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.


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