that changed the landscape of junk bonds forever. Carr worked at First Executive bank, and like every other bank at that time, they held a large portfolio of junk bonds. At the time, regulations required Carr to fully finance his reserves for these junk bonds. In other words, regulators were concerned that these junk bonds might default, so they made First Executive keep cash on hand, in case they failed. For every dollar of junk you hold, you must set aside a dollar in your vault. This was to ensure that First Executive could continue operations in case the bonds defaulted, or could not be sold due to market conditions.

Carr took all his junk bonds and pooled them together into a new corporation (Special Purpose Entity). Once all the junk bonds were in a separate entity, that SPE issued three types of shares. Class A would be guaranteed a return of 4%. Class B would get a return of 6%. The final class would get whatever was left over, and was by far the riskiest class since it was not guaranteed to get anything.

Carr knew that the risk of all the junk bonds defaulting at once was low. By pooling all the junk bonds together, he created a new financial instrument. Sure, maybe one or two bonds in the pool might default, but most of them would be fine. In the new pooling scheme he created, he could easily promise the first two share classes a reasonable return, while leaving the risk to the final share class that may or may not benefit - the risk of those few bonds defaulting fell entirely on the last share class.

After creating this new corporation that was made up entirely of junk bonds, First Executive proceeded to purchase 100% of the SPE. In reality, First Executive had the exact same portfolio as it did before the transaction. However, the way he had designed the shares of the new corporation (A & B shares being promised a fixed return, while the final share class bore all the risk of default), he was able to get around the reserve requirements. The first two share classes of the CBO would be rated highly by the rating agencies, and only the riskiest share class (aptly referred to as “toxic waste”), would receive a junk rating.

Previously, First Executive had to keep cash on hand for the entire pool of junk bonds. Now, they only had to set aside money for the riskiest share class. As a bank, there is an inherent advantage to keeping fewer reserves. It means they can lend more of their cash on hand, which means they can make more money. The risk to First Executive was exactly the same as before, yet by changing the legal form of their portfolio, they had persuaded the rating agencies using the junk bond logic of the 1980s.

For the next 20 years, everyone is doing what Carr did, except they're using mortgages, car loans and credit cards. Because the first two share classes receive the good credit rating, the public pools of money could now buy these products. And buy it they would. That public money has an insatiable appetite for above-average returns with investment grade risk. Add to that, it was in the bank's interest to facilitate these deals because they were incredibly profitable.

Rating agencies, often thought of as gatekeepers, opened the doors so our money could participate in credit pools that were previously restricted. Imagine, if you were Claire, and you showed up to school on Monday to discover that all your friends suddenly had a big crush on Bender. At that point, you don’t ask why; you just go for it.

Goldman on Trial - Part 1

Get used to Goldman being in the news for the next little while. According to this NY Times article, Goldman Sachs is being sued for knowingly packaging poor quality mortgages and other loans into a large credit derivatives bundle, and then selling it to the market. More than likely, the lawsuit is sparked by the fact that Goldman has been profitable throughout the financial crisis and it's really pissing everyone off. News of this lawsuit has triggered banks from other nations to begin investigations to see if they have a similar case. Did Goldman sell them shitty mortgage-backed securities too?

Winning this case is going to be next to impossible. Yesterday, I pretended to be a Goldman Sachs attorney while my father, quite angry over the matter, represented the prosecution.

Dad: How is this different than selling me bad apples? You hid the rotten apples at the bottom of the basket, so I didn't find them until later on.

Me: Let's make it a carton of eggs. If you walk out of the store with a carton of eggs, and discover that one is broken, is it the store's fault for selling you a broken egg or your fault for not checking? Don't buyers have to perform their due diligence on something before buying?

Dad: No. You knowingly made it hard for me to find these bad apples. You tied bows on top and hid them in a place where I couldn't see them until much later. And we can prove you knew this, because not only did you sell these apples to me, but after selling them, you short-sold the very same assets, fully knowing they were total shit and that they were going to drop in value. So not only did you gain from not holding them anymore, you actually profited from me losing.

