Monday, April 26, 2010

Squid at the Horse Races

The question of whether Goldman Sachs is “guilty” is a question that needs a qualifier. Are the guilty in the moral or legal sense? Were they breaking the law or simply being unethical? The Securities and Exchange Committee (SEC) certainly wants to put the proverbial noose over the Vampire Squid’s neck. For those of you who are out of the loop, Vampire Squid is the endearing nickname that has recently been bestowed upon dear old Goldman Sachs. So, “are they guilty or not?” we are all wondering. This writer says “yay” to unethical, but “nay” to criminal.

These fraud allegations have emerged from a certain financial derivative known as a collateralized debt obligation (CDO). The specific type of CDO in question is a synthetic CDO. This is important because it turns the investing process into a zero-sum game. With synthetic CDOs if one person makes money off of it, someone else has to lose. A lot of misinformed individuals have attacked these complex financial instruments and claimed that not even investment bankers can explain what they are. This is not true. My father and I were discussing the Goldman case recently. The analogy of a horse race seems to be the easiest way to describe what happened.

When two people bet differently on a horse, one person wins and another loses. Now let us say that the person betting against the horse, gets to pick which horse is running. This person is going to, obviously, pick a “bad” horse. John Paulson was the horse-picker. He was an investor who rose to fame as someone who successfully anticipated the housing bubble collapsing and found a way to make money on it. John Paulson was helping put together these CDOs that Goldman was selling, and he was betting against them. Much like the horse-picker, Paulson was picking “bad” CDOs to help himself. Goldman claims that they showed the investors who were buying these CDOs the “horse.” As in, the buyers knew exactly what they were getting. They could check the horse’s teeth, its legs, and anything else they wanted before they placed their “bets.” The only thing they did not know was that Paulson was picking the CDOs, which Goldman claims is irrelevant. Since Goldman’s clients are mostly wealthy, supposedly financially literate institutions, I see nothing wrong with the Squid’s actions. I have no sympathy for those European banks who did not have the wherewithal to properly analyzes the “horses” before placing their “bets.”

The SEC wants to sue Goldman over the fact that they held Paulson’s name as a secret. The SEC says that all the information should have been made public. As aforementioned, Goldman says that is irrelevant, since all the necessary information was given to clients. Both sides do have a point, but I just do not see enough evidence of intent to defraud clients for the great Vampire Squid to get slapped with criminal charges.

Around 10% of Goldman’s operations are investments for clients. Much of the rest of their operations involve making money for itself. When the Squid went public 11 years ago, its prospectus said, “Our clients’ interests always come first. Our experience shows that if we serve our clients well, our own success will follow. Our assets are our people, capital and reputation. If any of these is ever diminished, the last is the most difficult to restore.” It would be hard to argue that Goldman has proven that it still fully embraces this philosophy. As I already said, I do not think the Squid is criminally responsible for anything. However, as its own prospectus claims, reputation is of the utmost importance. While Goldman’s clients were losing money, the Squid was reeling some in. It is not illegal, but it is also not the best way to treat your clients. At this point, the end results of the trial are probably not as important as what has already occurred. The intangible charges against Goldman are going to sting a lot worse than the real ones. And always remember, never trust a squid at a horse race.