Tuesday, April 20, 2010

The Goldman Sachs Scandal

by Richard Crews
Yesterday the Securities and Exchange Commission (SEC) filed charges against Goldman Sachs, one of the largest and most prestigious investment banking and securities firms on Wall Street. The charges described that in 2006 Goldman Sachs created a series of derivatives worth about one billion dollars that were designed to fail. These complex securities grouped together bad mortgages--mortgages that were known to be beyond the owners' abilities to pay. Goldman Sachs then sold these securities to some of their clients without disclosing that the securities had been designed to be weak. They then also allowed a large client to go short these securities so that when they failed, that client would make money.

Goldman Sachs of course charged brokerage fees on both sides of the deal--a total of some $15 million. They also bought insurance (credit default swaps) against future losses.

There are several truly amazing things about this constellation of transactions.
First: it probably was not illegal.
Second: there was no regulatory agency effectively overseeing such transactions.
Third: the process could be accomplished entirely out of sight without full disclosure to the parties involved or to the financial community at large.
Fourth: this sort of activity was common among Wall Street firms.
Fifth: the Goldman Sachs executives involved in this paid themselves multi-million dollar salary bonuses in 2006.

Now do you think that there should be new and stronger laws regulating financial institutions?


Mitigating factors:
In 2006 "everyone" was long real estate; it was the height of the housing bubble so suckers to buy grouped mortgage derivatives were easy to find.
Such complex derivatives had only been around a few years and were not well understood by anyone--investors or regulators. They were not sold (or "cleared") on an exchange.
Financial transactions, on real estate or anything else, are always a gamble. It is only in retrospect now that the housing bubble has burst that a deal like this looks like it was set up for suckers and sharks.