Jesus, where to begin? First, let’s quickly tick off the first handful of arguments, which you eventually acknowledge are made in feigned ignorance of the real issue:Anonymous is clearly a professional wordsmith, and as he certainly doesn't use his skills lightly. However, I would like to point out just how Anonymous's response in fact highlights and supports the main point I was making in my original post: that by being successful in spite of the economic crisis that's destroy so much of America and the world, Goldman Sachs has become public enemy #1, guilty until proven innocent, despite the incredulous and completely unrealistic nature of the claims leveled against them. How can I say such a thing? Read on.
1) Anybody could see the housing collapse coming, and none of the big players on Wall Street suffer from bubble amnesia. This ignores the incentives created by transaction fees levied irrespective of performance -- a primary, if not the main avenue through which most street-level traders make their money. That strongly encourages amnesia.
2) The banks that survived did so because of their wise investments, not because they were and are propped up by government intervention. Those in the know seem pretty confident the Fed’s balance sheets tell a different story.
3) Others did worse things than Goldman and have been punished, therefore Goldman should face no repercussions for its actions. In a functionally unregulated market, Goldman does the least damage of any major player. This is not actually a defense.
4) This is just innuendo on the level of celebrity gossip, planted because Goldman is doing so well and people like scandal among the rich and famous. This argument might hold more water if every other TARP institution wasn’t refusing to acknowledge a single day of losses this year.
5) Bank of America’s debt-forgiveness program is proof that the industry is trying to help lift all boats! Believe me, the banks are spending much more time and money lobbying against cramdown or compulsions to lend.
6) Goldman didn’t need to be bailed out, they just went along with a conspiracy to force them to take the money, for … public confidence reasons, I guess? Goldman made more money by successfully lobbying for full payouts to AIG counterparties than they received in direct TARP loans. Like the other TARP banks, they are also still deep in hock to the Fed, in the sense that they are playing with a ton of Fed money at zero percent interest. The TARP-money show was all about executive compensation, as Blankfein will gladly tell you.
Although basically irrelevant, these arguments are surprisingly ingenuous. You seem to be thinking critically about the statements and motivations of every voice in this story EXCEPT Goldman, the party with the most at stake.
That brings us to the actual question the Times story explores: Not whether, as you suggest, Goldman simply hedged its clients’ risks given the complexity of the financial products they were selling, but whether Goldman specifically created financial products they knew were garbage, pitched and sold them to clients who couldn’t see what was in them, and then turned around and bet against them, knowing they would fail because, well, they designed them that way. That is not a simple case of caveat emptor; that is fraud.
You do see how that’s different from a poker tournament, right? It’s not like Goldman’s clients simply gambled on pocket kings and lost due to the random chance that the guy next to them had pocket aces; they paid their stake to the house unaware that the house had ensured beforehand that they, the client, would always be dealt the only two and seven the house hadn’t pulled out of the deck.
This particular article lays out the case against Goldman’s standing counterargument: If we rigged the system, how did we lose money? The answer, as the leaked Goldman e-mails suggest, is stupidity, along with a healthy dose of hubris and contempt for the clients whom Goldman was so vehemently protesting are its top priority, as contractually obligated.
I’ve just stumbled upon your blog, but hopefully the imminent passage of an anemic financial reform package after the deployment of 2,000 finance lobbyists to Capitol Hill has soothed your fears that the poor banks are being pushed around by the mean old government and their feckless journalist cronies. More recent revelations, on the other hand, have not weakened the Times story’s case that Goldman was actively involved in a huge -- and criminal -- bait-and-switch.
The Abacus deals Goldman Sachs sold were a far cry from the "stacked decks" purposefully constructed by the house to swindle innocent players money, no matter people like Anonymous may have you believe. Instead, they were actually a financial instrument called a synthetic collateralized debt obligation, or synthetic CDO. I first read about such things in the 2008 book 'Traders Guns & Money' by Satyajit Das, which I came across on the Econophysics blog after trying to figure out what the heck was happening financially two years ago.
