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The big news item for the last week has been the SEC (security and Exchange Commissions) charge of fraud against Goldman Sachs (NYSE:GS) last Friday. The charge is based upon the idea that Goldman and its employees were, “making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) GS&Co structured and marketed to investors”.

You can read that as a giant conflict of interests. This particular charge is based on a product named “ABACUS” which was a synthetic collateralized debt obligation with sub-prime collateral. In layman’s terms, it’s a group of credit default swaps (derivatives, not actual bonds) linked to the performance of crappy subprime mortgages.

The CDO structure slices the risk into least risky (super-senior) and most risky (equity) tranches with everything inbetween. The super-senior tranches were most likely rated AAA and swallowed up by a bunch of naive investors.

Propublica has put out a rather popular piece in which they put the Chicago hedge fund Magnetar on the chopping block as well. They point at the fact that Magnetar got long the equity portion of the CDO (which pays a nice premium until the CDO blows up) in order to fund a larger short CDS position on the underlying CDO tranches. Many would say good for them, they were smart enough to know they were buying garbage. Did they deceive investors? Sure, but who said hedge funds need to play by the SEC’s rules when they are catering to smart “accredited” investors?

First, let me say that I will not shed a tear for Goldman Sachs. The really interesting aspects of this news item comes when you put the whole story together.

There are so many players, that it is difficult to fully articulate, but let me try:

1) Every bank has skeletons in the closet

The most interesting aspect of the immediate media reaction is that Goldman Sachs is the “devil”.

They are right, Goldman Sachs is the devil, but so are every one of the Wall Street Banks. Citigroup, Merrill, Bank of America, JP Morgan, Deutsche Bank, Lehman Brothers, Bear Stearns, Morgan Stanley…they all did the same thing because that’s what was making money. They bought crappy mortgages, packaged them up in structured products and sold them to whatever sucker they could find.

This game is nothing new, it was just much larger than any other game they played in the past with over 1.5T in CDOs issued in about 5 years. This was a very profitable business for many years and they merely chased the money. Do bankers act ethically on their own accord? Not unless grandma is watching and there are no bonuses at stake.

2) The banks and hedge funds were not the only ones keeping the dance alive

There is no such thing as a one way market. You cannot force someone to buy something from you. The banks were able to get the rating agencies to put “AAA” stamps on the garbage that they were selling to investors, but so what? Shouldn’t fund managers who handle billions of dollars be able to think past the AAA stamp and see what they are truly buying? It reminds me of a very humorous scene from the late Chris Farley’s “Tommy Boy”:

Tommy: Let’s think about this for a sec, Ted, why do they put a guarantee on a box? Hmm, very interesting.

Ted: I’m listening.

Tommy: Here’s how I see it. A guy puts a guarantee on the box ’cause he wants you to feel all warm and toasty inside.

Ted: Yeah, makes a man feel good.

Tommy: ‘Course it does. Ya think if you leave that box under your pillow at night, the Guarantee Fairy might come by and leave a quarter.

Ted: What’s your point?

Tommy: The point is, how do you know the Guarantee Fairy isn’t a crazy glue sniffer? “Building model airplanes” says the little fairy, but we’re not buying it. Next thing you know, there’s money missing off the dresser and your daughter’s knocked up, I seen it a hundred times.

Ted: But why do they put a guarantee on the box then?

Tommy: Because they know all they solda ya was a guaranteed piece of sh**. That’s all it is. Hey, if you want me to take a dump in a box and mark it guaranteed, I will. I got spare time. But for right now, for your sake, for your daughter’s sake, ya might wanna think about buying a quality item from me.

3) The whole financial crisis could not have happened without the government’s “help”

The Banking Act of 1933 (AKA Glass-Steagall) was repealed on November 12, 1999. The Glass-Steagall act was put in place to keep commercial banking separate from investment banking and thereby separate those who lend from those who invest. By knocking down this wall the government created one big pipeline for subprime lending and CDO creation.

We also know that low interest rate environments (thank you Greenspan) can fuel speculation. By artificially keeping interest rates low, investors look for higher yielding and riskier assets.

In addition, the government nearly made it a mandate to put more Americans in their own homes, particularly those in low-income brackets. The only way to promote home ownership to low-income households is to extend more credit to those who would not normally be given credit. Why would anyone lend money to someone who they thought had no way of paying them back? The only way to stomach it is to sell that risk to a bigger sucker.

4) The timing and target of this charge are highly suspect

As the formerly respected Eliot Spitzer put it, “There are no coincidences in this world. None.”

Goldman Sachs has a huge target sign on its back. You could not pick a better target for the SEC to flaunt its ultimate power against and you can be assured that the public is happy to see the richest bankers with the biggest bonuses take a tumble. This not only lets the SEC flex its muscles, but it provides a nice push for lawmakers to try to get some financial reform legislation passed. My only guess is that Goldman is the first name, not the last, in this witch hunt. There is no such thing as just one cockroach in the kitchen.

Disclosure: No positions

Source: Goldman Sachs: (Lack of) Ethics on Wall Street