While watching the Goldman Sachs hearings during lunch earlier this week, I couldn't help but feel like it was a political setup. People are upset about the financial crisis (rightfully so) and many senators are feeling the heat from constituents. While there were many companies involved in trading the mortgage securities market, it seems like Goldman has become the target - likely because Hank Paulson the former Treasury Secretary was the CEO for Goldman and many believe the bailout was a direct attempt to help Goldman survive. Given all the discussion this week, I thought it would be helpful to look at some of the issues surrounding the case. We will don't believe Goldman acted in the best interest of clients at all times, based on the current information available, Goldman Sachs likely didn't do anything illegal - however, Goldman acted in a way that was socially unacceptable and improper.
First, we have to go back to the late 1990's and the passage of the Commodity Futures Modernization Act, which exempted swaps and derivatives from regulation. All the big problems in the country seem to stem from something the government does or in this case didn't do. Below is a link to the BAM Weekly Bulletin article from last year.
http://brightassetmgmt.blogspot.com/2009/04/blame-commodity-futures-modernization.html
Second, Goldman didn't cause the financial crisis. They participated in trading and creating swaps and derivatives in the mortgage backed securities market, but they single handily didn't cause the collapse. It was a combination of several events happening at the same time. Remember, nothing Goldman or any other firm did with respect to creating or trading derivative products was illegal - the products were unregulated so technically there were no rules.
The word "synthetic" is the word that is important in this discussion. It's not a real asset, like the peanut butter and jelly you might find on a peanut butter and jelly sandwich. When an asset is "synthetic", every buyer for the product creates a seller who is effectively short the asset. Since the asset doesn't actually exist, there needs to be a buyer and a seller; it can't be one-sided. So, if a customer wants to buy a "synthetic" asset from Goldman Sachs that would make either Goldman or a third party the seller.
One of the reasons Goldman Sachs created the synthetic products was because there was strong demand from its customer base and this is an important point. Customers wanted to purchase assets that were tied to sub-prime mortgage back securities (and other mortgage related securities) either directly or synthetically, in order to increase risk or reduce exposure to risk, because they believed the underlying position would be very profitable or wanted to hedge an existing position. Because there was such positive sentiment about the mortgage market at the time, there weren't many investors interested in taking a negative view. Goldman and some other seemingly smart investors had an idea that the mortgage market may unravel at some point and were comfortable with betting against the mortgage market, or taking the other side of the trade in this example. We also have to remember that the average investor doesn't have access to a "synthetic CDO". Most sophisticated investors (hedge funds, pension funds, endowments) who were buying the synthetic products from Goldman and other firms for that matter were smart enough to understand what they were involved in. Goldman Sachs basically created products that were demanded by its customers and took, with other third parties, the other side of the trade.
We will have to wait and see what happens next...
