Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

17 April 2010

The SEC’s Suit against Goldman, Sachs: What it Means


Introduction
Why the Markets Dropped
Caveat Emptor and Regulation
Prosperity
Complexity
Conclusion

Introduction

Today the Securities and Exchange Commission sued the investment bank Goldman, Sachs for securities fraud. Apart from the bailouts, this was the first major governmental response to the malfeasance at our big banks that nearly created a second Great Depression. Borrowing Churchillian language from World War II, a guest writer for the New York Times called the suit, “the end of the beginning.”

What he had in mind was the end of the beginning of a long, hard war against greed, swindling and vastly overvalued paper pushers. The suit also may have marked the beginning of the end of our brightest youth falling into the maw of law and investment banking, where they dream of getting obscenely wealthy while still young, without doing or making anything of lasting value.

You might think that sort of event would make the markets go up. You might think it would provoke a vast sigh of relief and catharsis―a green shoot of hope that on some bright future day we might actually set our financial sector right. But the markets went down. Go figure.

Iceland’s volcano, whose ash decimated European air travel, undoubtedly was partly to blame. Unlike the derivatives that Goldman allegedly sold fraudulently, air travel and the international trade and business its supports are real things. No one knows how long the volcano will keep pumping out the high-altitude ash that hobbles them.

The volcano’s direct hit to airlines is about $200 million per day. The “collateral damage” to other business and trade is impossible to estimate but undoubtedly very high. Mother Nature and the Earth’s crust don’t always answer human prayers, so the uncertainty is daunting.

When you recall that Iceland was one of the first and principal victims of the derivatives debacle, it’s enough to make you believe in poetic justice. Maybe there is a God after all, and She has a sense of humor.

Why the Markets Dropped

But I digress. The nation’s major financial reporters all cited the Goldman suit as the reason for the markets’ drop. That view might be just another instance of New Yorkers’ myopia and financial gurus’ overestimating their own importance. But if New York’s financial reporters know anything, they know what investment advisers and the sheep they lead to slaughter are thinking. So we have to assume that the Goldman suit is the market drop’s primary cause.

The obvious question is why. Why would the markets tank at the mere thought that architects of our global financial catastrophe might at last get slapped on the wrist? If their gambling on derivatives becomes more cautious, they’ll have more money to capitalize real businesses, won’t they? Wouldn’t that be a good thing?

One answer is clear and simple. We are ending an era in which the cleverest propagandists since Goebbels managed to promulgate a myth that just isn’t so. According to that myth, the government that [search for “public sphere”] won World War II, helped create our global air travel system, beat polio and smallpox and contained AIDS, put men on the Moon, and created the Internet (among many other things) is incompetent and can’t do anything right. In contrast, private business, which gave us the savings-and-loan meltdown, the dot-com bubble, Enron, Countrywide, Bernie Madoff, our energy crisis, the housing bubble, and global economic meltdown, can do no wrong. To people nursed on that myth from birth, the thought that the wicked witch of government might regain the power to quell the exuberance of private swindling brings fear and uncertainty.

So the markets went down because businesses―in particular banks―will likely have to change their ways. They might even have to make money by capitalizing real businesses that make such things as the Dreamliner, the iPod and iPad, electric cars, and even electricity-generating windmills. What a catastrophe!

But to really understand why the markets went down, you have to understand long-term market psychology. From a psychological perspective, capitalism looks a lot like a manic-depressive patient. Boom times are the manic phase. Our latest ended in September 2008 with our financial system’s near-meltdown. It began (roughly speaking) when grade-B actor Ronald Reagan decided he knew more about economics than the “brain trust” that had saved us from the Great Depression and had build the longest and strongest surge of prosperity in human history.

With his world-class charm and temperament and his fourth-rate intellect, Reagan got a generation and a half of Americans to believe the myth. The Cold War’s end reinforced it [search for * * *] by convincing us of our national omnipotence and (by extrapolation) the omniscience of the cartoon ideology that we thought had triumphed. The result is our economic condition today.

Normally, bust times follow boom times as the night the day. The nineteenth century saw a series of regular financial booms, followed by busts. The Crash of October 1929 and the following Great Depression were the worst busts in our short history. Japan's “lost decade” of the 1990s was a pale echo.

