Monday, May 03, 2010

The Meaning(s) of Goldman Sachs

By Bob Hockett

So much has been said of late about Goldman Sachs -- by pundits, by members of Congress, and now by the SEC and, most recently, the DOJ -- that it might be helpful to disentangle the sundry 'issues' that seem to be implicated, though not yet adequately differentiated, by all the chatter.  As I see it, there are in fact three principal issues on the minds of those now talking about Goldman, while only one of them is what I'll call Goldman-Sachs-specific. 

1.  The first 'issue' concerns Goldman's fortunes (pun intended) during our recent real estate bubble and burst, along with their nasty sequelae.  Many have accused Goldman of profiting as real estate markets tanked, hence of having 'bet against American home-buyers' and profited by both their misfortunes and the misfortunes of others as the effects of the crash have radiated outward.  Goldman for its part has defended itself partly -- and I think unhelpfully -- by arguing that in fact it suffered significant losses in the wake of the real estate crash and subsequent credit cruch and recession.  Recent publication of internal Goldman email messages highlighting Goldman successes accordingly were seized upon by critics as belying Goldman's protestations and corroborating claims that it had profited by the misfortunes of ordinary Americans.

With all the concern in the world for those now suffering both the proximate and the broader consequences of our real estate bubble and burst -- indeed, in part because of that very concern -- I have to say that I find this particular complaint about Goldman a bit difficult to credit (yep, this pun's intended as well).  The reason is that one of the principal and indeed salutary purposes that financial markets serve -- and in fact one of the principal reasons we both foster and carefully regulate them -- stems from their enabling people with differing views of the future prospects of firms and assets to 'put their moneys where their mouths are.'  The secondary financial markets -- which is precisely what the exchanges and over the counter markets are -- are nothing other than the venues where people with differing expectations about various future prospects that bear economic significance place their bets.  And there seems little if anything that is inherently wrongful -- let alone illegal -- about bets placed on any side of any such prospect.  Indeed, there is good reason to hope for as many such sides as can be to be represented -- assuming, of course, that the bettors are of sound mind and neither cheating nor cheated. 

Why might one say that?  The answer is not unfamiliar:  Allowing as many such bets as the bettors can make good on when they lose, the argument runs, serves at least two socially useful purposes: First, it 'deepens,' or 'liquifies' those secondary 'betting' markets, which by offering ready exit to primary investors tend to render primary investment itself more forthcoming.  They lower 'the cost of capital' faced by producers, in other words, and thereby stimulate production and the employment entailed by production themselves.  Second, deep secondary 'betting' markets are thought to provide a powerful inducement to people worldwide to ferret out economically relevant information -- precisely by dint of their offering the 'ferrets' in question the opportunity to profit or avoid loss in the trading markets by buying and selling on the basis of such information.  So long as the information in question is not the product of 'insider' access or other fairness-implicating process failures, the thought here continues, it is good that it be traded upon.  For the trading itself in effect publicizes the information in question, in the form of the prices of traded instruments.  (Of course, some -- notably Henry Manne way back when -- have argued that this informational efficiency property offers good reason to allow even insider trading itself; but such arguments, which ignore externalities that I must ignore too for the present, have for good reason never been bought (sorry, pun unforeseen this time) by the SEC.)

Against this well understood backdrop, it is easy to see why, provided that Goldman played by the rules, it would have been good for all of us for it to have bet against real estate during the bubble.  Indeed, one way the bubble might have been prevented -- or at least kept smaller and accordingly less dangerous -- would have been for many more dollars to have been spent shorting real estate.  For 'more shorts and/or fewer longs' here effectively just is 'lower real estate prices.'  The two scare-quoted phrases are extensionally equivalent: notwithstanding their distinct connotations, they denote the same thing.  A 'speculative euphoria' or bubble just is an unsustainable pathological disproportion in favor of long positions with respect to an asset, while a burst or a panic is a symetrically pathological disproportion in favor of short positions.  One way to lessen the amplitude of such 'mood swings' -- to smoothen-out price-volatility, in other words -- is to facilitate betting on both sides of the asset in question.  That is precisely what the development of short-selling strategies and derivative instruments is meant to do.  So long as, again, bettors are able to back up their bets, and so long as fraud is prevented and the information upon which traders trade is fairly acquired -- caveats to which I'll return below -- the existence of these betting markets is salutary and those who bet short are no more to be deplored than are those who bet long.  If Goldman did bet against real estate, then, they should probably be thanked -- provided, again, that they played by the rules.  More on that caveat presently.