Essentially, investing in a tranched CDO is a bit like buying an apartment building someplace that stands a small but significant chance of flooding, sometimes catastrophically - say a 1-2% chance of a flood in any given year. Now, if there's only a small flood, the perhaps only the lowest floor will be effected. However, in the case of a 45 foot flood, an entire three story building could be submerged completely underwater. Of course, a 45 foot flood is a completely catastrophically rare event, at least when you consider just how often they happen as compared to just how often your basement floods. Because of this statistical nature of floods, you can easily imagine that the apartments on higher floors (or tranches) would be more expensive than those on the lower, more likely to flood floors. Typically in a CDO apartment building, there were three floors: the equity or first floor, the mezzanine or second floor, and the senior or third floor, though some CDO apartment buildings got crazy in their design. Now because of how debt is structured, the more senior tranches (higher floors that are less likely to flood) floors didn't "cost more" so much as they paid less every month - they were more secure investments that were less likely to be "flooded" or ruined, so they paid a smaller amount; conversely, investments in the first floor equity tranche were the most likely to be flooded first, so thus they earned a higher return for every dollar invested when compared to higher floors.
So how exactly were Goldman Sachs and every other bank on Wall Street building these collateralized debt obligation apartment buildings on such unstable flood lands? Its actually a neat statistical trick: essentially, a bank would take a collection of about 100 different smaller fixed income assets and pool them together (in banking parlance, fixed income is anything where the bank receives a predictable, regular payment each month - mortgage payments by home-owners being the culturally and topically salient example). The different tranches or floors were built as follows: investors on the first floor would receive high rates of return from the instrument, but only as long as no more than say 5 out of the 100 fixed income assets remain out of default. Meanwhile, investors in the second floor (aka mezzanine) would get a slightly lower rate of return, but would get it until say 10 out of the 100 constituent instruments defaulted, which is obviously less likely and at the very least would take longer to wipe out than the lower equity level. Finally, the senior tranche would be safe until perhaps 20 out of the 100 defaulted - the supposedly safest tranche of them all. Investments in these most senior tranches were the ones labeled AAA by S&P, Moody's, and every other rating institution that handles this type of thing. If you're curious to read more about how these things were built and work, check out the Wikipedia article on CDOs - pay particular attention to the section on how they're structured, especially what "synthetic" means in this context.
So whereas Anonymous's metaphor of a rigged poker game is certainly an easily understandable and emotionally inflammatory one, its definitely far from correct - investing in these things was really a lot more like buying a condo in an apartment built on what everyone knows to be unstable, flood prone land. Make no mistake about it - the exact terms and conditions of these deals were known or easily understandable to everyone who dealt with these sorts of things. I don't even work in debt or financing, and even I came across the easily understandable and highly predictive 2006 book "Traders Guns & Money" by Satyajit Das that explained precisely how synthetic CDOs were built, as well as exactly how they were actually much much more risky than the AAA labels given to them. This wasn't some big banker schenanigans where the wool was pulled over unsuspecting poor investors eyes - no, this was just some basic common sense that was available in a $25.00 book on Amazon or a bit of thinking about what the CDO debt structure implies. And remember: Das published his book that explained all this in 2006 - so to assume that this wasn't common knowledge to professionals in the industry years before would be sheer tom foolery.
So why are CDOs so risky? There's nothing inherent to their structure that would lead them to be a priori a bad investment - they can be appropriately and fairly priced. The unfortunate thing was that they simply weren't priced correctly by the market. See, because of mathematical convenience and a general desire among Wall Street investors not to really have to think too hard about anything, everyone just assumes that credit risk follows independent, identically distributed distributions (i.i.d. in statistical parlance), and moreover the street models these distributions as normal or gaussian - e.g. completely statistically describable via a mean rate of default and an expected variance about this mean. Now basically, what this assumption says is that if you're given the average or expected default rate of each instrument in the pool, you can model the overall failure rate of the pool by flipping 100 biased coins who's probability of coming up "defaulted" is equal to the expected rate of default. Statistical independence is achieved since the results of one coin have no influence on the results of any other coin. Of course, we all know this isn't true - as the hundreds of other economic cycles over the course of human history have taught us, economic defaults and failures tend to cluster significantly - when one company fails, several more failures are likely to follow. However, because all the models used by banks, investors, and rating agencies to assess the risk of these instruments stalwartly followed the identically and normally distributed assumption that had worked for so many years, almost everyone completely ignored this simple and obvious business reality in favor of personal profit - the bankers for their fees, the investors for their higher returns that still had an AAA rating, and the rating agencies because they had absolutely no incentive to challenge the status quo when neither of the parties they were supposed to advise wanted to. Note that I say almost everyone - a few of the more common-sense driven out there definitely saw these obvious realities from a mile away. Hell, Warren Buffet is in fact on record as early as 2003 as calling CDOs "financial weapons of mass destruction" - haven't people learned to start listening to that man yet? At this point, can anyone really say that the buyers of synthetic CDO obligations were getting into a game they couldn't understand with an appropriate amount of due diligence, something as easy as reading a book.
