I am Worried About Goldman Sachs

I cannot remember if I have disclosed this before, but I own some Goldman Sachs stock. It is not a particularly large position, less than 1% of my net JapaneseAmericanGrocer1942 worth. But it worries me. I came close to selling yesterday and might just let it go today.

It is not that I don’t think Goldman is a great company. And it is certainly not that I think the stock is overpriced. With a trailing PE of less than 7 and no obvious threat to near term profits, it is, or ought to be, compellingly cheap.

The problem is that there is a chance, maybe not a big one, but a significant one, that the stock will go to zero. Not because of a problem in Goldman’s business, nor because the firm did anything it should not have, but because the federal government will decide to destroy it. Basically, I am worried that Goldman will get lynched.

It has happened before. When there is a confluence of politicians desperate to keep their jobs, government agencies trying to avoid responsibility for their failure to regulate, and an angry and ignorant public searching for somebody other than themselves to blame for what has happened to them, innocent people can go to jail and law-abiding companies can be vaporized.

Two weeks ago the SEC filed a compliant alleging that Goldman defrauded some investors in a synthetic CDO deal in 2007. A person’s opinion of the merits and meaning of the complaint seem to be neatly determined by whether or not the term “synthetic CDO” means anything to them. For the vast majority of folks, including, it would seem, everybody in congress and many in the media, “synthetic CDO” might as well be the name of an Icelandic volcano. And for these people, the complaint is gratifying evidence of what they suspected all along, that the financial crisis was ultimately caused by a bunch of crooks in Manhattan.

For the tiny minority of us who understand what the SEC is talking about, the complaint is shockingly weak. As the Wall Street Journal said a few days after the compliant was filed

The Securities and Exchange Commission’s complaint against Goldman Sachs is playing in the media as the Rosetta Stone that finally exposes the Wall Street perfidy and double-dealing behind the financial crisis. Our reaction is different: Is that all there is?

After 18 months of investigation, the best the government can come up with is an allegation that Goldman misled some of the world’s most sophisticated investors about a single 2007 "synthetic" collateralized debt obligation (CDO)? Far from being the smoking gun of the financial crisis, this case looks more like a water pistol.

Indeed, a person might argue that this complaint makes the case that Goldman must be squeaky clean if this is all the SEC could come up with. And make no mistake, the SEC specifically targeted Goldman.

The deal in question was cookie-cutter identical to hundreds, perhaps thousands, of others done all over Wall Street. According to the Economist, Goldman ranked 9th in terms of number of similar deals from 2005-08. There is a Dutch bank suing Merrill Lynch for doing the same thing the SEC accuses Goldman of doing. Although that case has something the Goldman one doesn’t, a complaining victim, the SEC is apparently uninterested in it.

Merrill, you see, is comparatively wholesome, a retail broker to millions of Americans. It also nearly went under in 2008 before being taken over by even more wholesome Bank of America. Goldman, on the other hand, does not do business with consumers at all and, worse, has the tiresome habit of being profitable even when common decency would call for them to lose their shirts. They are the New York Yankees of the financial world, methodically successful to the point that they serve as a constant and unwelcome reminder of the failings of others.

Under any sort of thoughtful examination, the SEC’s case can be shown to have the structural integrity of a wet paper bag. Others have already taken it apart in detail, for example the WSJ editorial linked above. (See also this insightful column from the same paper.) But I cannot help but to repeat a few highlights.

The SEC alleges that Goldman concealed the fact that John Paulson, a then fairly obscure hedge fund manager who had managed to consistently lose money for his clients over the previous few years, had helped pick the synthetic mortgage bonds that went into the synthetic CDO, of which Paulson took the short side. They concealed this information from the buyers on the long side, somehow convincing them that they, the buyers, had done the picking.

That seems like a remarkably unlikely story. But even taken at face value, it is pretty obvious that who picked the bonds is completely immaterial. First, because the buyers of the synthetic CDO knew exactly what was in the CDO when they signed the deal, and indeed had previously reviewed and rejected from the pool 68 of 123 possible synthetic bonds that they did not like and then added in 14 that they did. The buyers were not asked to trust anybody else’s judgment on the bond selection.

Secondly, and maybe more obviously, the selection of the bonds turned out not to matter at all. The buyers could have picked a basket made up of their most favorite sub-prime mortgage bonds in the whole world and they still would have lost their shirts.

But, alas, none of this really matters. Indeed, Wall Street’s reaction to the complaint, a sharp sell-off in Goldman stock and a dip in the market in general, was not despite the flimsiness of the SEC’s case. It was because of the flimsiness of the SEC’s case. The lynch mob is out for blood and innocence is no defense.

