By Fareed Zakaria
Monday, April 26, 2010; A15
There's so much resentment toward banks these days -- some of it quite justified -- that anything resembling a defense of them is bound to anger people. But the rage surrounding the Goldman Sachs case can cloud our perspective and distort public policy. We need to step back and try to understand what happened.
Evidence may yet be presented that documents specific misrepresentations and false claims by Goldman, but much of the public debate has struck me as guided more by emotion than careful analysis. Even if some Wall Street practices seem dodgy, or unethical, that's not the same as illegal. I want financial reform, but I also want our system of governance to be characterized by fair play and equal justice -- even for people making $10 million bonuses.
There are two core claims of wrongdoing. The first is that hedge fund manager John Paulson was allowed to select the securities he wanted to bet against. This is disputed -- but in a routine hedge transaction on Wall Street somebody decides to bet against some set of stocks or securities; that person approaches a firm, which finds someone with the opposite view on those securities. This is how large companies offset the risks to their balance sheet from fluctuating currency, energy or commodity costs. Both sides examine carefully the securities involved in the wager.
The main institution that took the other side here, IKB, is a large German bank that had whole departments devoted to analyzing just these products -- departments many times larger than Paulson's firm. IKB surely knew that someone was betting against them: Otherwise, there would have been no transaction. Did IKB realize that the other party thought these securities were garbage? Yes -- disagreement over the value of stocks or securities is what creates the market.
The second charge is that Goldman Sachs designed a product it "knew" would decline in value. Dozens of transactions like this took place in 2005, 2006 and 2007. In most, the people who bet that the housing market would go up made money, and those betting it would fall lost money. These kinds of collateralized debt obligations went up in value in 2006. In fact, had this bet been made nine months earlier, Paulson would probably have lost a huge sum and IKB would have been a winner.
It's easy to say now that the housing market was doomed to go bust by 2007. But Michael Lewis documents precisely the opposite point in his recent book "The Big Short." He shows that in 2006 and even 2007, almost all the storied names in finance -- Lehman Brothers, Bear Stearns, Merrill Lynch -- were betting that the housing market would continue to rise. Only a handful of contrarians believed the opposite, and many of them had lost money for years on bets that the market would drop. At the time of the Goldman deal, Paulson was still seen as an oddball.
Thoughtful commentators, including my colleague Robert J. Samuelson, have argued that whether or not Goldman did anything illegal, this kind of casino gambling should be more tightly regulated. I agree, and I'm in favor of most of the proposals the Obama administration has put forward. But it would be a mistake to criminalize retroactively what was standard business practice. New rules going forward are the best avenue for our outrage. In general, regulation by litigation only creates an atmosphere of uncertainty and capriciousness around America's framework of laws and rules.
What this case highlights is that the old Wall Street is dead. Its firms were once partnerships in which the managers were betting with their own money and served as trusted advisers to clients. The new companies are big players in the markets and have subordinated their advisory functions. But they are also much larger and more lucrative, and have dominated the global financial industry as it has grown over the past three decades. American business has moved away from long-term stewardship. In fact, incentives, including compensation, are wildly skewed today toward short-term profits and risk-taking at the expense of long-term strength.
One can only hope that this crisis and new regulations will make Wall Street firms more responsible. So far, most have seemed deaf to the need for new attitudes. That has fed the anger that has erupted over this case. Whatever the new rules, one thing will not change: We can't be sure in advance which securities are "good" and which are "bad." If you doubt this, pick any asset you think is overvalued -- American stocks, Chinese real estate, Pakistani bonds -- and bet against it. Six months from now, you'll be proved a genius or a fool. Oh, and to make the bet you'll have to find someone to take the other side, so you'll need someone to handle the deal. Calling Goldman Sachs . . .
Fareed Zakaria is editor of Newsweek International. His e-mail address is firstname.lastname@example.org.