Goldman Sach vs. SEC By: Lemar Clayton

The Goldman Sachs situation presents a leadership ethics dilemma. Is it okay for banks to bet against their customers to manage risk and hedge their bets? In fact, I’m willing to bet that opposing sides in the argument don’t even see this as a dilemma. “The senate subcommittee grilled Goldman executives for 11 hours because they clearly think that what Goldman did was morally wrong, if not illegal.” ("Sec charges goldman," 2010) Contrast that with Goldman’s shareholders, who probably think it’s unethical for Goldman’s executives not to hedge against a mortgage collapse. There is a middle position that says the hedging itself wasn’t wrong, it was how Goldman did it that was questionable. Goldman should have disclosed its short position and possibly even details about the origins of those CDOs to customers.
Let me begin by explaining what is a CDO, Goldman takes a reference portfolio, or a bunch of bonds. A bond is a formal contract to repay borrowed money with interest at fixed intervals. Each set of bonds is senior to all the bonds below it, and they pay principle in order of their seniority. You can view it as a pyramid with different slices. The portfolio is giving a rating by Wall Street. Each slice has a different maturity and risk associated with it. The higher the risk, the more the CDO pays. Level E will take losses before D, and level C will take losses before B. It’s important to note the bonds don’t have to be owned by Goldman. The portfolios are synthetic or made artificially. The categories of the portfolio can be created upon request. You will have two parties involved in the transaction, one partner is betting long, and the other betting short. “The probe is reportedly examining a couple of Goldman’s CDOs, which were created in late 2006 and based on $2 billion worth of low-quality subprime mortgages.” (Schneider , 2010) In this case, the CDO was made of mortgaged backed securities and given the name ABACUS. Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio or CDO, while telling other investors the securities were selected by an independent, objective third party and worth buying. Goldman Sachs sold the CDOs to buyers, but failed to disclose a financial hedge that would was in place to gain profits, if the housing market collapsed. Goldman felt no obligation to inform buyers of the hedge in order to keep client confidentiality. Goldman told investors the securities in ABACUS had been chosen by ACA Management LLC, but the portfolio was put together by John Paulson, a hedge fund manager who paid Goldman $15 million to create the deal. In 2005, Paulson became nervous about the housing market and decided to bet against it. In 2007 alone he made $15 billion for his firm. He anticipated the housing market crashing. He analyzed the underlying criteria of recent mortgage backed bonds before making his selection. “Paulson’s selection criteria favored high percentage adjustable rate mortgages, relatively low borrower FICO scores, and a high concentration of mortgages in states like Arizona, California, Florida and Nevada that had recently experienced high rates of home price appreciation.” (Barr, 2010) The SEC had retrieved an e-mail of a Goldman Sachs employee that described the ABACUS CDO as junk to even further justify the research of Paulson.