Having neither the facts nor the law on their side, the anti-Goldmanites have tried to make the case about some kind of vaguely defined betrayal of clients, portraying the synthetic CDO as being “designed to fail.” Again, this story works only if the term “synthetic” means nothing to you.

A synthetic CDO is not a basket of actual bonds, it is a derivative instrument in which somebody who thinks that the prices of the named bonds will go down makes a bet with somebody who thinks that the prices will go up. Both sides know this and, by definition, after a while one side will be the winner and one side the loser. All Goldman did was bring the bettors together and charge a tidy fee for their trouble. (As it turned out, Goldman got stuck with some of the long side of the deal, essentially as unsold inventory, and wound up losing money on the transaction. Far from quieting critics, Goldman’s foolish disclosure of this fact merely inspired more charges that they were being deceitful.)

The core of the anti-Goldmanite faction, which has long had the firm at the center of a variety of conspiracy theories, is currently pedaling the story that Goldman is a villain who profited from, and maybe even caused, the economic misery of everybody else. This narrative might be slightly more convincing if these same people had not so recently been accusing Goldman of hiding the extent of its losses in the financial meltdown, instead of hiding the extent of its gains.

Not that anybody but me notices these things. Goldman is down another 9% this morning, on a rumor that the Justice Department has opened a criminal investigation of the matter the SEC is suing over. Are we to believe that the SEC did not share its findings with Justice before? Or that, on further consideration, the DOJ now thinks that the SEC has a good case after all?

I am not sure I can bring myself to sell here. The stock is just too cheap. But this is now a high-risk high-reward holding, not the steady earner I once had in mind. And I am not happy about that.

21 Comments

  • By Mark Wolfinger, April 30, 2010 @ 12:45 pm

    Sometimes a prosecutor has to settle for a charge it can prove to (as you say) the ignorant public who comprise the jury.

    There are any number of potential charges. If they are not brought, it does not mean the prosecutors have no case.

    Al Capone comes to mind – tax evasion.

    Regards,

  • By jim, April 30, 2010 @ 2:34 pm

    Its a witch hunt for sure. I don’t think the government will destroy Goldman over it. The congressmen will likely be happy getting on TV in the hearings looking like they’re actually doing something. There could be a fine over it. Probably not big enough to scratch Goldman profits. The stock price will suffer due to perceptions.

    I don’t know why Goldman is singled out other than they’re successful. But Goldman’s practice of giving out gigantic bonuses has not helped them in the public eye. I’m not sure why but ‘bonus’ seems to carry a very negative connotation lately. It seems the word ‘bonus’ equates to ‘loot’ or ‘theft’ for some reason. Goldman should just stop giving bonuses and instead give their people something else with a different name of equal financial value.

  • By Adam, April 30, 2010 @ 2:42 pm

    “that the financial crisis was ultimately caused by a bunch of crooks in Manhattan.”

    Crooks? No. Idiots who bought into irrational exuberence, and whose actions not only damaged their own business but served as an exogenous shock that brought down the rest of the real economy? Yes.

    You take issue with the lack of understanding of the general public and most of the media when it comes to this case, but your defense of Goldman is just as glib. This “Abacus” deal wasn’t quite the straightforward act of financial intermediation you portray. Felix Salmon looks at it with more of a fine tooth comb and concludes that there were errors of ommission http://blogs.reuters.com/felix-salmon/2010/04/23/goldmans-biggest-lie/ (and he isn’t exactly a pitchfork-wielder:
    http://blogs.reuters.com/felix-salmon/2010/04/24/the-goldman-wars-continue/ and http://blogs.reuters.com/felix-salmon/2010/04/27/levin-vs-blankfein/ )

    Does this constitute a civil crime? I don’t know, I’m no securities lawyer. But my point is, it’s complicated.

    And beyond that, as you correctly say, politicians will politic, it’s what they always have done and will do, just as businesses will work to protect their own interests. Instead of complaining about it, I’d love to see an explanation of how unfettered financial markets are long run pareto optimal, which is what you always seem to be hinting at. I tend to disagree, but I have an open mind.

    Or, please, write a take down of The Simple Dollar, which is more harmful to society than GS, imho.

  • By Mike Piper, April 30, 2010 @ 3:32 pm

    @Adam: I can’t help but be curious. What in particular about The Simple Dollar do you take issue with?

  • By JohnB, April 30, 2010 @ 5:53 pm

    Frank -

    Two possible strategies to ease your concern:

    1. Sell half of your GS. If it goes up, you still gain nicely; but if it tanks, you won’t feel so bad.

    or 2. If you are ahead of what you paid, sell an amount equal to your cost basis. If it goes up, you still gain something; but if it tanks, you laugh all the way to the bank.

  • By hickchick, April 30, 2010 @ 9:03 pm

    So Goldman just provided the ring for the dog fight.

