The Goldman Sachs fraud case explained
April 19, 2010Jon Brooks Comments OffTime magazine describes the SEC fraud case against Goldman Sachs this way:
Economists Do It With Models tries to explain this in a little more detail and in layman’s terms:
Hedge fund guy: I think the housing market is going to go to s**t in the next few years. More specifically, I think I know which parts of the housing market are particularly vulnerable. In order to profit off of this information, I would like to short sell a financial product that is tied to the housing market. In other words, I’m going to borrow one of these securities, sell it at the current high price, buy it back once it’s worthless and then give it back to the original owner, keeping the profit for myself. (Update: Technically the short position was achieved via a credit default swap as opposed to a regular short sale. This doesn’t affect the overall analysis, and you can see my comment below for more detail.) Now, there are a few products out there that would be appropriate for this, but it would be totally better if I could design the product myself, since then I could be extra sure that it would tank as much as possible, thus maximizing my profit. Let me call my buddies at Goldman and see what they can do for me.
Goldman Sachs, to hedge fund guy: Sure, we can do that, just tell us what you would like the crappy product to look like. But wait a second…you do realize that it’s hard to short sell something unless other people actually hold the product in their portfolios, right? And who in their right minds would buy something that you, as a smart guy, specifically picked as being the bottom of the housing market barrel? That kind of throws a monkey wrench into your plan…but wait, I think we might have a solution to this problem. So here’s the deal – you’re gonna get a call from another financial firm, and you’re gonna tell them that you are looking to create a product to invest in. Now, this is technically true, so all you’re really doing is leaving out the teeny detail that you are taking a short position rather than betting on an increase in value. No big deal, right? Just tell them what you want in the product and they will make it happen.
Goldman Sachs, to other investors: Hey look, we have this new awesome product for you. The assets in the product have been hand-picked by an outside firm who specializes in this sort of thing, so you can be confident that’s it’s going to do well. *snicker*
And then, big shock, the product tanks, the investors lose over $1 billion and the hedge fund guy makes a corresponding $1 billion. Note that the real problem here is not that Goldman Sachs purposely created and sold a crappy product. The problem is instead one of asymmetric information, which in this case is the financial equivalent of Groucho Marx’ “I don’t care to belong to a club that accepts people like me as members” quote. Simply put, if you have a really smart guy trying to sell you something that he owns, he’d better have a good reason for needing to sell it, since otherwise you’re probably getting taken for a ride. This situation is a classic example of the lemons problem- you know, where the shady dude is trying to sell you his used car and not telling you that it’s been in 5 accidents and has a faulty transmission- except that we’re talking about a financial product rather than a Honda Civic with a rolled back odometer.
I try to generally be as objective as possible (and have in fact defended Goldman’s business practices in the past), so I want to stay way more out of the discussion of whether this is a sign that more financial regulation is necessary than Rachel Maddow does in the video above. I will, however, point out that what Goldman Sachs is accused of is already illegal under current law, so I’m not sure how new regulations in and of themselves would prevent this behavior. Cue the oversight conversation…
