Is Goldman Sachs Turning Into a 'Big Short'?

| About: Goldman Sachs (GS)
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After peaking at 175 in January 2011, Goldman Sachs (NYSE:GS) closed at 134.38 on June 2, 2011 and appears to be in the throes of a downward spiral. “Let the trend be your friend” cannot be Goldman’s friend right now.

I don’t know about you, but when the Senate hearings aired, and Goldman execs were interviewed (interrogated….grilled), I found myself watching with rapt attention.

Books and articles have created new financial catch phrases. Some of them are the titles of fascinating books such as, The Big Short, Too Big to Fail, and The Greatest Trade Ever. Goldman was ever the survivor while many of their cohorts went bankrupt or came close to bankruptcy.

Here is what I perceive to be a big irony concerning the Big Short of 2006-2008. While Goldman may have survived the financial crisis, it remains an open question how well they will survive their alleged breaches of fiduciary duty.(1) (2) “Full Disclosure” is becoming ever more important among financial firms and their boards. Goldman is now getting into trouble for what could be termed “Inadequate Disclosure.“ Indeed, their predatory reputation, putting their interests over their clients, may be coming home to roost once again.(3) (4)

Questions to consider when pondering Goldman’s plight include the “different hats” theory. The very instruments (weapons of mass destruction?) they created to intelligently and strategically protect themselves against the financial crisis were sold to their clients. If these activities were performed by separate departments, does that pass legal muster in terms of fiduciary responsibility?(3)

Time will tell if further civil or criminal prosecution is imminent.(5) Time will tell what toll this will take on the company if prosecution continues to go forward from various directions, and judgments are awarded or other penalties are handed down. Law professors have differing opinions concerning the merits of the April 2010 SEC civil fraud lawsuit against Goldman Sachs. However, In July 2010 Goldman admitted wrongdoing and paid a $550 million penalty.(6)

In 2004 the FBI warned of mortgage fraud becoming epidemic.(7) This was about two years before the fraud really got going in snowball fashion. The CDO market (the kind of risky investments Goldman was marketing, selling, and betting against) was referred to as a Ponzi scheme.(7) Hence, Goldman (the scapegoat?) was possibly involved in a Ponzi scheme, but this had become systemic, and not Goldman specific.

Goldman Sachs and fiduciary duty, harking back to U.S. Senate hearings, has once again become a big news item. Too big to ignore, and the shorts are apparently taking action. This is yet another irony in my view. My wife grew up in another country. She finds things like this very perplexing. I attempt to explain it to her in this rather whimsical way, “American’s love to get ripped off, and there are plenty of volunteers to oblige them.” Avoiding your so-called fiduciary duty could be described in another way: moral morass.

References and Notes:

(1) “Goldman Said to Get Subpoena From Manhattan Prosecutor Over Senate Report,” Bloomberg, June 2, 2011. The subpoena relates to Goldman’s role in misleading clients who were buyers of mortgage-backed securities during the years leading up to the 2008 financial crisis, as revealed in the 640 page report, see (2).

(2) “Goldman Pays to End State Inquiry Into Loans,” NY Times, May 11, 2009. Goldman pays $60 million to end an investigation by the Massachusetts attorney general’s office into whether the firm helped promote unfair home loans, mostly subprime, that were destined to fail. The money would be used for loan modification programs. This was perhaps a seminal moment which basically opened the door to other investigations, fines, and penalties which continue to this day.

(3) “Goldman's 'Big Short' Could Be a Big Problem,” The Atlantic, June 2, 2011. This excellent article discusses Goldman’s possible conflicts of interest and whether or not it had a fiduciary duty to disclose its shorting strategy to its clients.

(4) "WALL STREET AND THE FINANCIAL CRISIS: Anatomy of a Financial Collapse" Government Report, April 13, 2011. Contains rather broad allegations concerning Goldman’s strategy of shorting the mortgage market while selling clients the mortgage losses from which it profited. See pages 321 and 609 to gain some insight into how investment banks blur the fiduciary duty concept. The investment advisor arm has a duty, the broker-dealer or trading arm does not. Footnote 2597 on page 609 seems almost antithetical to the whole purpose of the report in terms of trying to pin Goldman with a specific wrongdoing: The Subcommittee did not examine the extent to which Goldman was acting as an investment adviser within the meaning of the Investment Advisers Act when recommending that various customers buy its RMBS and CDO securities.” Let the law professors debate this, but it appears to go in the direction of exoneration. However, other sections are very ominous.