    There’s a difference between being innocent and being law-abiding.

  • By craig, April 30, 2010 @ 11:24 pm

    Well, we’ve disagreed on the subject of Goldman before and may do so again. The question of their legal wrongdoing in this matter turns on very close analysis of what is a “material fact,” which I do not pretend to be able to undertake. But fairly smart people such as Steve Waldman of Interfluidity come down powerfully on the “illegal” side of the debate. And as for the editorial pages of the WSJ…I keep a link (http://delong.typepad.com/sdj/2007/07/most-dishonest-.html) to the most dubious graph I have ever seen published for whenever I need a little pick-me-up.

    One obvious purchaser of default protection on a mortgage is the the very holder of that mortgage, who is hedging risk, not betting against the asset…no more than I am “short” my own house because I have fire insurance on it.

  • By Hibryd, May 1, 2010 @ 4:25 pm

    This is a very informative post, but I think that in the grand scale of things – how much damage was done and how much government intervention was required in response – turning the focus onto a single company is… pathetically mild, really. Not witch-hunty enough. Something was obviously very broken and if there’s no proportionate response, it will just happen all over again. The market was like a teenager who totaled the family car, and now Dad’s going to have to take the keys away and ground them for a bit.

    Based on what little I know, I’d suggest investigating both the rating agencies that gave all these CDOs (and other products) stellar ratings for a price, and the companies which paid that said price. Any other suggestions?

  • By kitty, May 1, 2010 @ 5:17 pm

    Wow, and I have Goldman bonds. I am perfectly find with holding to maturity, but if the government bankrupts the company… Oh well, it’s unlikely.

    I think what keeps bugging me about the whole “lynch the company”, “company is evil” mentality is that everyone who subscribes to this mentality thinks of a company as one person. But Goldman employs a lot of people, most of whom had nothing to do with whatever wrongdoing (if any) there was. There are also a lot of people who invest in Goldman either directly or through funds who stand to lose money.

    If there indeed are some guilty parties – why not find the individuals, prove the case (if any) against these individuals in court, and punish them if found guilty. But it seems to me that the mob is perfectly willing to punish thousands even hundreds thousands of innocent people just to prove their point.

  • By Freedom is for suckers., May 1, 2010 @ 10:21 pm

    Of course you are not gonna sell. And GS is not going down the tubes either. Its theatre and we know you are smart enough to know it so get back to regular bad money blogging.

  • By Mt, May 1, 2010 @ 10:45 pm

    We have yet to see if the government brings similar cases against a bank with customer deposits and branches like Citi or BofA. I guess it just depends on hard evidence – they’re only bringing cases they think they can win. The SEC doesn’t have time to throw things at the wall and see what sticks.

    I’m not agreeing with those who think GS is innocent or that public indignation is wrong. It is a fickle public: we recently found out that the Red Sox won the World Series with major contributions from a player who used PEDs to hit home runs (Ortiz). We didn’t much care.

    But what if we found out that the Red Sox were secretly allowed to decide who the Expos drafted, and stocked them with mediocre players? Some would care quite a bit, and others would point out that the best team won and the Expos were a NL team that the Red Sox probably didn’t play head-to-head. It would only have helped the Phillies and nobody cared about the lousy Expos anyhow.

    The difference is that the PEDs were a case of everybody did it, it’s a competitive move, and it wasn’t specifically against the rules. But the “secret deal” to allow one already loaded team an unfair and unique advantage would land very differently.

  • By Neil, May 2, 2010 @ 1:34 am

    I don’t really get why Goldman’s been singled out by the public and others. I do understand to a large extent the frustration with a financial system sufficiently complex that no one really understands what’s going on, (and those who understand more than others then sneer and complain about the ignorance of the general public).

    Anyway, I doubt Goldman is going to zero. Even if the government went apeshit on them (something I doubt will happen), the worst that I could see happening would be to split them up into smaller pieces and I’m sure that shareholders will come out just fine.

  • By bex, May 2, 2010 @ 12:06 pm

    I’m of the opinion that if GS broken the law, they did it only in small instances. First of all, they’re too smart to open themselves up to too much risk. Secondly, there’s a very good chance that they helped WRITE the laws that apply to them. Thus, odds are low that they did anything seriously illegal.

    However… that does not exempt them from doing things people consider seriously UNFAIR. Which is the primary cause of all this anger.

    The fact that GS stands firm, insisting they broke no laws, makes just abut everybody say there’s something wrong with the laws.

    The real estate market was overheated… this means people who are normally smart act quite stupid, and buy synthetic CDOs when they really should not. Should the investment bank warn them? Should some government consumer protection agency warn/stop them? Should investors have to pass a yearly test to push more than $1 million in a year?

