Make our market grow

Market maker should indeed be the catchphrase of the day in the Goldman testimony. Is it an adequate defense?  Does being a market maker for a financial product absolve one of all responsibility for the quality of that product?

Goldman was doing business as market maker for CDOs while its proprietary trading took positions against some of the products it was working with on the other side. Are the evident conflicts of interest in this situation outside the norm for an investment bank? These kinds of conflicts must be commonplace, and the ability to work with capital in these ways are part of the attraction to risk that is a hallmark of investment banking. Fees alone are not enough to support outsize bonuses and average salaries that push into the high six-figures.  The line between investment banks and hedge funds is very blurred with one frequently doing the other’s bidding, as was evident in Abacus.

The unfortunate problem of investment banks offering highly complex investment vehicles as institutional investments is that nearly everyone—including those averse even to the risk of fixed income—ends up becoming an unwitting investor.  Yes, IKB is a large and sophisticated investor, but they are investing with the money of many small and unsophisticated (and probably risk-averse) investors.  While Goldman’s legal responsibility is solely with IKB, its moral responsibility extends to the millions who invested in leveraged subprime debt because of the market that Goldman made.

They say: “We make the market.”  Investors at all levels should demand: “Make our market grow.”  When these markets are for products so abstract that even “sophisticated” investors (not to mention the people packaging them) are baffled, one must ignore the prestige of the market maker and turn to investments that are truly analyzable.  That’s the recipe for making the markets grow.

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Timberwolf: A wolf in wolf’s clothing…

Goldman correspondence in the press today regarding its CDO investments extend beyond Abacus to Timberwolf I, a related investment that may have been funded with proceeds from Abacus.  According to Marketwatch, $300 million of Timberwolf CDOs were sold to Bear Stearns within one year of its collapse.

The intriguing subtext to most of the suppositions on the part of the media is that Goldman had 100% certainty that its positions were going to earn outsized returns. There is no question that risk was involved and that its bets, with a different set of circumstances, could have led it to a similar fate to Bear Stearns.  The media mythologizing of Goldman’s prowess is not an accurate representation of the facts.  Yes, Goldman may have been incrementally smarter than Bear, Merrill, Citi, etc., but there is no question that it was luckier.

While Timberwolf turned out to be a bad deal for its buyers, the comments currently being circulated from those on the Goldman side of the deal are not evident of wrongdoing.  Goldman could have been wrong about it being a bad deal for the buyer. The media appears to forget this, again contributing to the myth of Goldman outflanking the mortgage meltdown on its wits alone.

Back to material information: if Goldman withheld material information from the buyers of Timberwolf, this is serious wrongdoing.  If they truly knew that it was a bad (or misrepresented) investment, the gloves should come off at the SEC.  This investment was a wolf in wolf’s clothing, but they weren’t telling.

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Goldman & the SEC

The legal experts who have weighed in on the recent SEC charges against Goldman are no doubt correct in asserting that the government has an exceedingly difficult case to prove—and an adversary that will fight long and hard.  The legality of Goldman’s actions (and the court’s eventual decision on what constitutes material information in this case) is certainly not the real issue here.  The real issue is the effect of these revelations of the Paulson dealings on the firm’s reputation.

Due diligence on the part of the buyers of the investment package may have revealed Paulson’s hand and stance.  The large European banks that were the primary investors here must take the blame for their losses.  Goldman claims that the deal was not profitable in the end for them either, however the promotion of the fund manager would suggest otherwise.  One may hope that the trial would bring to light any deal between Paulson and Goldman that ultimately may have made it a profitable venture for the investment bank.

Whether or not that was the case, the extreme moral hazards that accompany extreme sums and limited personal risk are at play.  It is a matter of degree.

Was Goldman’s role in this deal ultimately that of a book-keeper set to make money whether its investment failed or not?  It gets back to the question of disclosure and material information.  On any given day, a banker may advise one investor to sell and another to buy, content simply with the fees both transactions will earn for them.

This is the nature of this part of the game at all levels.  Goldman will avoid SEC sanction, and its reputation on Main Street as the bank that outsmarted the housing meltdown will be tarnished.  At least everyone can feel good that their disdain is not just reserved for the little guy; it’s for the big guys, too.

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