There is no doubt that the sentiment toward big banks is negative. Many resent that these banks were bailed out during the financial crisis, when the individual citizen who suffered as a result of irresponsible lending practices, misrepresentation of the safety of securities backed by those loans and resulting falling home prices, paid for the bail outs with their tax dollars. When, added to that, historic profits are earned by those very banks, and enormous bonuses are paid to their employees, while ordinary citizens battle near double-digit unemployment, that anger is understandably exacerbated.
Few news reports give details of this charge, describing it as “complicated, difficult to explain, and hard to understand.” I disagree. I think that, when explained properly, this is very understandable.
In plain English, Goldman is accused of selling derivative securities to their clients in April, 2007. Derivative securities are securities that derive their price from another asset. The assets on which the price of these securities was derived, were residential mortgages, which were rated BBB-, the lowest “investment grade” rating available, by ACA Management, LLC, a company with experience rating securities like these.
A Goldman employee, Fabrice Tourre, allegedly led ACA to believe that a hedge fund, Paulson & Co., Inc., was investing in these securities, when in fact, Paulson was investing in the other side of the transaction, i.e., a “short” position, or an interest in the securities losing value. The securities that ACA approved as investment grade were chosen from a list that Paulson had chosen to invest against.
The approved securities were described as “Selected by ACA Management” and were marketed, not to individual investors, but to “sophisticated investors,” like banks and pension funds.
When explaining the difference between what much be disclosed to such sophisticated investors, former SEC lawyer Jacob Frenkel, explains,“Materiality is a lot like a continuum. The amount of information that needs to be disclosed to institutional investors at the highest level, where they’re doing their own research and analysis, is less. Their criteria for the investment decisions tend to be far more sophisticated than the individual investor’s.”
So, the case is this. A hedge fund wants to bet against sub-prime mortgages, and brings a list of the mortgages it feels will go down to Goldman. Goldman takes the list to a rating agency, does not tell that rating agency that it received the list from a hedge fund that thinks the securities will go down, and gets an investment grade rating for most of those securities from that rating agency. It sold those securities to banks and pension funds without telling them that a hedge fund was betting against them. The banks and pension funds lost money. So did Goldman, by the way. They received $15 million for structuring this deal, but they lost $90 million investing in it.
The SEC alleges that Goldman should have told ACA and its investors that Paulson was investing on the other side.
Here are some questions that may help you decide how you feel:
1. Should rating agencies rate securities on their own merit (not by considering who may or may not be investing in them)?
2. Since ACA chose the securities in this investment from a list given to them by Goldman (from a Paulson list), was it a misstatement that ACA was “Portfolio Selection Agent?”
3. Since banks and pension funds are defined as “sophisticated” investors, should they analyze the investments they are considering on their own merit (not by considering who may or may not be investing in them)?
I understand the anger many people feel toward investment bankers. That said, I also feel that the analysis of securities, particularly by those who buy them on behalf of institutions or pension fund participants, should be based on analytical evaluation, not by “who else is buying this?”
I believe this to be a fundamentally weak case, and cannot help but notice that it was made public during the Financial Regulatory Reform debate.
For the record, I am in favor of Financial Regulatory Reform. While this case may increase the likelihood of the passage of such reform, I find it largely without merit.
I welcome your comments.
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This is such a passionate subject in my eyes. I worked in investor relations at my last job (been unemployed now for about 18 months) and I used to meet with hedge funds and investors on a regular basis. There is a huge difference between responsible investing in order to grow portfolios, and greed in order to pocket huge fees at the expense of the people they’re supposed to be helping. It’s like healthcare…we need transparency in both areas. If the insurance companies and Wall Street would embrace transparency, we might need less regulation. Unfortunately, I don’t think that’ll ever happen.