2.  The second 'issue' that seems to be on the minds of those talking about Goldman right now takes up that last 'played by the rules' caveat, but seems to rest on a misconception about what the rules actually are.  Here I allude to the oft-heard complaint -- which featured prominently both in the Angelides hearings this past January and in Congress this past week -- that Goldman was not only betting against certain mortgage-tied securities, but also was selling some of these same securities to its clients.  In contrast to the first complaint, this one begins to draw closer to something potentially serious -- but it isn't there yet.  Indeed, it is not even Goldman-specific. 

The reason is simple:  Goldman is, primarily, what in financial and finance-regulatory parlance is called a 'broker-dealer.'  In the same parlance, in turn, a 'broker' is one who purchases and sells securities on another's account -- s/he is an agent, a fiduciary of that other, trading for and advising him or her.  A 'dealer,' by contrast, is one who purchases and sells securities on her or his own account -- s/he is a principal.  The fact that both of these roles might be played by a single firm -- the presence of the hyphen in 'broker-dealer,' in other words -- seems to be occasioning some surprise and indignation among members of Congress and, especially, the general public right now.  And well, I suppose, it might.  But the fact is that the law as it presently stands, as well as the ethics of the broker-dealer profession, permit this -- rather as the law yet more surprisingly permits a single broker to serve as agent for parties on opposite sides of a real estate transaction in most state jurisdictions.  The law, that is to say, expressly permits a single firm to occupy an inherently interest-conflicted role, and the ethics of the profession of course presuppose the existence of that role.  Goldman is no different from any other broker-dealer firm in this connection.  What is actually surprising people here is accordingly not so much that Goldman acts as a broker-dealer, but that the law permits the hyphen, so to speak -- i.e., that it permits the broker-dealer firm form at all.

How can it be that the law permits this?  Well, in the wake of the 1929 stock market crash, of course, Congress reexamined our then-system of financial regulation with a view to preventing a recurrence.  And as is by now well recollected, among the changes it introduced was a prohibition on combination or affiliation among depository institutions (principally comprising 'commercial banks' and 'thrifts') on the one hand, and securities firms (a.k.a. 'investment banks' or 'broker-dealers') and insurance companies on the other hand.  That was Glass-Steagall.  What fewer now seem to recall is that Congress also considered introducing a Glass-Steagall-style 'wall of separation' between brokers and dealers as well, which would have removed the hyphen that joins 'broker' and 'dealer' today.  Instead, Congress contented itself with the disclosure and anti-fraud measures of the Securities Act of 1933 and the Securities Exchange Act of 1934, as enforced since 1934 by the then new Securities & Exchange Commission (SEC).  The SEC, for its part, polices the dangers inherent in what I am calling the 'broker-dealer hyphen' largely by requireing that certain 'firewall' protections between departments be observed within broker-dealer firms, as well as by enforcing the aforementioned disclosure and anti-fraud rules more generally. 

None of these rules, however, prohibit the same firm's -- as distinguished from the same department within a firm's -- betting against securities in its proprietary trading capacity that it purchases on behalf of, or even recommends to, its varied clients with varied portfolio needs in its brokering and advising capacity.  So long as the firm is attentive to the needs of its customers, and does not act to mislead them or omit to disclose relevant information to them, it is free in effect to 'bet against them' in the form of betting against some of what it facilitates their purchasing or even sells to them.  It might well be a bad idea to permit this (I tend to think so as a matter of basic inclination, but I suppose I'm sort of a Roosevelt on afterburners), yet the fact is we do permit it, for better or worse, and expressly declined to prohibit it during our last great finance-regulatory overhaul in the 1930s.  Hence once again there is nothing illegal or even industry-relatively unsual about Goldman's activities targeted by this second complaint -- provided, again, that it complied with the rules that we actually have.

