By Robert J. Samuelson
Thursday, April 22, 2010; A19
It's unclear whether the Securities and Exchange Commission can prevail over Goldman Sachs in court. Goldman's legal obligations in this complex and contested transaction are murky. But whatever happens in court, the complaint against Goldman represents a watershed. It challenges a moral transformation on Wall Street that has justified behavior that most people would regard as deceptive or dishonest.
Once upon a time, Wall Street's leaders saw themselves as arbiters of capital, helping allocate society's savings to productive uses. By contrast, Wall Street's major firms now see themselves as captains of "the market," navigating it -- for themselves and sometimes their clients -- for maximum gain. This is a distinction with a difference.
As arbiter of capital, Wall Street was paid to make judgments. It tutored investors on which stocks to buy. It advised companies on which mergers and acquisitions to pursue. It decided which companies deserved capital through the sale ("underwriting") of new stocks and bonds to investors. Wall Street made money through fees and commissions. Now the prevailing model is very different. Wall Street firms still give advice -- and earn fees. But their main business is trading for their own accounts and creating trading opportunities for clients.
Just coincidentally, Goldman Sachs's recent profit report underlined the extent of the shift. In the first quarter of 2010, about 80 percent of Goldman's $12.8 billion in revenue came from its trading and proprietary investment accounts. The remainder represented underwriting, financial advice and management.
Greed and shortsightedness didn't originate yesterday. Wall Street's old model bred abuses. Brokers "churned" clients' accounts to generate commissions. Investment bankers earned fees by rubber-stamping dubious mergers. Underwriters blessed poorly managed firms or companies with no real businesses (remember the dot-com bubble?). And there were swindles. Long before Bernie Madoff, Richard Whitney, the head of the New York Stock Exchange in the 1930s, went to prison for embezzling funds.
But under the old model, lapses were usually recognized -- at least with hindsight -- as moral as well as financial failures. They were "deviant." Wall Street's new model is more permissive.
Consider the SEC's complaint against Goldman. In early 2007, at the request of a hedge fund run by John Paulson -- no relation to former Treasury secretary Henry Paulson -- Goldman created a synthetic collateralized debt obligation (CDO), Abacus 2007-AC1. By its nature, this was not an investment security; it was an instrument for betting on the housing market. The synthetic CDO's value was tied to a series of mortgage bonds. If the mortgage bonds declined, one set of investors (the "shorts") would win; if the mortgage bonds strengthened, another set (the "longs") would win.
Paulson told Goldman that he would go short. His hedge fund suggested 123 mortgage securities to be included in the CDO. But to enhance the CDO's appeal to investors, Goldman wanted an independent third party to be identified as selecting the mortgage bonds. It picked ACA Management, a firm experienced in the mortgage market. Negotiations ensued between ACA and Paulson. ACA rejected 68 of Paulson's original 123. Ultimately, they agreed on 90 mortgage securities; it's unclear from the complaint how many were proposed by Paulson. Goldman never disclosed to ACA or investors that Paulson would go short, the SEC said.
That, alleged the SEC, represented the "material" omission that defrauded investors. The mortgage bonds quickly lost value. Paulson made about $1 billion, the SEC said; other investors lost $1 billion.
Goldman's reply is defiant: Everyone knew the synthetic CDO had both "long" and "short" sides. The "long" buyers were "among the most sophisticated mortgage investors in the world." Goldman did earn a $15 million fee from Paulson for creating the CDO, but it kept a "long" exposure on which it says it lost more than $100 million. (The net loss: around $85 million.) As middleman, Goldman doesn't reveal buyers' and sellers' identities to each other.
A court will presumably decide the legal issues. But the moral question is more insistent. Goldman abdicates some of Wall Street's role as arbiter of capital, deciding what should be financed and traded. It adopts a strict market standard: If buyers and sellers can be found, we'll create and trade almost anything, no matter how dubious. Precisely this mind-set justified the packaging of reckless and fraudulent "subprime" mortgages into securities. Hardly anyone examined the worth of the underlying loans.
Judgment was missing. Many factors moved Wall Street from the old model to the new: the end of fixed commissions on trades in 1975, which squeezed revenue; computer technology, which made rapid trading and exotic financial instruments possible; and the replacement of partnerships with publicly held corporations. When partners were individually responsible for a firm's losses and mistakes, they restrained excessive risk-taking. These changes won't be reversed. But if Wall Street can't control itself, someone else will.