God Is Dead: The Implications of the Goldman Sachs Case

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HCMThis essay is excerpted from the most recent version of the HCM Market Letter.  To subscribe directly to this publication, please go here.

 

“For some reason it was the fate of America not to become itself, not to build its house upon the foundation of a loss for which no recovery was possible.  Its fate, rather, was to sacrifice its freedom to nationhood, to reiterate and exasperate the rage for possession, and to fall into the watery mire of what is not life.  Instead of a nation of poets, it became a nation of debtors, property owners, shopkeepers, spectators, gossipers, traffickers in rumor, prejudice, and information – capitalists who in their strange uncertainty about life pursue the delusions of recovery in their appropriation of everything.  In its continuous flight from the conclusions of a mortal career, America became not the caput mundi of poetic freedom but the caput mortuum of modernity – capitalism turned into the death’s head.”

Robert Pogue Harrison1

If there was any doubt that the era of gentlemanly capitalism was dead, the lawsuit filed by the United States Securities and Exchange Commission against Goldman Sachs & Co. should put that doubt to rest.  Several months ago, Goldman’s Chairman Lloyd Blankfein made the remark that his institution was doing God’s work.  The unfortunate comment was allegedly made in jest, but has come to represent the arrogance emanating from Wall Street that is feeding a public outcry against the financial sector.  But it also points to a deeper truth about Wall Street. If transactions like the synthetic collateralized debt obligation known as ABACUS 2007-AC1 constitute God’s work, then Friedrich Nietzsche was right and God is dead.

The United States v. Goldman Sachs

Drexel Burnham redux?

The government’s civil lawsuit against Goldman Sachs raises many thoughts in the mind of an alumnus of Drexel Burnham Lambert, Inc.  Readers of this publication, as well as of my forthcoming book The Death of Capital, certainly should not be surprised by the revelations concerning the conduct of Goldman Sachs or the other institutions that will likely be hit with similar allegations.  Wall Street long ago stopped worrying about how it made its money and only concerned itself with how much money it could make without crossing the blurry lines of legality painted by the securities laws.  But whatever the outcome of the legal case against Goldman Sachs, the firm’s participation in John Paulson’s scheme to profit from the subprime debacle again points to the firm’s failure to ask itself whether it should be engaging in certain types of activities simply because it is capable of executing them.  In the words of Dr. Ian Malcolm in the film Jurassic Park, Goldman’s financial scientists “were so preoccupied with whether or not they could that they didn’t stop to think if they should.”2

Goldman’s reaction to the government’s charges is reminiscent of Drexel Burnham’s attempts to fight government allegations of wrongdoing two decades ago.  Lloyd Blankfein’s characterization of the charges to clients as “political” may be understandable, but it bespeaks a lack of historical memory that will likely do Goldman and Mr. Blankfein little good. Of course the charges are political!  But this is what happens when a firm grows so powerful that it can no longer be reined in by competitive forces alone.  In this case, however, the legal challenges may prove to be far more manageable than the public relations and political ones.  For Goldman’s labyrinthine conflicts of interest have provided sufficient fodder for politicians and the public to chew on for months. 

Only the most highly compromised apologist can argue that a synthetic CDO is a socially productive financial instrument or that the world cannot prosper without such concoctions.  This was the type of transaction – the type of trade – in which neither Goldman Sachs nor any institution that wants to be seen as contributing to the productive capacity of the economy should be participating.  All of the post hoc rationalizations in the world cannot explain away that reality.  Synthetic CDOs do not contribute to capital formation; they are merely exercises in financial onanism. The transactions created a playground in which excessively liquid institutions could wager on the direction of the United States housing market.  In the process, these institutions diverted both financial and intellectual capital away from productive uses.  The cost to society of such squandered resources will not be known for a long time, but it is certain to have been significant.

From a practical standpoint, Goldman is facing a terrible dilemma.  History has demonstrated that securities firms are far better served by working with their regulators than fighting them and accusing them of improper motives (as accurate as those accusations may be).  What is most reminiscent of the Drexel affair two decades ago is that a single firm grew so wealthy and powerful that the system could no longer tolerate its power.  Unable to rein in the firm competitively, the system reacted by mounting a legal attack.  Such an approach is rationalized on the grounds that the conduct in question falls within the gray areas that dominate financial regulation (concepts such as what constitutes a “material” disclosure).  This is a type of self-corrective mechanism that the U.S. financial system engages in from time-to-time when firms or individual grow egregiously successful. 