Hi sagein2010, and thanks for your comment. The point in this article is the difference in responsibility in information disclosure to individual investors vs. sophisticated investors. The point you raise, which shows your understanding of investor relations, is one of transparency, which would more accurately address the fiduciary responsibility (as opposed to “appropriate investment” standard), currently contained in financial regulatory reform. I concur with your position, but note that, as the law stands now, it does not appear that Goldman is guilty of a crime.
Thanks again for your comment.
I agree. All participants were highly sophisticated institutions that were knowledgeable about subprime securitization products. The SEC only voted 3-2 to pursue the case which suggests that the government wasn’t so sure what their obligation is either. Now, the UK is investigating Goldman.
Goldman wasn’t the only financial institution repackaging ill-fated subprime mortgages to sell to some customers. Deutsche Bank, UBS and Merrill Lynch also created and sold packages of subprime mortgages that quickly went bad as the housing market collapsed.
If you’re interested in reading the charge by the SEC, it is available here
http://www.sec.gov/litigation/complaints/2010/comp21489.pdf
http://articles.moneycentral.msn.com/video/default.aspx?vid=e6c3c94d-7da1-4af4-9a9b-08adbc55ce42%26tab=Today%20Show&from=en-us_money
This 4/22 article shows that culpability is likely to fall where in belongs – with the company who rated the securities http://www.cnbc.com/id/36710264
http://www.newsweek.com/id/236936 gives the most easily comprehensible and succinct explanation. I had already read The Big Short, which was great, but struggled with it. In any case, the investment banks employed hundreds of thousands (literally) of people worldwide. Maybe a few hundred were involved in this hideous mess. So why are they all being vilified?
Great question, K Grandma. It is not as simple as pointing to one investment bank and saying “Those are the culprits.” In fact, JP Morgan started the ball rolling with their mortgage backed securities when they felt that, since real estate in all the country had never fallen all at once, a diversified portfolio would be safe. Then the other investment banks joined in, thinking that, in a rising market, creditworthiness of the borrowers was secondary. After all, the borrower could just sell their home in a rising market for a profit. Then, other banks had to compete, or lose their loans to the investment banks. A bigger and bigger bubble happened. It was no one institution or borrowers who “fudged” their applications in any particular area.
One thing was for certain. The rating agencies who rated these mortgage backed securities as AAA were at fault, but since they were being paid by the companies who issued the bonds, what could we have expected?
There’s lots of blame to go around. It’s time to fix the problems, and stop pointing fingers, no?
HI Kitty. Yes, I think it is time to move forward and fix problems. I’m curious about your impression of the hearings so far and have a question: I was surprised to hear this from Susan Collins:
“I raised what I think is an essential issue, and that is whether Goldman Sachs is acting in the best interest of their clients and whether there should be a fiduciary obligation imposed on broker-dealers, imposed on the large investment companies.”
Do broker-dealers not have a fiduciary duty to their clients? I sold real estate for years and my fiduciary duty to my clients was foremost in my mind.
Under current law, with respect to individual investors, brokers must adhere to “suitability” standards. That means that, for individuals, the broker must recommend only investments that are suitable for that person’s risk tolerance. There is a much different standard for “sophisticated investors,” i.e., banks, pension funds, etc. These investors are assumed to have more knowledge regarding investments and additionally are assumed to do independent research.
There is a standard being considered in current financial regulatory reform that brokers adhere to “fiduciary” standards, i.e., putting the interest of the client ahead of their own. That is not, however, current law. As I have said previously, I am in favor of financial regulatory reform.
Thanks, as always, for clarifying. I agree we need financial regulatory reform-this isn’t just about Goldman Sachs.
Thanks for your comment, winelover. It is interesting timing for bringing this suit, though, isn’t it? Maybe it’s the publicity that is needed to pass reform, since there doesn’t seem to be much bi-partisan support.
I wouldn’t doubt it!
http://www.cnbc.com/id/36885741
It’s always nice to find Warren Buffett in agreement.
Buffett defends Goldman
http://online.wsj.com/article/SB10001424052748704608104575218071029226354.html?mod=igoogle_wsj_gadgv1&