    I don’t know the answer…

  • By Kent @ The Financial Philosopher, May 3, 2010 @ 9:37 am

    Please allow my cynicism to alleviate your fears: The Goldman grilling is purely a surgical strike for political show.

    Politicians often act as ideological idiots but Washington is fully aware that if their trials of GS are too successful, there may potentially be more economic unrest or even a panic-driven decline in capital markets, if it appears as if the entire investment banking system is being sued and re-structured.

    A quick public spanking resulting in a relatively painless fine for Goldman will be just enough to “prove” that Washington is on the side of Main Street, not Wall Street.

    For similar history, go back to the “Mutual Fund Scandals” of 2003, where Eliot Spitzer sued mutual fund companies for “late trading.” Much of this behavior was highly unethical but not quite illegal. The capital markets went on to improve and build a new bubble for four years. You know the rest of the story…

  • By Patrick, May 3, 2010 @ 9:49 am

    I’m going to go way out on a limb here and make a bold prediction that your investment is safe. I’d consider this an opportunity to top up your investment at panic-induced bargain-basement prices if you are so inclined.

  • By Boston Steve, May 3, 2010 @ 12:03 pm

    If you truly believe they are innocent then buy a bunch more….back up the truck as Peter Lynch would say.

    If they’re innocent they, and you, will be vindicated after they’re found innocent in one of country’s fair and honest courtrooms.

    The main reason for this “witch hunt” is obviously to sway public and political viewpoints toward passing pending wall street regulation bill(s).

    Any while GS might not be guilty of this particular charge there should be absolutely no doubt that Wall Street and Washington bear most of the responsibility for this, and numerous other, financial meltdowns.

    As you said there were thousands of these deals all over the street, the results wall street (and Washington via lobbyists) gets the rest of the world’s money.

    http://www.smartmoney.com/breaking-news/smw/?story=20081223090238&hpadref=1

    Any wonder that people are upset…

  • By Alexandra, May 3, 2010 @ 1:02 pm

    I think it’s time to double-down on GS. They aren’t going anywhere.

    The politicians are doing a great job of showing the public that they are “punishing the banks” that “caused” the recession. They won’t go so far as to actually inflict fatal financial harm to GS because they need them to help lead the charge out fo the recession.

    It’s a delicate balancing act, and a good time to lower your dollar-cost average on GS stcok.

  • By racy, May 4, 2010 @ 7:19 am

    “Be greedy when others are fearful”, Warren Buffett. Buy more while they’re cheap!

  • By Betty Kincaid, May 5, 2010 @ 11:41 am

    @BostonSteve “there should be absolutely no doubt that Wall Street and Washington bear most of the responsibility for this, and numerous other, financial meltdowns.”

    BostonSteve is half right. The current financial crisis is because of unintended (sometimes intended) consequences of government regulation (deregulation)and interference in our financial system.

    -Fannie, Freddie and FHA are all propped up by taxpayer money.
    -Too big to fail banks are “rescued” while community banks, who actually lend money, are regulated to death.
    -Democrats force banks to make loans to unqualified borrowers (some weren’t even legal citizens.)
    -Republicans supported the repeal of Glass Steagal setting up the no “skin in the game” scenario
    -And, everybody in WDC takes money from Wall Street.

    “Government is not the solution to our problem, government is the problem.” Ronald Reagan.

    Betty

    Here’s our take on GS:
    http://bit.ly/aRqSkC

  • By Hibryd, May 6, 2010 @ 10:17 pm

    Betty – “-Democrats force banks to make loans to unqualified borrowers (some weren’t even legal citizens.)”

    Yeah, can you provide a source for that?

    Because I’ve heard this claim a few times, and when I ask for verification, the only cases people can ever point out to me involved the government suing banks over very real instances of “redlining” minority-heavy zip codes, which IS discriminatory and should not be allowed. Other people point to instances where the government merely “encouraged” banks to loan to minorities to combat said redlining discrimination.

    I have yet to see any proof that a government official walked into a bank and “forced” them to loan to someone who couldn’t pay it back. It’s been repeatedly said that banks did not CARE if someone could pay it back – they were selling the loans faster than they could sign them, so it was zero risk for them.

    http://www.thisamericanlife.org/radio-archives/episode/355/The-Giant-Pool-of-Money

  • By Boston Steve, May 21, 2010 @ 9:37 am

    Betty K,

    I love that you quote Ronald Reagan who caused more harm to this economy than Bush and Clinton combined, which is quite a feat.

    Please don’t listen to what politicians say look at what they do…..Reagan for instance raised social security taxes by the second highest amount of any president (the most was by Eisenhower and the third most was by Nixon – two more great Republican free market heros)

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