This is a complex phenomenon that speaks to America’s ambivalent attitude toward success.  On the one hand, Americans admire and even emulate success, but on the other hand look to tear down the most successful members of society if they stumble even modestly.  An individual or an institution that is successful in this country better insure that it is purer than Caesar’s wife because there will be legions in the media and government looking to make an example of them if they have strayed a single time.  In a nation of laws, there are so many lines that can be crossed that it is almost impossible to rise to the top without tripping up somewhere, and once the powers of antipathy target an individual or an institution it is only a matter of time before the hammer falls. 

But when firms or individuals are challenged in the way that Goldman is being challenged, that is when the real test begins.  That is also why America remains a land of second chances.  Unfortunately, the giants of finance may have run out of second chances after tempting the fates with their manipulation of the technology sector during the Internet bubble and, having been let off the hook by regulators despite gross crimes and misdemeanors during that period, aiming their corruption even more directly at the heartland of the American economy and destroying (with the able assistance of the political class) the American housing market.  Wall Street’s conduct has lapsed so severely over the past decade that one can legitimately question whether the industry is entitled to another opportunity to operate beyond the purview of significantly stricter regulation.   HCM for one has long maintained that Wall Street is no longer entitled to the benefit of the doubt and needs to be reined in by a new set of rules.

The legal case

As a purely legal matter, Goldman’s culpability will be determined by whether it omitted to make “material” disclosures concerning ABACUS.  The question of materiality is one of those infamous gray areas in the securities laws.  Materiality is determined by the specific facts and circumstances of the situation in question. In this case, taking the SEC’s allegations at face value, the issue will come down to whether the decision of a reasonable purchaser of the debt and equity securities issued by ABACUS (in this case, IKB Deutsche Industriebank (IKB), a German bank, and ACA, which also acted as Collateral Manager and selected the securities in the portfolio) would have been affected or altered by the disclosure that the hedge fund Paulson & Co. (“Paulson”) played an important role in choosing the securities to be owned by the CDO.  But Paulson’s role was not limited to choosing the securities – the hedge fund appears to have initiated the transaction with the goal of shorting those same mortgage securities once the CDO was put in place.  Speaking as an experienced CDO investor and manager, only a fool would not have wanted to know what Paulson was up to (and only a fool wouldn’t have known since Paulson made its views widely known at the time).  ACA appears to have known about Paulson’s role, having participated in several meetings with the hedge fund regarding the deal, and wrote protection on (i.e. insured) $850 million of the transaction, so it is unclear who was fooling whom. 3  There does not appear to be any mention of Paulson in the offering materials related to the transaction, although HCM has no idea what was discussed in the meetings or discussions with investors in which such disclosures could have been provided.  If Paulson’s role was not disclosed to IKB, Goldman arguably failed to meet its disclosure obligations under the securities laws even if IKB had an opportunity to discover this information on its own.

Goldman Sachs may try to raise the defense that these securities were privately issued to sophisticated investors under Rule 144A and therefore were not subject to the same disclosure obligations as publicly issued securities.  This is a losing argument that would do Goldman more harm than good.  Rule 144A offers an exemption from registration for certain securities issued to investors deemed sufficiently large and sophisticated to be able to protect themselves and therefore not require the ambit of the securities laws.  Rule 144A, however, does not obviate the anti-fraud provisions of the securities laws.  Underwriters that sold billions of dollars of debt for WorldCom, Inc. shortly before the revelations of the telephone company’s accounting fraud attempted to use this defense to avoid liability when they were sued after WorldCom filed for bankruptcy and caused huge losses to bond investors.  The federal courts refused to let the underwriters off the hook, however, holding that Rule 144A does not relieve underwriters of their obligations to perform adequate due diligence and make full and fair disclosures to investors.  This defense would not only be legally vacuous but would be an insult to any client to whom Goldman Sachs sells securities and expects to be told the truth about what it is being sold.


1 Robert Pogue Harrison, Forests: The Shadow of Civilization (Chicago: University of Chicago Press, 1992), pp. 231-232.

2 Michael E. Lewitt, The Death of Capital  How Creative Policy Can Restore Stability (Hoboken: John Wiley & Sons, 2010), p. 164, citing David Knoepp, Jurassic Park, a screenplay based on the novel by Michael Crichton and on an adaptation by Michael Crichton and Malia Scotch Marmo.  Final Draft December 11, 1991.

3 Specifically, Steve Liesman of CNBC reported on April 21, 2010 that Paolo Pellegrini of Paulson & Co. testified that he informed ACA’s CDO manager Laura Schwartz that Paulson intended to short the ABACUS deal, a key point that is omitted from the complaint and would seem to undermine one of the legal allegations against Goldman Sachs.  As noted above, since ACA wrote $850 million of insurance on this deal, money that was lost (and ultimately paid to Paulson who took the other side of the trade), it is unclear exactly who was being duped, if anybody.