The housing market crashed in 2007 and Paulson becomes a rich man. Goldman is now liable for paying Paulson on one end of the deal, and the second piece of the deal is the banks that purchased securities from Goldman. Goldman has to cover their losses from the mortgage failure to make those companies whole ,if they purchased security from Goldman. Those that didn’t purchase insurance from Goldman will need to find other means to reoup the losses. Goldman thought ahead of time about their current situation and entered into a deal with AIG to protect themselves if the cash was not available to pay both side of the financial deal. Goldman bought protection from AIG, in the form of a credit-default swap.
A swap is a financial deal with a fixed and a variable component. The fixed piece of the deal is what Goldman Sachs possessed. I’ll us 45$ as an example, If the variable price or the market reaches a number higher than $45, Golman Sachs has to issue collateral to AIG to cover the risk of selling at price lower than the market value, and vice versa if the price drops below $45. AIG makes a profit by charging Goldman a premium for doing the deal. Goldman has the security or shield in place to allow them to construct the same form of deals with smaller banks. Goldman Sachs was paying a fixed amount to AIG to cover the housing market. Goldman charged more than AIG for the protection to smaller banks, so it was able to pocket the difference, making millions while moving the default risks to AIG. In 2007, the housing market begins to sink. When the economy collapsed and companies such as Goldman Sachs were short on cash. They triggered their insurance policy(AIG) to cover the cost. AIG wasn’t able to insure the debt so the American government stepped in and bailed out AIG.
Paulson & Co haven’t been charged of any wrongdoing in the case against Goldman because they weren’t obligated to notify investors of the conflict of interest. Goldman had their hands out once AIG received the funds to cover their losses with their clients. Goldman Sachs was also one of the few insurers that were able to recover after the market collapse leaving them with a small number of competitors and a government bailout of 10 billion dollars. The 10 billion dollars was used to make risky decisions due to the understanding that “They were too big to fail” and the government has turned into their new security blanket. In 2008, the New York Federal Reserve approved a change in Goldman Sach’s legal status from that of investment bank to bank holding company, enabling it to qualify for a government bailout and access to cheap money fro the Federal Reserve.
Goldman Sachs also had friends in high places that wanted to ensure that Goldman survived the meltdown. Examples include former Goldman exec Henry Paulson, who led the Treasury Department when the bailout was first formulated last September, and who appointed former Goldman vice president Neel Kashkhari to oversee the massive $700 billion TARP fund. There is also the current Treasury Secretary Tim Geithner, who installed a circle of former Goldman bankers to help him navigate the country through the financial crisis.
The economy is turning around and now the government is investigating Goldman for earning record profits during a time of financial crises. Paulson & Co haven’t been charged of any wrongdoing in the case against Goldman. Paulson wasn’t obligated to notify investors of the conflict of interest The ABACUS deal appears to be unethical and illegal, but is Goldman the scapegoat. How was the CDO able to get such a high rating? Did Goldman Sachs really need the Bailout money, or were they just rewarded money without a complete understanding of the company’s current position? How did former executive Neel Kashkhari of Goldman Sachs become responsible for allocating the relief funds to banks?
The former global investment bank Stearns, now a part of JP Morgan Chase, turned down a similarly structured deal to the one under scrutiny between Paulson & Co because it "didn't pass the ethics standards.” The bank, which collapsed during the credit crisis, "smelled trouble" when John Paulson, the hedge fund's founder, approached it with the idea of creating an investment that the fund could bet against, according to author Gregory Zuckerman in his book on Paulson, The Greatest Trade Ever” Paulson & Co haven’t been charged of any wrongdoing in the case against Goldman because they weren’t obligated to notify investors of the conflict of interest.
Let’s look the current event described above in an ethical context. Goldman Sachs CEO Lloyd Blankfein was quoted as saying that he's "doing God's work." He latter recanted the comment and stated the quote was taken out of context. His actions lead me to believe that his moral values are aligned with the Catholic moral tradition. Believers are actually led by the idea that God is talking to them. The teeter between reason and revelation led Goldman Sachs to huge profits in 2007 and beyond. Let’s dive deeper into the Catholic tradition to find conflicting arguments of the ethical nature of Goldman Sachs actions. Lets’ begin with a moral analysis. The object of the act was viewed immoral by many due to the lack of information given to Goldman’s clients who purchased the CDO. They should have been told that a seperate client was betting against the portfolio. Client should have also been made aware that package was formed by the person who was betting against it. The client should have performed research to find out what was inside the financial package instead of relying on the rating as an indicator of performance. A CNBC poll seems to indicate that, at least among nearly 20,000 respondents, the answer to the question “Do you think Goldman Sachs did something wrong?” is anything but clear cut: 38% said No, Goldman Sachs did nothing wrong, 29% said Yes, criminally and ethically wrong, and 23% said Yes, ethically wrong, and 9% said Yes, criminally wrong. “If the SEC's allegations are true, then at the very least we are witnessing a real breakdown in ethics—people, ordinary men and women, failing to "do the right thing." In one sense, this ought not to shock us because an essential part of true ethics is the belief that ethics are grounded in some transcendent authority. And this belief in a transcendent authority is clearly on the wane in postmodern American life.” (Colson, 2010)
I’ve explained in my paper what is going on, and I believe it to be illicit. I think there is common understanding that financial deals are going to be hedged, but the manner of construction of this particular financial deal was morally wrong. Portfolios with AAA ratings were being sold only to later find out that the ratings system was fraud. There are several banks that purchased the ABACUS CDO’s that are now suing the company for providing false information. It appears that Goldman was more focused on collecting transaction fees from deals, in comparison to making sure the client made a sound decision based upon available knowledge.
The circumstances surrounding the actions of Goldman were not of their control. The housing market collapsed due to the open nature of home loans. They helped propel several companies into bankruptcy by not be able to cover all of their insurance obligations in a timely manner, or by palcing AIG in the situation of not being able to insure their client. I do place some blame on other participants(mortgage lenders) who were also committing the similiar acts by handing out risky home loans to people who couldn’t afford the lifestyle. The customers of Goldman were big institutions that knew exactly what they were getting into and have plenty of lawyers and money to sue Goldman if they so choose.
Goldman Sachs was material to the illicit act of selling junk CDO’s, but they are not the only actors in the stage play. Paulson & Company created a financial package with the intentions of mortgages going into default. They wanted people to fail in making their mortgage payments. I’m under the understating that being ethically sound is desiring the best for everyone, or the largest amount of people. Paulson was formally participating in the illicit act because they intended for the wrong act to happen. Paulson was also the prime person in the act and Goldman followed suit. I’ll continue to follow this case until a verdict is reached in court. I believe it will also be interesting to see how the public opinion of Goldman Sachs changes as more information concerning there business practices becomes public information. Let me be the first to wish them “Good Luck”, they are going to need it.

Bibliography

Sec charges Goldman Sachs with fraud in structuring and marketing of cdo tied to subprime mortgages. (2010, April 16). Retrieved from http://www.sec.gov/news/press/2010/2010-59.htm

Schneider , H. (2010, April 4). Sec sued Goldman Sachs after secret talks failed. Retrieved from http://www.cbsnews.com/stories/2010/04/20/politics/washingtonpost

Barr, A. (2010, April 16). Paulson & co. not charged in sec suit against Goldman. Retrieved from http://www.marketwatch.com/story/paulson-co-not-charged-in-sec-suit-vs-goldman-2010-04-16

Colson, C. (2010, April 21). Why Ethics matters: the sec vs. Goldman Sachs. Retrieved from http://www.crosswalk.com/news/commentary/11629208