Sunday, May 2, 2010

Goldman Sachs Scandal Explained

by Richard Crews
Goldman Sachs designed derivatives built of weak mortgages at the request of a big client who wanted to sell them short (essentially sell them with the promise to buy them later in the hope they would go down in value). So far, so good.

But GS also sold those same derivatives to other customers ("long" not "short"). This would also have been ok, BUT they did so without disclosing to those other customers that the derivatives had been specially designed to be weak.

In doing this, GS violated good business principles of "consumer protection." Customers have a right to be told by a vendor if the vendor knows the product they are purchasing is defective. In the case of a securities firm, this violates a responsibility called "full disclosure."

Moreover, securities firms (like banks, accountants, lawyers, and real estate agents) have a special duty to their clients, a duty called "fiduciary." That means they are legally bound to act in the client's best financial interests.

One further sin: GS also traded for its own account. This means they were buying and selling stocks, bonds, and various derivatives with money they held in trust for their clients. In other words, in some cases they were using the clients' own money to bet against the clients' financial interests.

Add to this--from outside GS--the lack of government regulation, the lack of sufficient requirements for financial disclosure, the "purchase" of bond ratings (which are supposed to be objective), and patterns of bonuses to executives based on short-term profits (despite longer-term losses), and the recipe for a huge, murky financial disaster is complete.