Synthetic CDOs: Thoughts on Fiduciary Duty and the Victim Mindset

I wanted to avoid writing this post because anytime you write a story defending Goldman Sachs (GS) you have to deal with uneducated, moronic criticism from members of the Ignorati spouting what they've read on the internet about vampire squid.

This post is not a defense of Goldman Sachs, it's a defense of Capitalism. However, it is certainly not advocating a license to say "Caveat Emptor" as an excuse allowing any seller or provider of goods and services to plug the buyer of said services with crappy quality. I'm not advocating a society or fiscal system where it's the Wild West in terms of justifying all behavior with "Hey - buyer beware, you should have known" when the consumer buys a faulty good or an investment that loses money. I'm not pushing for an Ayn-Randian pure capitalist free for all (not in this post at least!) where the strong devour the weak and leave them to wither and die.

However, what I am advocating, as I've been advocating all along, is a return to the era of personal responsibility - a return to the realization that mortgage holders are not victims, that consumers are not victims, and that we can't just continue to castigate the Big Bad Banks as the cause of all our financial woes if we want to have any hope at all of righting our sinking fiscal ship.

The story of the week, that prompted this post, is the NY Times missive titled "Banks That Bundled Bad Debt Bet Against It, And Won." Your assignment as the reader is to first read the Times article in its entirety. Then read Barry Ritholtz's post on the subject, which is pretty neutral, although chooses to use some quotes which are very critical of GS's behavior. After that, read Felix Salmon's post on the subject, which I agree largely with, and focuses on the point I've been trying to make yet again: that the buyers of these synthetic CDO's that GS sold were sophisticated investors, not retail rubes who didn't know any better.

What I find frustrating is that the overwhelming response to the article in the comments on the NY Times site, Ritholtz's site, and even Salmon's site is of the "GS is the devil, hang these a-holes by their ankles" populist variety. I find the well reasoned, logical responses to be the ones that point out that the buyers of these assets that went bad, or ANY assets that go bad, are acting under their own free will, and need not be thought of as victims. This is NOT the same as saying "Caveat Emptor." It's important to understand that the buyers we're talking about here are sophisticated, professional money managers. They have responsibilities to their clients that go far beyond being able to use the excuse "but I bought it from Goldmans Sachs, it must be good," or "Goldman Sachs told me it was good, so it must be good."

I'll quote myself, as I wrote on Barry's thread:

I’ll leave you with this thought: again, it seems we’re putting the burden back on the Big Bad Banks and absolving the clients as innocent victims. It was the CLIENTS – the pension fund managers who bought this crap – the municipalities – who failed miserably in their fiduciary duties, and we need to stop holding them up as victims.

Felix Salmon expands on this point:

The 30,000-foot view of what happened here is that there was an enormous amount of mortgage paper flooding the market over the course of the 2000s. Goldman Sachs, as a sell-side institution which manages its risk book on a daily basis and doesn’t want to take long-term directional bets, hedged its mortgage exposure with short positions it created by structuring synthetic CDOs. The buy-side, by contrast, had an enormous amount of appetite for long positions in mortgages, and it was the job of banks like Goldman to feed that appetite: again by structuring synthetic CDOs. Goldman was killing two birds with one stone: no wonder Jonathan Egol, who was in charge of these deals, did so well there.

When the mortgage market started to turn, Goldman was smart and nimble enough to realize that it could make money on the way down as well as on the way up. That’s what traders do, and Goldman is the world’s largest and most successful trading shop.

The real lesson here isn’t that Goldman did anything scandalous. It’s just that if you’re making a bet and Goldman is your bookmaker, don’t be surprised if you end up losing.

Goldman sold these complicated structured products to investors because investors DEMANDED them - pension fund managers were CLAMORING for more exposure to the mortgage market - for more yield. These synthetic CDO's that GS was selling have the characteristic that for every buyer there is a matching seller. GS happened to be that seller, but Felix, quoting himself from over two years ago, explains,

If I’m an investor and I buy a stock from a broker, then I’m buying it because I think the total amount of money I’m paying is a fair amount for that security. I’m completely agnostic about whom, exactly, I’m buying the stock from: if a different broker has the same security for a lower price, I’ll go there instead. And I’m certainly not trusting the broker to assure me that my security will go up rather than down in value. In fact, at the margin I actually like it if my broker is shorting that stock and thinks it will go down in value – because that just means that I get to buy it at a slightly cheaper level.

If an investor buys any kind of financial security, he’s deliberately buying a risk product. He gets all the upside if that security rises in value. But he also gets all the downside if that security falls in value. It’s not the job of any securities firm to bail him out.

I also think the comment from "fixedincome" on Felix's post really nails the aspect of GS's fiduciary responsibility - or lack thereof - in this situation:

"Many of you are coming at this from the perspective of what one might refer to as a “retail” rather than institutional or at least, qualified, client.

Differentiation between the two is critical because the latter are generally considered to be both sophisticated and sufficiently capitalized to assume whatever risks they’re taking by–knowingly–purchasing securities that are not registered with the SEC and that do not come to market with regulated disclosure requirements. That includes just about every CDO ever built. It is illegal to otherwise sell such securities directly to “retail” investors.

I’m not certain that GS is entirely without guilt, but not for most of the reasons mentioned here.

It’s also critical to differentiate between a broker/dealer (the arm of an i-bank responsible for distributing securities) and a registered investment advisor. The former, in fact, owes no fiduciary duty to its clients (though for retail purposes this is a hotly contested issue in the industry), while the latter decidedly does.

And while GS does have arms of its business that function as RIAs (Goldman Sachs Asset Mgmt, which manages mutual funds, for example) the investment bank and broker/dealer elements responsible for building and selling CDOs do not operate under those registrations and their institutional clients absolutely, positively know that."

Goldman Sachs was not managing money for these clients. They do have an arm that manages money (GSAM), but that's totally separate and distinct from the branch we're talking about that created these synthetic CDO's and sold them to investors.

I keep getting brought back to my own summary of the situation. Any time someone comes up with an argument that places the burden on the banks selling bad assets, I think this quote is applicable. I'll quote it again, because I think it's simple and concise:

I’ll leave you with this thought: again, it seems we’re putting the burden back on the Big Bad Banks and absolving the clients as innocent victims. It was the CLIENTS – the pension fund managers who bought this crap – the municipalities – who failed miserably in their fiduciary duties, and we need to stop holding them up as victims.

Once we end the victim mindset, we can start holding the proper people accountable. In this case, the pension fund managers who failed miserably to identify the risks in the assets they bought are certainly responsible, among others, and should be removed from their roles as money managers. Then we can work on repairing the system to prevent future occurrences. If we continue to just say "hey - it's the Big Bad Banks' fault, there was nothing we could do," well then, we're guaranteeing that we'll repeat our same mistakes again.