But something funny happened in 2008 and 2009. That wicked witch―government―discovered an antidepressant. Heeding the Great Depression’s lessons, which Ben Bernancke spent most of his life studying, it gave the world a huge dose of Zoloft, paid for by American taxpayers. The result today? Global stock markets (all leading indicators) are up. Business profits are up. Consumer spending and construction are starting to rise. Employment and consumer confidence (lagging indicators) are showing signs of having hit bottom and are starting to rise. Every indicator suggests a rising economic tide, making the “bust” phase of our near-global meltdown one of the shortest in history, especially for a recession so deep.

Yet the myths remain. If government is a bumbling fool, can a recovery that it underwrote survive? If markets are omniscient and omnipotent, can restraining their irrational exuberance do any good? When juxtaposed to the facts of the last two years, the myths we have taught ourselves for the last thirty create cognitive dissonance. The result is fear on the part of those who believe the myth as well as those who feel real pain: the unemployed, the underemployed, and the foreclosed.

Caveat Emptor and Regulation

The SEC’s suit against Goldman, Sachs reflects one aspect of the boom-bust cycle. During boom times, exuberant markets adopt a philosophy of “caveat emptor”―Latin for “let the buyer beware.” During those times everyone seems to be making money, and making money seems so easy. Protecting the uninformed, unsophisticated and the “little guy” seems a waste of time and resources. Allowing robust business to work on its own seems more “efficient.”

But laissez faire markets, when coupled with natural human greed and self-interest, inevitably produce swindling. If swindling goes on too much and too long, its begins to kill markets themselves, as traders hesitate to trade for fear of being swindled. So eventually―at least in a rational society―the pendulum swings back from caveat emptor toward regulation. Society recognizes that unregulated markets with lots of swindling lead to no markets or (at best) weak markets. The Goldman suit marks a society (ours) at precisely that point.

Caveat emptor might work well with simple transactions like the sale of a cow or a used car. A dairy farmer who buys a cow ought to know how to inspect it for disease. A consumer who buys a used car ought to be at least savvy enough to take it to a mechanic and have it inspected. When the myth of rugged individualism prevails, as it does today, we are all deemed to be at least smart enough to protect ourselves as buyers in simple situations. And if we want more, we can ask the seller to put his claims in writing, in a guarantee or warranty that courts will enforce with damages if breached.

But stock and other securities are a bit different. You can inspect a cow or have your mechanic inspect a used car. But it’s hard to inspect a whole company, its history, its divisions and subsidiaries, its products and services, and its management. And that’s not all. The law―including the law of corporations and trade secrets― gives corporations the power to withhold vital information from the public, including buyers of stock. Deny buyers this information, and they will get burned. Deny them in mass, and you have the makings of a Crash.

So Congress in its wisdom passed a number of laws during the Great Depression. Several try to correct the inherent imbalance in access to information between corporations and buyers of their securities. They require public sellers of securities to disclose all material (important) information, without omission, and to do it accurately. If they don’t, buyers can sue them for losses. In effect, these laws turn securities sellers’ advertising and disclosures into the guarantees and warranties that even a rule of caveat emptor allows. They make disclosures by securities sellers act like a form of guarantee, automatically.

The SEC’s suit against Goldman differs in detail, but not in principle. Goldman sold its derivatives to private parties in private sales, so the laws governing public sales of securities don’t apply. But the SEC says Goldman committed ordinary fraud by making a materially misleading misstatement.

As the SEC tells it, Goldman sold derivatives of subprime home mortgages to two different types of parties. One, a well-known hedge-fund manager, bet on the downside. He correctly predicted that the housing bubble would collapse and the value of the underlying subprime mortgages and their derivatives would fall. The other parties bet on the upside. They predicted (incorrectly) that the housing bubble would continue to inflate (or at least not pop) and the mortgages and their derivatives would pay out as promised. The crucial point, says the SEC, is that the hedge fund manager, who bet on the downside, selected the mortgage portfolio on which the derivatives were based. At the same time, Goldman told the other (upside) parties that an independent consultant had selected them.