To continue the flood-like metaphor for modeling CDOs, its interesting that in his book "The Black Swan", Nassim Taleb actually uses flood prediction in the Nile as one of the first great examples of the failure of normal distribution statistics to adequately model important and naturally occurring events - and this research was done by the British back in the 19th century. As an investment banker himself, Taleb is yet another great example of someone who say the game on Wall Street for what it was. I imagine that if Taleb were to liken CDOs to any sort of casino game, it would be a slot machine - after all, its a well known fact that long run every dollar put into a slot machine is a losing investment, but that doesn't stop people from riding "hot streaks" and feeling "lucky" because of temporarily high returns.
Finally, as to the accusation that Goldman Sachs "bet against" these investments - again, I find this to be a very biased presentation and choice of words, because unfortunately its literally the truth. As responsible financial institutions, when banks sell instruments to clients, they need to take a correspondingly opposite position to the one they sold in order to maintain a "risk neutral profile". This type of financial behavior is called hedging and it is a perfectly normal, healthy, and expected thing for a bank to be doing in the course of its day to day affairs, the same way that it is expected behavior for air lines, industrial manufacturers, farmers, and nearly every other corporate entity. To fault Goldman Sachs for "betting against" the instruments they sold to clients would be to fault every other bank on and off Wall Street, as well as nearly every corporation, for engaging in what is well known, financially responsible behavior. It is here that I say Anonymous is judging Goldman guilty until proven innocent: she/he is much more willing to call day to day, responsible behavior on their part fraud than what it is much more likely to be: day to day, responsible behavior. At that point, the onus of proof is on the accuser, and beyond a few misleading metaphors and emotionally charged statements, Anonymous has provided little to support his criminal claims; similarly, as far as I can tell nothing has come out of any of the criminal investigations into Goldman Sach's behavior - if what they were doing was so obviously criminal, why would this be the case? If you're going to reference vague claims to "recent revelations" that supposedly support your liberal biased, narrow minded "big-bank-bad" attitude, Anonymous, please at least mention what these revelations are so that we can all discuss them fairly - otherwise you're no better than Fox news.
But what of the claims by the purchasers of these CDOs that they were mislead and otherwise poorly informed of the risks? Again, as Satyajit Das points out, investors who are taken for rides by economic bubbles always claim they were mislead about the risks - its much easier to make such claims after the fact and forget that the financial gambling agreements were signed before hand. Of course, from a self-interested perspective this makes complete sense: those clients who made now obviously stupid decisions and investments have only one chance to redeem themselves and save their career - blame the bank who sold them these things no matter what legal documents they may have signed indicating they fully understood and accepted the terms of the agreement. Again, from a simply reasonable, common sense perspective, why would the biggest, most successful bank on the street need to use fraud to make a profit? Even assuming the most criminal and self serving motives on the part of Goldman Sachs and their employees, it just seems like too much risk for the institution to engage in on a systemic level compared to the expected increase to profits that would result. While Anonymous rightfully points out my complete lack of questioning about Goldman's motives, I must conversely point out her/his complete inability to see any motives except criminal ones on Goldman's part. I thus expect the reality to be somewhere in between our two views, and given the extreme claims that he/she makes compared to the cold hard reality of how banking works, I wouldn't be surprised if that reality ended up being closer to mine than Anonymous's.