3.  That takes us to the third 'issue' to which our current wave of Goldman-discussion is directed -- and at last to an issue that really is Goldman-specific.  I refer to the recently issued SEC complaint brought against the firm, as well as the SEC's referral of the case late last week to the New York U.S. Attorney's office.  So what is Goldman alleged to have done?  As I read the SEC's complaint -- available here  -- there are effectively two factual allegations that could potentially (and I emphasize 'potentially') underwrite (sorry, another pun, foreseen but unintended) a finding that the law has been violated.

Here's the story in relatively nontechnical lingo:  Near the end of the recent real estate bubble, early in 2007, a hedge fund client of Goldman's -- I'll call it 'the fund' -- wanted to place bets against the future prospects of certain mortgage-tied securities.  It sought Goldman's assistance in designing, and then offering for sale, an instrument whose value would vary with the value of those securities, which the fund could then bet against by shorting.  The instrument would of course have to be sold in order for anyone to 'go long' on the securities that the fund wanted to short, for 'somebody's purchasing the insturment' and 'somebody's going long on the underlying securites' are effectively two ways of saying the same thing here.  And of course one cannot go short something unless somebody else goes long: you cannot bet against something, in other words, unless someone else bets for it, just as you cannot sell unless someone else buys.  So the fund was in essence asking Goldman's assistance in facilitating a very specific, narrowly targeted bet that the fund itself was defining and seeking counterbettors for. 

Goldman agreed to facilitate the fund's desired bet in the manner described.  It also sought the assistance of a well respected mortgage firm (which I'll keep calling 'the mortgage firm') in structuring the securities portfolio on whose value the fund-sought betting instrument's value would hinge.  Goldman sought that assistance, presumably, in part owing to the expertise of the mortgage firm; but it also seems pretty clearly to have sought it in owing to the reputation that firm enjoyed.  Recently released Goldman-internal communications certainly seem to suggest this.

Whence, then, the complaint?  What is Goldman alleged to have done in the course of transacting as just described that might -- might -- have violated the securities laws?  The answer is two things:  First, the SEC alleges that Goldman failed to disclose, to purchasers of the newly designed betting instrument, the fund's involvement in selecting the securities on whose value the value of the instrument would ride.  Instead, it maintains, Goldman named only the well reputed mortgage firm, effectively defrauding investors by omission in violation of 33 Act 17(a)'s, 34 Act 10(b)'s, and SEC Rule 10b-5's fulsome affirmative disclosure requirements.  (It would be a bit like saying you're in on a deal with Warren Buffet or Jimmy Stewart, while not mentioning that Al Capone's in on it too.)  Second, the SEC alleges that Goldman affirmatively misrepresented, to the mortgage firm itself, that the fund was going long -- betting for rather than against -- the new instrument, violating the same legal provisions just mentioned.  (It would be a bit like getting Warren Buffet or Jimmy Stewart in on a deal for the reputational advantages that they might be expected to bring, while also inducing them to join in by telling them Capone's not involved but Eliot Ness is.)

Very well, then, is there anything to these charges?  Well, as they say, this is for the trial and/or pretrial or settlement proceedings, and I'd truly be acting wrongfully were I publicly to prejudge the outcome here -- especially in view of the 'totality of the circumstances' style fact-intensity of the questions presented here, as a matter of securities law doctrine.  I can say that the second allegation will likely be somewhat easier than the first to decide.  For while the antifraud rules of the securities acts eliminated the old caveat emptor understanding of fraud, pursuant to which the latter was understood commisively and not omissively, the fact remains that allegations of commonlaw-style fraud by commission continue to be regarded more severely, and often are simpler to substantiate or refute, than are allegations of fraud by omission.  The SEC's fraud by omission allegation, for its part, will be inherently more difficult for the SEC to make stick. 