Now if you were buying securities hoping they’d go up, wouldn’t you consider it “material,” i.e., important, to know that the securities had been designed by a person betting they’d go down? Wouldn’t you want to know? That’s the essence of the SEC’s case for fraud.

Goldman will have its day in court. But if the SEC can prove the charges, it’s hard to see how any lay jury would fail to find fault. Furthermore, as the facts emerge at trial (assuming the SEC has done its homework) what remains of Goldman’s reputation will tank.

So it’s easy to predict what will happen. After lots of hemming, hawing and preparing for trial (and lots of fees paid to Goldman’s gold-plated law firms), Goldman will settle.

Goldman’s goal in settling will not be minimizing its monetary penalties. The entire amount of derivatives at issue (a little north of $10 billion) is pocket change to Goldman. Goldman’s goal will be to get a bland disclaimer of wrongdoing as part of the settlement, which it can tout to public and the marketplace, saying “See? We did nothing wrong.”

Disclaimers of that sort are commonplace in settlements of securities litigation. But this time the government should not allow one. Why? Because the whole point of the suit is to show that what Goldman did was wrong and to put the financial sector on notice. Without a public declaration of fault on Goldman’s part, we will never turn the corner from bust to recovery and from caveat emptor to regulation. Without one there will be no accountability for the near-destruction of the world’s economy and the real destruction of millions of consumers’ lives.

Prosperity

Whatever happens in the lawsuit, Goldman will still be Goldman. Any damages it may pay won’t even dent its profits. Its principals will still be obscenely rich, far beyond their real contribution to the commonwealth. But a public declaration of wrongdoing is an important goal in itself.

Goldman insists that its actions were fair because it was dealing with “sophisticated” investors, including managers of hedge funds and institutional investors. It wants to treat buyers of complex, abstract financial documents that it designed like the buyer of that dairy cow. Caveat emptor: if you buy one of these weird financial instruments, you are ipso facto sophisticated, or you should be. That’s Goldman’s pitch.

But that argument is retrograde to America’s history and economic development. It contradicts the principles that made our nation strong and our free markets unmatched.

To see why, think of Henry Ford. During the nineteenth century, only rich people could afford complex mechanical devices like cars. The rich maintained their disparate wealth by denying their workers a living wage. As a result, the markets for their consumer products were small, and they couldn’t sell much. Masters of industry like Andrew Carnegie made their fortunes by making and selling things for industry alone, such as steel.

In the early twentieth century, Henry Ford changed everything. Not only did he invent the assembly line, which made workers more productive. He also paid them a living wage, which allowed them to buy the cars they made. That simple change exploded the consumer market. A century later it has created the consumer economy that we know today, with the highest standard of living in human history.

The securities industry followed much the same path. During the Guilded Age, sophisticated insiders dominated finance. One financial guru famously said that he knew to sell out before the 1929 Crash because his taxi driver recommended stocks. When the plebes enter the market, he thought, it’s time for the masters of industry to leave.

We don’t think that way today. Today consumers own about fifty percent of all common stock, either directly or through mutual or retirement funds. That’s a good thing because it recycles consumers’ savings into capital for industry. It’s a win-win situation: business has greater access to equity capital, and (except during crashes) consumer-investors can earn better returns than they could from banks. That’s one reason why the US is still the world’s easiest place not only to start a business, but to finance it.

If Goldman wins the argument that derivatives are only for the sophisticated, the derivatives market will remain small. But if they’re as useful to real business as Goldman and the hedge funds insist, then they should be made available to any business that can use them, in fair and regulated markets. Any other approach would deny medium-sized and smaller businesses the benefits of derivatives. In so doing, it would promote industrial concentration and centralization.

Goldman’s CEO Lloyd Blankfein wants to keep all the derivatives business in a small circle because he thinks like J.P. Morgan and would like to rule finance as Morgan did. But keeping wealth in a small circle today is un-American. If derivatives are good for business and therefore promote prosperity, they should be made part of our general market economy, available to any business, of any size, anywhere. If not, their use should be restricted to specific situations that demand them, such as hedging commodities whose prices are volatile.

Complexity

The final general policy issue at stake in the Goldman suit is complexity. Derivatives require sophisticated investors, Goldman insists, because they are inherently complex.

