Don’t hate the player, hate the game

June 5, 2010 — by Anoop Galivanche

Less than a year ago, Lloyd Blankfein was the envy of every banker on Wall Street. At a time when most banks were struggling to remain solvent, his firm Goldman Sachs had reported the largest profits in its 140 year history. Employees gleefully made down payments on yachts and Ferraris as Blankfein announced the company would dole out at least $23 billion in bonuses—or $600,000 on average per employee. Blankfein himself made more than $140 million, telling The Sunday Times that he was “doing God’s work.”

Without warning, the tide turned. On April 16, Goldman Sachs was charged by the Securities Exchange Commission (SEC) with failing to disclose serious conflicts of interest. As its stock fell from more than $200 a share to $170, the SEC followed through with criminal fraud charges against its senior executives. All major investment advisories have changed their rating of Goldman Sachs stock from a vehement “buy!” to a dismal “sell,” and the Wall Street Journal editorial board, among many others, has passionately called for the resignation of Blankfein from his capacity of chief executive. The Obama administration has even used Goldman as a poster child for why banking reform is necessary.

From an ethical standpoint, Goldman is unquestionably a rogue, shamelessly taking advantage of market conditions at the expense of millions of families’ financial security. Legally, however, targeting Goldman has dangerous implications. In charging Goldman with financial crimes, the SEC has circumvented the real issue of Wall Street reform and has turned it into something it is not—a problem with just one bank.

The exact reason behind the SEC’s misgivings about Goldman have been obscured by the media, which seems bent on denigrating Goldman Sachs, regardless of whether it did anything legally wrong. Most outlets agree that Goldman overstepped ethical boundaries when it chose to continue brokering collaterized debt obligations, despite the fact that it was short-selling them itself. The SEC was quick to point out that Goldman also should have warned clients not to purchase CDOs. But the fundamental flaw in these condemnations is that Goldman Sachs was a market maker, a broker of sorts, rather than an issuer—and therefore had no obligation to warn its clients. Its sole responsibility, along with banks like JP Morgan, Bank of America, and Citigroup, was to ensure that the trades were being made.

And trades were made—albeit lucrative ones. In fact, Goldman’s true merit was that it was able to make money during the crisis, so much money that a more appropriate name for the bank would be gold mine. As Blankfein acknowledged in a Congressional pre-hearing, Goldman initially was an issuer of CDOs, but when it realized they were going to crash, it quickly set up short-sell schemes. Goldman shareholders were exposed to record low immediate risk, and its stock was able to hover around pre-boom prices while banks such as Citigroup and Bank of America ran to the government for help. This pecuniary shrewdness, at once brilliant and immoral, used to be applauded on the Street. Now, it is apparently a criminal offense.

Consistent with its role as a market maker, Goldman interacted with the party that was issuing the securities, as well as party that was buying them. The legal twist in this deal lies in the structuring of the CDOs themselves. Collaterized debt obligations are derivatives that are correlated with a package of mortgages. If the mortgage payments are made, then the CDO appreciates in value.

But there was a third facet to this convoluted financial engineering. Another Goldman-advised contingent—Paulson and Co.—was short-selling the securities. The SEC alleges that Goldman allowed Paulson and Co. to also choose what mortgages would be packaged into the CDOs. Paulson and Co. would then choose mortgages that were doomed to fail, thereby reaping huge profits. Yet the SEC, and in turn the media, have ignored the fact that Goldman cannot be held responsible for this conflict of interest because the actual packager of the CDOs, a company called ACA Management that is also a client of Goldman’s, should have realized this conflict of interest. ACA’s failure to do this was what exacerbated risk exposure of investors holding these securities.

While Goldman may not have actually been doing God’s work when it was engaging in sketchy transactions like these, its being scapegoated will set a dire precedent for future financial reform. Its role as a market maker, ability to stay solvent and mitigated liability mean that Goldman should not have to answer, at least unilaterally, for these unfortunate circumstances. Not only do such esoteric lawsuits attempt a futile approach to reconciling the inherent conflict between ethics and corporate responsibility, but targeting Goldman will also hurt the economy and people everywhere.

1 view this week