Me: First, I think you have to agree with me that in a free market, you have to at least squeeze the apples before you buy them, or accept the bad ones if you didn't bother to check.

Second, since when am I not allowed to change my opinion on how I view the markets? Initially, we were happy to hold all sorts of apples here at Goldman. We had a very optimistic view of the mortgage markets, just like everyone else. But in 2007, it became clear to us that we might be too optimistic. We had to shed our risk by selling some of our mortgage-related assets. But since we were still holding on to some, we wanted to hedge ourselves by taking further positions reflecting our new point of view, that mortgage markets were inflated. We had to protect ourselves from the risk that there was a mortgage bubble.

Dad: But you knew they were bad assets. What if I can prove that you knew that?

Me: Even if you can prove that we knew that, how can you possibly blame us for wanting to protect ourselves. Acting in our self interest is not illegal. You had access to the same information on mortgages, so did Lehman, so did AIG, yet all of you continued to take the position that housing prices would continue to rise.

If you had come to the same conclusions as us, we would not have been able to sell those assets the way we did, we would have had to sell them for much less. But in any market, a seller is supposed to get as much as he can, while a buyer is supposed to pay as little as he can. If the real estate markets continued to rise, we would have lost and you would have won. Should Goldman then be able to sue you for being right?

It was at this point that my father became aggravated with me, and I had to hold his hand and remind him that I wasn't really a Goldman lawyer, and that I hated what was going on as much as he did.

My point was this is a very difficult thing to prove in court. There are some famous cases in derivatives law against Banker's Trust (Proctor & Gamble and Gibson's Greetings being the victims). In the P&G case, for example, Banker's Trust was able to persuade the Treasurer at P&G into entering risky interest rate swaps. At the time, interest rates were low, and P&G bet that interest rates would remain low. The treasurer there was making a tidy profit each month, which of course translated into better performance results for him as the treasurer.

In the early 1990s, the Fed reserve raised interest rates by a hair, and it came to be known that P&G had made some massive bets against rising interest rates. All of a sudden, P&G found itself trying to explain to its shareholders how it had incurred massive losses that had nothing to do with operations. It was natural for P&G (and similar victims) to pursue legal action against Banker's Trust.

P&G accused Banker's Trust of selling them something that didn't meet their requirements. They were sold a product that was excessively risky and complex, when really P&G just needed a simple hedge against interest rates. Their case, by itself, probably would not have held water, but as it turned out, Banker's Trust had been sloppy.

One of the traders was caught on tape talking to his girlfriend on the phone about how he was passing off risk to the P&G treasurer, and that the treasurer was clueless. In addition to this, the traders were caught talking to each other about how this deal was a "wet dream." Not only could they sell the swaps and collect a huge transaction fee, but when it came time to settling the cash involved, the traders had learned that P&G didn't know how to determine the payment. So Banker's Trust would call P&G and say, "so we're going to pay out at $89,000," and the treasurer would agree that this number sounded reasonable. Then they would hang up and giggle to each other about how they really owed ten times that amount.

Banker's Trust ultimately settled. They had to because the behavior of the traders was not about to gather any sort of sympathy. We will see if there is evidence of Goldman acting in a similar fashion, and surely if there are phone calls to girlfriends, and emails about how stupid the rest of the world is, they too might start to scramble. Currently, their stance is to claim this entire lawsuit is completely unfounded.

When the entire financial system collapsed in 2008, when small banks were allowed to fail, we effectively destroyed trillions of dollars. That was our money. All of us. The US government should be looking for a way to permanently change the structure of the financial system instead of trying to recoup a tiny fraction of the losses.

Pursuing legal action against Goldman will not fix the problem that hit all of us in the face in the fall of 2008. I'm skeptical about their chances of success in the lawsuit, but the bigger issue is that this lawsuit isn't suddenly going to scare those with better information from taking advantage of the weaker players in the market. Unfortunately, the pursuit of justice will only serve to distract us from the real issue, which is that the financial system has become an uncontrollable monster that very few people understand, and that nobody can control.