The Outlook for Goldman

May 5, 2010 -- “Billionaire Warren Buffett said he has studied the civil fraud charges against investment bank Goldman Sachs and has no problem with the transaction involved. Buffett, who is Berkshire Hathaway’s chief executive [and a major investor in Goldman], said yesterday that he thinks he understands the allegations against Goldman better than most people, and he does not believe the Abacus deal at the center of the case constitutes fraud.”

So says an Associated Press report published on May 3. Unfortunately, I do not believe that Goldman’s chances of prevailing in court are as good as Warren Buffett thinks they are.

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Did Goldman commit fraud?

The essence of the legal case is this: An investor (Paulson & Co.) wished to bet against the housing market and hired Goldman Sachs to help him put together a vehicle for doing so. The instrument used was named “Abacus 2007 AC-1,” and it was one of twenty-three such “Abacus” wagers that Goldman put together between July 2004 and April 2007.  

In order to assemble Paulson’s particular Abacus, Goldman employed an outside firm (ACA Management), which had the task of choosing and evaluating a package of mortgage securities that Paulson and other sophisticated investors might disagree about. That would allow Goldman to find people who would take the other side of Paulson’s wager, that is, people who were willing to bet in favor of the housing market.

ACA understood that it was assembling and evaluating a package that would have bettors on each side, pro and con. But, according to the SEC, what Goldman did not tell ACA, when it was negotiating with Paulson about the securities that should go into Abacus, was which side of the bet Paulson would be taking. Indeed, at least one email cited by the SEC (from Goldman vice president Fabrice Tourre) seemed to imply that Paulson would be taking the side of the bet that favored the housing market.

If the SEC’s allegations are true, did Goldman commit fraud? Like Warren Buffett, pro-capitalists are inclined to say no. ACA’s job was to assemble and evaluate a package of securities that sophisticated investors could disagree about. Naturally, it had to put together a package that Paulson would accept, because Paulson was sponsoring the project. But whether Paulson was betting for or against the package—or for some segments and against some others—should not have mattered to ACA. ACA’s package had to attract both sophisticated investors who viewed the market favorably and those who viewed the market unfavorably. So, it could not slant the package either way. And that means: The fact that Paulson worked with ACA to assemble the package should not have mattered to those who agreed to bet against Paulson. Moreover, potential investors were provided with all the information they needed to evaluate each and every element of the package, independently of ACA. And they were urged to do so before betting on the package or any segment of it.

But to take this view of the matter is, I fear, to view the issue of fraud commonsensically: Because investors had all the information they needed to assess their wager, Goldman’s failure to discuss the process by which the package was constructed could not have been material to their decision to bet on it. To me, it seems a good argument, and if the question could somehow have been discussed prior to the bet’s being made I suspect that the participants would have accepted it.

But the issue is now being discussed after the bet’s winners and losers have been determined. Will the people who lost hundreds of millions on Paulson’s bet come forward to testify that they were not misled by Goldman’s failure to mention Paulson’s involvment with ACA--if there is a chance of recovering their money in a suit against Goldman?

Perhaps they would if they were businessmen like Warren Buffett. But the two firms that lost money on Paulson’s bet (the Royal Bank of Scotland and IKB Deutsche Industriebank) were ultimately taken over by the British and German governments respectively, and public officials will now be in charge of pursuing the matter. The German government, under Angela Merkel, seems to be taking a wait-and-see attitude, perhaps because IKB lost only $150 million. But the Royal Bank of Scotland lost more than $840 million, and the British government is pursuing the matter aggressively. Hector Sants, head of the Financial Services Authority, started a formal investigation of Goldman Sachs on April 20, working closely with the SEC. Since Sants is famous for saying “People should be very frightened of the FSA,” I believe that the chances of his endorsing Goldman’s perspective on the matter are nil.

Still, Goldman Sachs possesses the wealth necessary to see this case through, something that is rarely true when a firm or a businessman is targeted by the government. Thus, the firm’s decision—to capitulate or to defend itself—will be interpreted very differently from similar decisions made by other regulatory victims. If Goldman capitulates, it will be widely understood as an agreement from the highest levels of the capitalist establishment that a company’s clients and customers can no longer be expected to take responsibility for themselves. But if Goldman fights, it will become a chance for pro-capitalists to defend, morally, the free-market ideal of economic individualism, according to which all participants are responsible for making their own decisions about their own best interests.

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