Goldman and the blame game

Wednesday, April 28, 2010

THERE'S PLENTY of blame to go around for the financial crisis of 2008. And yesterday, it was Goldman Sachs's turn to face the wrath of a U.S. Senate subcommittee on investigations, and its chairman, Carl M. Levin (D-Mich.). The investment bank stands accused of profiting from homeowners' misfortunes and concealing self-serving trading strategies from hapless clients. "Goldman Sachs made billions of dollars from betting against the housing market, and it placed those bets in some cases at the same time it was selling mortgage-related securities to its clients," Mr. Levin thundered. "They have a lot to answer for." Colorful e-mails from inside the firm rounded out Mr. Levin's case.

It's counterintuitive, to say the least, that one part of Goldman could be taking "short" positions on some of the same mortgage-backed instruments that another part was making available to "long" investors. Indeed, the Securities and Exchange Commission has accused Goldman of civil fraud for allegedly selling a German bank, IKB, $150 million in mortgage-backed instruments without disclosing that the portfolio had been selected in part by John Paulson, a housing-market bear. Goldman denies the allegation, and barring a settlement, a court will have a chance to decide whether the SEC's case holds water.

But the broader implication raised by senators at Tuesday's hearing -- that Goldman somehow rigged the market in subprime mortgages, and that this led to the meltdown -- does not strike us as a terribly useful or even accurate analysis of the crisis. Yes, in its capacity as a market-maker, the firm sold complex derivatives to market players who wanted to bet on a rosy view of housing long after Goldman had turned more pessimistic. To that extent, Goldman's interest in short-term revenue clashed with what, in hindsight, was society's need for a whistle-blower. For the most part, though, these were large, sophisticated institutional investors who had the opportunity to conduct the same analysis of economic data that Goldman did. They knew that there was someone on the short side of every trade. And Goldman had no legal obligation to trade in the same direction as these clients did. Indeed, if it had, then Goldman could not have started hedging its own bets on housing early, as it did. The firm would have lost billions, and it might have wound up needing an even bigger bailout by U.S. taxpayers than it actually got. It could have ended up like Citigroup, which tried to ride the bubble until it was too late and had to be propped up with hundreds of billions of dollars in federal cash and credit guarantees.

Implicitly, Tuesday's hearing was an attack not only on Goldman but on short selling itself. "Shorts" have never been popular, because they do, by definition, profit from the misery of others. However, they can inject a valuable note of realism in overheated markets; perhaps the housing bubble would have been mitigated if more shorts had piled in earlier. True, the derivatives that Goldman and other market-makers dreamed up helped long investors take on what we now know was more mortgage risk than the system could bear. This is why it's good that the financial reform legislation before the Senate would move more derivatives to clearinghouses and exchanges. But recent experience suggests that the markets need more and better ways for contrarians to challenge the conventional Wall Street wisdom.

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