Brain Freeze in D.C.: What the Real Insiders Think about the Goldman Case

WaPo has a short feature out today on the legal team surrounding the Goldman Sachs fraud case. The article is here and it is worthwhile reading. The team is a very sharp group of people, but they have to be in some sort of brain freeze. It's a phenomena you run into often in D.C., very bright people who are somehow in denial about the basic elements of what they are doing. They are so caught up in the bright lights, glamor and power that they simply ignore the fact that at the core of what they are doing is an obvious but very ugly truth that there is no fundamental reason they should be dong what they are doing. Whether it is promoting or carrying out some regulation that at its core is evil, or promoting legislation they know has no chance of achieving its stated goal, or bringing a court case that has no merit, they march on. At best it is a brain freeze, at worst they have sold their soul.

The Goldman Sachs fraud case is such a situation. The people identified in  the WaPo story are working on a case that simply had no reason to be brought. Goldman Sachs, especially Lloyd Blankfein, are evil bastards for the way they raped America through the bailout of AIG, but the SEC case has nothing to do with that. It is a case about a trade that went down between very sophisticated financial  people on all sides, who certainly had all the information they needed to analyze the security they were buying or selling.

Major players in the world of finance, and I am  talking about the top players, tell me that they are yet to find any top level lawyer who thinks there is any merit to SEC's case. They are quite simply amazed that the SEC brought this case.

One player directed me to an Op-Ed by Fareed Zakaria, editor of Newsweek International. The Zakaria piece reflects the insider thinking. He wrote:

There's so much resentment toward banks these days -- some of it quite justified -- that anything resembling a defense of them is bound to anger people. But the rage surrounding the Goldman Sachs case can cloud our perspective and distort public policy. We need to step back and try to understand what happened.

Evidence may yet be presented that documents specific misrepresentations and false claims by Goldman, but much of the public debate has struck me as guided more by emotion than careful analysis. Even if some Wall Street practices seem dodgy, or unethical, that's not the same as illegal. I want financial reform, but I also want our system of governance to be characterized by fair play and equal justice -- even for people making $10 million bonuses.

There are two core claims of wrongdoing. The first is that hedge fund manager John Paulson was allowed to select the securities he wanted to bet against. This is disputed -- but in a routine hedge transaction on Wall Street somebody decides to bet against some set of stocks or securities; that person approaches a firm, which finds someone with the opposite view on those securities. This is how large companies offset the risks to their balance sheet from fluctuating currency, energy or commodity costs. Both sides examine carefully the securities involved in the wager.

The main institution that took the other side here, IKB, is a large German bank that had whole departments devoted to analyzing just these products -- departments many times larger than Paulson's firm. IKB surely knew that someone was betting against them: Otherwise, there would have been no transaction. Did IKB realize that the other party thought these securities were garbage? Yes -- disagreement over the value of stocks or securities is what creates the market.

The second charge is that Goldman Sachs designed a product it "knew" would decline in value. Dozens of transactions like this took place in 2005, 2006 and 2007. In most, the people who bet that the housing market would go up made money, and those betting it would fall lost money. These kinds of collateralized debt obligations went up in value in 2006. In fact, had this bet been made nine months earlier, Paulson would probably have lost a huge sum and IKB would have been a winner.

It's easy to say now that the housing market was doomed to go bust by 2007. But Michael Lewis documents precisely the opposite point in his recent book "The Big Short." He shows that in 2006 and even 2007, almost all the storied names in finance -- Lehman Brothers, Bear Stearns, Merrill Lynch -- were betting that the housing market would continue to rise. Only a handful of contrarians believed the opposite, and many of them had lost money for years on bets that the market would drop. At the time of the Goldman deal, Paulson was still seen as an oddball.

Whatever the new rules, one thing will not change: We can't be sure in advance which securities are "good" and which are "bad." If you doubt this, pick any asset you think is overvalued -- American stocks, Chinese real estate, Pakistani bonds -- and bet against it. Six months from now, you'll be proved a genius or a fool. Oh, and to make the bet you'll have to find someone to take the other side, so you'll need someone to handle the deal. Calling Goldman Sachs . . .

This is pretty much the case that I have been making since, a day after the charges were brought when I called SEC enforcement chief Robert Khuzami a buffoon for bringing the case. There is really no case here, unless there is the highly unlikely situation that the SEC is holding back a smoking gun.

Bottom line: Nothing new in D.C., we have a bunch of very bright people in brain freeze being controlled by a buffoon with power.