Ultimately, I'll say this: as far as I can tell, its simply far more likely to me that Goldman Sachs was simply going about its business selling CDOs to consumers who demanded them and then hedging those positions in a responsible way. Did the divisions in charge of risk loss probably have more adequate models that allowed them to understand the true risk of toxic assets like CDOs? Almost certainly - such things are valuable trade secrets. However, the thing that most people forget is that clients were the ones who were purchasing these instruments - most of the investors who bought these CDOs were institutional investors that couldn't invest in anything less than AAA rated debt by their institutional bylines and regulations. As such, when they saw CDOs with extraordinary returns and the required AAA ratings, they bought into them heavily with little due diligence - after all, the bylines had shifted that onus onto the ratings agencies in the form of ratings. These investors in these Abacus deals were not financially naive people who needed Goldman's brokers to help guide and protect their best interests - they were savvy, profit driven individuals who were driven by greed to buy these amazing CDO products without questioning their perfect story; if they weren't able to purchase them from Goldman, they would have simply gone a couple blocks in any direction down Wall Street to another, more than willing broker.
Ultimately, where does the blame lie? On everyone who participated in this fucked up game of musical chairs - the basic story I see being told here over and over is not one of fraud, but one of lustful greed so taken up in its passion for profits that it simply refused to take into account some fairly obvious realities simply because it would have meant less profit. However, such animal spirits have existed in humans since the dawn of time (remember the Dutch Tulip bubble of the 1630s?), and I doubt we will ever be able to eliminate them from our economic behavior. Instead, we should remove the false signals of security and trustworthiness - namely, the ratings agencies. The whole CDO song and dance could have never occurred if rating agencies had used more realistic models to assess debt. However, as everyone is more than well aware, the agencies had absolutely no incentive from either the banks or the clients to point out the well known fact that these investments were actually terribly risky. At this point, any agencies that didn't sing along were quickly forced out of business, so the rating agencies quickly because filled with a bunch of parrots who were more than happy to sing back whatever stories were told to them. However, this isn't criminal - its simply human nature. Typically, such inefficiencies in capitalistic systems are addressed through competition - if someone can come up with a better way to rate debt and no one in the existing power structure will listen, said individual always has the right to start their own rating agency and compete; if their method is truly better and everything is functioning correctly, they should eventually beat out their less effective competitors. Unfortunately, rating agencies weren't paid in a way that depended on how accurate their ratings were - they were simply paid a transaction fee. The fact that the incentives here are completely out of whack here is obvious, and anyone banker, client, or otherwise who believed otherwise is simply a fool. Moreover, the inordinate amount of trust that everyone - Wall Street, Main Street and elsewhere - put in institutions like Moody's and S&P such that they allowed their ratings to effectively find their way into regulations and laws governing institution behavior shows just how messed up this system had become: individuals and entities were willing to put their personal best interest and long term financial solvency into the hands of rating institutions that had absolutely no incentive to challenge the status quo because to do so would mean losing business. Who but a fool would trust the AAA ratings given by such agencies, especially when it was so obvious even at the time that the ratings were absolute bunk?
There's a general rule across all walks of life that there's no such thing as a free lunch. In finance, this takes the form of the rule that there's no such thing as increased reward without increased risk. Throughout the economic history of the United States, especially during heady bull periods of economic growth, investors are more than willing to temporarily suspend disbelief and believe in stories that fly completely in the face of this simple well-known fact. Historically, they always cry foul and fraud afterward, regardless of who should actually be at fault - after all, it definitely shouldn't be the people who lost money, right? Unfortunately, people like Anonymous are more than willing to champion this essentially Communist ideology, especially when it jives with their own personal socialist stories about big, evil banks making money while the poor proletariat suffer, which is terrible because it absolutely fails to recognize the real fucked up incentives that went into creating this situation - not fraud as Anonymous suggests, but stupidity, hubris, and contempt for financial common sense in favor of greed and personal profit on the parts of all involved parties. If we're to do anything more than indulge knee jerk emotional reactions and actually fix this situation, we have to be willing to see reality for what it really is: not a few evil characters, but rather a bunch of generally animal spirits masquerading as rational, independent, reasonable bankers, traders, legislators, reporters, regulators, and whoever else we may pretend knows what they're doing when it comes to running our country. I have just as much desire and incentive to blame and punish whatever individuals acted criminally in the course of the recent financial meltdown, same as I do at any other time. However, I'm unwilling to ignore the obviously complicated reality in favor of an overly simplified story that may satisfy both the public's desire for blood as well as the news media and government's need to produce that blood, but willingly omits and often simply outright misrepresents the reality of what actually went down. After all, that story would be both far more boring and far less easy to sell or politically spin - and then what would people like Anonymous write about?
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