Much if not all in this case will hinge on what securities-regulatory doctrine labels the 'materiality' of the information at issue -- that is, the degree, if any, to which a reasonable investor, under all of the circumstances, would regard the information as germane to her decision whether or not to invest.  Materiality in the requisite sense here might well be difficult to establish precisely because those who go long on complex, customized derivative instruments like the betting instrument at work here tend to be quite sophisticated investors who know (a) that they're betting on a carefully tailored set of prospects, (b) that this means that other sophisticates are counterbetting on and indeed often designating the same set of prospects, and (c) that Goldman and other securities firms are in the business, among other things, precisely of facilitating such customized bets at the behest of betting and counterbetting clients.  My guess is accordingly that the SEC will hit hardest on the commisve fraud claim rather than the omissive one -- even though materiality is at stake and hard to show here as well -- if for no other reason than that alleged affirmative misrepresentation always looks more potentially serious than omission.  But of course only the trial -- or more to the point here, the pretrial proceedings -- will tell the tale in this characteristically fact-intensive issue.

How about the SEC's referral of the case to the US Attorney?  This is of little significance thus far, though the media's reportage last Friday might have led some to think otherwise.  It is not uncommon for the SEC to refer, almost as a matter of routine, its civil-regulatory suits to Justice for inquiry into whether criminal proceedings might be worth initiating.  Stay tuned on this one, but -- please pardon one last pun -- don't bet on it.

Let me close on a brief note of anticipation:  Most of my students, colleagues, family and other friends know, I am sure, that my sympathies generally tend more in the 'Main Street' than in the 'Wall Street' direction, at least when those interests diverge (which they don't always do).  And so naturally I fret over the prospect of this post's appearing to be some sort of class-rooted apologetic.  It's not.  There should be little if any doubt that the American financial economy has grown profoundly dysfunctional and is in need of serious structural repair -- repair much more serious than that in contemplation in Congress right now.  It is rife with collective action problems that no collective agent is now addressing; and most of its ingenious new products, which could be employed on behalf of Main Street just as readily -- and rather more safely -- as on behalf of the currently dominant clients of Wall Street, are tapped only by the already fabulously wealthy.  Most of my writing these days is on this general subject, as will be further posts here.  But the fact is that misdirected complaints like the first two and maybe the third I've discussed here are both (a) unfair to their objects -- in this case Goldman -- and (b) unhelpful to the real cause we must take up: serious structural reform.  In a very real sense, they are a distraction, and in that sense a colossal and scarcely affordable opportunity-cost. 

It is understandably maddening not to know -- and not to know even how to know, thanks in large part to modern finance's extraordinary complexities -- just whom or what to blame for our recent and ongoing troubles.  And so there's a symmetrically understandable comfort to be had in the seeming 'closure' we find in the long-awaited naming of an unsympathetic would-be culprit like Goldman Sachs.  But that is itself part of our problem.  I suppose one might say that my larger point, then -- and hence, in the terms of my title here, the fourth and perhaps principal 'meaning of Goldman Sachs' -- is that we ought not content ourselves with this false comfort -- any more than investors should content themselves with their proverbially ephemeral 'short term gains.'  The real meaning behind all the present public discussion, in other words -- the meaning that we ought to 'buy and hold,' as the long term 'value investors' do -- has much more to do with what I shall be calling the financial 'architecture' than with the rooms' current inhabitants.  And so to that we'll return in the weeks ahead.


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I am in complete agreement, x7&*0-$#, and thanks for the effusive compliments.

All best,

Michael C. Dorf said...

Bob, are you sure you want to be so quick to agree? Here's what I get when I plug the prior comment into my translation program:

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Pretty subversive stuff!

(The program that's supposed to block comment spam is active but apparently it's not much better than the translation software.)

Bob Hockett said...

Oh heavens, Mike, thanks for the alert! My translation program yielded the following: 'Your offering here is characteristically well reasoned, informed, and insightful; needless to say, it is not the opinion of NPR, it's affiliates or lackeys. Anyone who says otherwise is itching ...'

Phew, another bullet dodged.

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