But in general complexity is not a good thing for business. Some real products are inherently complex. They include Boeing’s Dreamliner and the software for Apple’s new iPad. But even in real engineering complexity is undesirable. That’s why both Apple (in Snow Leopard) and Microsoft (in Windows 7) recently made great effort to simplify and streamline their operating systems.

Outside the realm of real engineering, where complexity may be unavoidable, complexity is undesirable because it opens the door to swindling and makes markets opaque.

Let’s take two examples. The first is the now-infamous AIG. At the height of its success as an insurance company, it had (if I recall correctly) over 250 distinct corporations in its organization chart. Its CEO Hank Greenberg was famous for creating that complex structure and reportedly carrying it around in his head.

There is a plausible reason for an insurance company to have so many separately incorporated divisions. The corporate form limits a business’ liability to the capital invested in it. By separately incorporating divisions in different countries and different markets, Greenberg insulated his business in each market from unanticipated losses in the others, including foreign nations.
Yet as I’ve explained at length in connection with health insurance, insurance generally works better the bigger the market (and therefore the larger the pool of insureds). Large pool size (and therefore lower average costs and risks) might not have mattered to AIG in markets where it was the first entrant or lacked competitors. But that awesome complexity always made we wonder whether Greenberg was up to no good, or whether he simply wanted to be the indispensable man―the only one who understood the whole structure. As a result, I refused ever to consider investing in AIG. My caution proved prescient when the same sort of gratuitous complexity (in derivatives) on which Greenberg build his empire (in insurance) undid it.

My second example of complexity gone awry is Goldman itself. Derivatives of mortgages are not rocket science. They need not be horrendously complex. You take certain aspects or risks from a portfolio of similar mortgages and define them as “derivatives.” Some complexity inheres in how you define those aspects or risks, but most inheres in what mortgages you call “similar,” i.e., those you choose for a particular derivative portfolio.

For simplicity’s sake, you might use categorization. For example, you might take all mortgages on homes in a give ZIP code, or all mortgages above or below a certain principal amount. Once you get away from simple, transparent rules, you open the door to fraud. That’s precisely what the SEC alleges Goldman did: letting a downside bettor select the mortgage portfolio for the upside buyer, without telling the buyer.

If Goldman had only used simple, neutral rules for collecting its portfolios of mortgages, which any buyer could understand, it would not only have created transparent markets. It would also have protected itself against claims of fraud. The fact that Goldman didn’t do so suggests that it was bent more on lucrative swindling that on creating vibrant and useful new markets.

Conclusion

The Goldman derivatives story―as the SEC tells it―is an old plot with a new twist. If you want to see what’s going on, look not at the financial instruments’ complexity, but at how the sales are made.

Honest business people generally avoid complexity and disclose fully. They want customers to know what they’re selling because they are proud of it. They keep things simple in order to promote understanding. When people make things too complex and fail to reveal “details” like obvious conflicts of interest, they are generally bent on swindling, not honest business.

Business in a complex, high-technology economy of 307 million people is not always a simple thing. But it’s a good idea, in general, to beware of complexity, especially in business and financial matters not dictated by complex technology. Caveat emptor is a bad rule for a modern economy based on consumer sovereignty and consumer participation. It makes customers fearful and markets smaller. But omnes caveant complexitorem may be a good rule: let everyone beware the mystifier, who is usually up to no good.

Besides a grasp of the essential policy issues, the SEC’s action has another benefit. It illustrates the Obama Administration’s multipronged approach to governance, about which I’ve written before.

Congress is now deliberating comprehensive financial reform. Goldman and the other big investment banks (and some of their clients) are vigorously resisting the notion of regulated, transparent markets for derivatives. But what Congress does may not matter. If the SEC wins the lawsuit, or if it extracts a settlement with an admission of fault, preparing and selling derivatives as Goldman is alleged to have done may entail too great a risk of liability to gain business traction.

There’s more than one way to skin a cat. Our President, who was trained at the nation’s leading law school, knows them all. So masters of our finance sector had better get used to a new regime: if Congress doesn’t reign them in, the SEC and the courts will.

Once big banks could mumble “free markets” and get free reign to enrich themselves with cockamamie experiments that imperil the national economy. That era is now over.

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