(5) “Goldman Discloses More Subpoenas,” NY Times, May 10, 2011.

(6) "WALL STREET AND THE FINANCIAL CRISIS: Anatomy of a Financial Collapse," April 13, 2011. Page 621 references the July 2010 securities fraud complaint brought by the SEC in which Goldman agrees to pay $550 million admitting wrongdoing for taking the other side of a trade, i.e., selling a risky security, and believing so much that it would fail that they bet against it 100%.

(7) “FBI: Mortgage Fraud Becoming an ‘Epidemic,’” USA Today, September 17, 2004. As early as 2004, the FBI made dire warnings in this report, “The potential impact of mortgage fraud on financial institutions and the stock market is clear.” Page 10 of “Anatomy of a Financial Collapse” references Greg Lippman of Deutsche Bank calling the CDO market a Ponzi scheme. “Offering fraud,” the most notorious of which is the Ponzi scheme, was basically what built up this house of cards.

Excerpts taken from "WALL STREET AND THE FINANCIAL CRISIS: Anatomy of a Financial Collapse" April 13, 2011.

Page 10: In the case of Anderson, Goldman selected a large number of poorly performing assets for the CDO, took 40% of the short position, and then marketed Anderson securities to its clients. When a client asked how Goldman “got comfortable” with the New Century loans in the CDO, Goldman personnel tried to dispel concerns about the loans, and did not disclose the firm’s own negative view of them or its short position in the CDO.

Page 10: In the case of Abacus, Goldman did not take the short position, but allowed a hedge fund, Paulson & Co. Inc., that planned on shorting the CDO to play a major but hidden role in selecting its assets. Goldman marketed Abacus securities to its clients, knowing the CDO was designed to lose value and without disclosing the hedge fund’s asset selection role or investment objective to potential investors. Three long investors together lost about $1 billion from their Abacus investments, while the Paulson hedge fund profited by about the same amount. Today, the Abacus securities are worthless.

Page 36: U.S. financial regulators failed to stop financial firms from engaging in high risk, conflict-ridden activities. Those regulatory failures arose, in part, from the fragmented nature of U.S. financial oversight as well as statutory barriers to regulating high risk financial products.

Page 38: Another group of financial institutions active in the mortgage market were securities firms, including investment banks, broker-dealers, and investment advisors. These security firms did not originate home loans, but typically helped design, underwrite, market, or trade securities linked to residential mortgages, including the RMBS and CDO securities that were at the heart of the financial crisis. Key firms included Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, and the asset management arms of large banks, including Citigroup, Deutsche Bank, and JPMorgan Chase. Some of these firms also had affiliates which specialized in securitizing subprime mortgages.

Page 41: Between 1990 and 2004, homeownership rates in the United States increased rapidly from 64% to 69%, the highest level in 50 years. While many highly regarded economists and officials argued at the time that this housing boom was the result of healthy economic activity, in retrospect, some federal housing policies encouraged people to purchase homes they were ultimately unable to afford, which helped to inflate the housing bubble.

Page 319: In the case of Goldman Sachs, the practices included exploiting conflicts of interest with the firm’s clients. For example, Goldman used CDS and ABX contracts to place billions of dollars of bets that specific RMBS securities, baskets of RMBS securities, or collections of assets in CDOs would fall in value, while at the same time convincing customers to invest in new RMBS and CDO securities. In one instance, Goldman took the entire short side of a $2 billion CDO known as Hudson 1, selected assets for the CDO to transfer risk from Goldman’s own holdings, allowed investors to buy the CDO securities without fully disclosing its own short position, and when the CDO lost value, made a $1.7 billion gain at the expense of the clients to whom it had sold the securities. While Goldman sometimes told customers that it might take an adverse investment position to the RMBS or CDO securities it was selling them, Goldman did not disclose that, in fact, it already had significant proprietary investments that would pay off if the particular security it was selling or if RMBS and CDO securities in general fell in value. In another instance, Goldman marketed a CDO known as Abacus 2007-AC1 to clients without disclosing that it had allowed the sole short party in the CDO, a hedge fund, to play a major role in selecting the assets. The Abacus securities quickly lost value, and the three long investors together lost $1 billion, while the hedge fund profited by about the same amount. In still other instances, Goldman took on the role of a collateral put provider or liquidation agent in a CDO, and leveraged that role to obtain added financial benefits to the fiscal detriment of the clients to whom it sold the CDO securities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.