Sunday, April 18, 2010

Understanding Wall Street

Henry Blodget is doing some  great reporting and analysis of the specifics of the very weak fraud charges against Goldman Sachs, but I think the general reaction to the fraud charges, i.e., the gut reaction by the man on the street, is that, "Yes, Goldman did commit fraud."  This reaction comes from a failure to understand how Wall Street works.

Wall Street is essentially the land of dealmakers where, day in and day out, Wall Street brokers and investment bankers are approached to raise money, or create products. Most of the deals brokers and IB's are approached about are turned down because the brokers and IB's know that there is no one in their network to take the other side of the deal. If, say. Apple approaches a broker to sell some stock, the broker is likely to agree to the deal because he knows that he can sell the stock to his network. If Johnny down the street approaches a broker to sell stock in his company that hopes to someday capture flying saucers and turn them into tourist travelling air ships, a broker might have problems placing the deal, and turn Johnny down.

It's the same with constructing product, Goldman or any other broker is only going to take on the construction of a product for a client when Goldman knows it can place the opposite side of the product.

It might be a great idea right now to create a product that owns land directly under the Icelandic volcano that is erupting  and short that product. Goldman isn't creating this product because it knows that no one would take the opposite side of that trade. Who afterall is going to buy land right at the core of the erupting volcano? On the other hand, when Paulson approached Goldman about creating a CDO that could be shorted, Goldman knew it could find investors who would be interested in taking the other side of that trade, i.e. people who thought real estate prices were going to continue to climb higher (Note to the SEC: In 2007, there were a few people who thought real estate prices were going to be climbing higher.)

When Goldman agreed, Goldman  was doing what it does every day simply putting a deal together.

Now, the SEC further alleges that Paulson put the deal together. This is not true. Whenever anyone brings a potential deal to a broker or IB, they are going to try and get the best terms they can. When a company negotiates with a broker on the price of an IPO, the company tries to influece the broker for the highest price possible, i.e. one could say the company had input in setting the price.

In the same way, if Goldman is putting together a CDO for Paulson, Paulson is going to, very logically, want the weakest mortgage backed securities in the world in that CDO. There is nothing wrong with this. Paulson can suggest anything in the world. Goldman took it to an independent third party, ACA, to evaluate the securities Paulson wanted in the CDO. They allowed some, and disallowed others.

ACA and Goldman Sachs then bought some of this CDO. Got that? For all practical purposes, Goldman and ACA thought Paulson was an idiot for thinking the real estate market was going down. Goldman and ACA, which let me emphasise again was the independent third party brought in to evaluate the potfolio, bought part of the CDO. This was a regular everyday transaction on Wall Street. As far as Goldman failing to disclose that Paulson was on the other side of the trade, disclosure like that  is simply never done on Wall Street. You do your own analysis and you take your chances. It is the only logical way to do things.How could Warren Buffett, for example, ever buy or sell stock if his broker had to disclose to the opposite party, "Hey, you are trading against Warren Buffett."

You would think that Robert Khuzami, Director of the Division of Enforcement at the SEC would understand this. Thus, it appears that the charges are complete grandstanding by the SEC for political reasons. It's feeding Goldman meat to the masses, now that Goldman CEO Lloyd Blankfein dissed President Obama, when Obama called for a sitdown.

Goldman raped America when Blankfein, in cahoots with then Treasury Secretary Hank Paulson, bailed out AIG for the benefit of Goldman Sachs. That was criminal, so it is hard to feel sorry for Goldman, but on the other hand, this charge against Goldman is not about justice, it is about big game politics, and there is not a more evil bunch of people on earth than government officials who will twist facts and situations to fit power agendas. Power agendas must always and everywhere be fought, and this move by the SEC and Khuzami is nothing but a power agenda move. If they get away with this one, the next time they may try it on you.


  1. Wenzel - well said. Sadly this excellent understanding of the market is not widely held and so government power will continue to grown while the real crime is ignored. But Wenzel certainly did his part to explain the problem.

  2. The other indication the government's case isn't strong is they filed a civil suit. The burden of proof is much lower than in a criminal case.

  3. Bob -

    ACA accepted the rating by Moody's..
    and believed that Paulson was not long the deal...Goldman deliberately lied about that.
    ACA thought Paulson was LONG and Goldman made them think that.

    They might have bought some of the stuff to get ACA to believe that too.
    Read the emails

    Khuzemi is bringing a civil suit for other reasons than that the fraud is not evident.
    This is I believe political theater...

  4. The case focuses on the firm America loves to hate, Goldman Sachs and a hedge fund manager, one that cashed in big in the meltdown.

    Who's not involved? Private equity, the group getting a virtual free pass in the Dodd bill.

    This civil lawsuit pushes Obama's reform memes. Rahm and company (Jim Messina) worked their campaign style magic on a last ditch health reform push. This could be similar.

  5. @Lila

    What does Paulson being long or short the deal have anything to do with ACA's independent evaluation? Do they only give independent evaluations when Paulson isn't involved? Further, as Henry Blodget points out, Paulson was a nobody before the real estate crash. His views on the market would have carried no weight.

    Goldman Sachs didn't buy "just some of the stuff". They lost more than $90 million. Their fee was $15 million. They did not buy into a deal to convince ACA of anything and lose $90 million to earn a $15 million fee.

  6. OK...I'll buy that...I didn't see the 90 million figure.

    It's not a question of ACA's giving evaluations only when Paulson is on board. It's that they were TOLD, when they specifically asked,that Paulson was an equity investor. They are entitled to use whatever criteria they want to come to their decision, and if they thought
    that Paulson's position was something they needed to know and they asked for that information and were lied to, then that is certainly fraud.

    The 90 million could have been something they got back at some other end.

  7. @Lila

    ACA shouldn't have even asked. That's at least a violation of an ethical code. There is no investment firm in the world that would have relied on their "independent" evaluation if it was based on who was buying.

    As for Goldman getting the $90 million back some other way, there is no proof and you could say that about most business transactions. Without any evidence it's a meaningless statement.

  8. Perhaps you should swing over by and read their take on Goldman's crimes.

  9. @annonymous

    If Goldman was knowingly ripping people off with these deals, then why was Goldman long the Paulson deal, which resulted in their losing $90 million?

    Second, the ZeroHedge post shows how a proper analysis from the facts would have highlighted the problems with the CDO's. So if enough disclosure is made to understand how dangerous, these CDO's were, where is the problem?

  10. Hi Bob -

    The ZH post doesn't show that. It says that an analysis that uncovered everything would have to have been very extensive..and it WASN'T easy to discover.
    ZH substantiates what I said - which is that they were taken in by the ratings agencies.