The government might not win its lawsuit against Goldman Sachs. But even if it doesn't, the scrutiny is shining some much-needed light into one of Wall Street's most opaque "black boxes." And what we've seen so far supports the view that Wall Street has become a vast gambling operation that doesn't deserve the bailouts it's gotten.
Goldman is notoriously circumspect about its operations, assuaging investors with fat profits but keeping many of its operational details secret. The SEC complaint against Goldman suggests why. Finance is an arcane business to start with, made more so by "derivatives" that are linked to real assets but don't have any inherent value of their own. Some derivatives, such as certain hedges or futures contracts, help real companies reduce the risk of unforeseen price changes or other sudden events that could wreak havoc with their business. But increasingly, the financial community has been hiding behind the legitimate use of derivatives to simply make speculative bets that do nothing for the real economy—except jeopardize it.
The 22-page SEC complaint against Goldman helps explain how this happens, by reconstructing the creation and demise of a single derivative linked to mortgages: a security that Goldman created called Abacus 2007-AC1. But first, it's helpful to review the way mortgages get financed in the first place—and the extent to which global finance has diverged from real economic activity. Some banks still grant mortgages to their customers and hold onto the loans, earning money the old-fashioned way, through the interest paid. But the majority of mortgages these days are bundled into securities that are sold to institutional investors. This has been common since the 1980s and generally creates more demand for mortgages, which keeps money flowing to homeowners looking for loans. Shares in a mortgage-backed security, or MBS, can be bought and sold, and those shares are generally backed by real collateral: the homes themselves.
A collateralized-debt obligation or CDO is a more complicated type of security that includes shares in other types of securities, including MBSs. The collateral in this case is the original security, which in turn is backed by real assets. Then there are "synthetic" CDOs, a Wall Street concoction from the late 1990s, which aren't backed directly or indirectly by any real assets. These are basically wagers that something will or won't happen in the real economy, with some investors betting one way and some betting the other. If it sounds confusing, you're not alone. Fabrice Tourre, the Goldman trader who created the Abacus deal the SEC is investigating (when he was 28 years old), wrote in a 2007 E-mail that he was "standing in the middle of all these complex, highly leveraged, exotic trades [I] created without necessarily understanding all of the implications of those monstruosities!!! [sic]" Perhaps now he understands.
Wall Street defenders argue that derivatives like CDOs and synthetic CDOs and the credit-default swaps used to gamble on them help investors dilute the risk of investing too heavily in any one bundle of assets. Maybe, but it's also now painfully clear that some derivatives create huge new risks and amplify problems like the housing bust. Wall Streeters also argue that there's real market value in betting against assets you believe to be overvalued, or "short-selling" them. They're right about that: Short-selling is an important check against hype and hucksterism that forces companies to justify the value of whatever security they're peddling. The whole question, however, is determining when legitimate finance becomes exploitative speculation. And where to stop it.
Goldman portrays itself as an important cog in the U.S. economy. There's a picture of a Boeing assembly line on the cover of its 2009 annual report, as if Goldman's activities routinely create jobs for ordinary Americans. But the firm's financials suggest that Goldman mainly generates money for itself, with any collateral benefit to the broader economy being mere coincidence. In 2000, the first full year after the firm went public, Goldman earned 40 percent of its net revenue from its trading operation, 32 percent from investment banking, and 28 percent from managing assets for clients. In its latest earnings report, Goldman said it earned 80 percent of its revenue from trading, about 11 percent from asset management, and 9 percent from investment banking. So Goldman's trading desk accounts for twice the portion of revenue that it did 10 years ago—and the vast majority of its business.
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There's nothing inherently good or bad about any of those lines of business. But investment banking and asset management are at least linked to stock offerings and the real financial needs of companies and investors. Trading, by contrast, is meant to generate revenue whether it creates anything of lasting value or not, which is why Wall Street can make handsome profits—with million-dollar bonuses—even in the midst of a grueling recession. "Wall Street basically doesn't create value," says Richard D'Aveni, a professor at Dartmouth's Tuck School of Business and author of Beating The Commodity Trap. "It's a giant leech on the neck of the American economy. They just transfer money from one place to another and take a fee every time they do that."
Synthetic CDOs and other financial "innovations" weren't just Goldman's doing. They were common on Wall Street, with about half a trillion dollars worth of CDOs issued in 2007, before the market dried up. The question now is whether manufactured securities such as these benefit the overall economy in any meaningful way, or just benefit Wall Street traders gaming the system. The SEC complaint against Goldman singles out one CDO that clearly did nothing for the economy, except transfer about $1 billion from a few unfortunate investors to a hedge fund, Paulson & Co., that turned out to be smarter. The Abacus CDO plunged in value almost from the moment it was finalized, eventually wiping out the investments by those who thought it was a good buy. Readers of the SEC complaint probably won't feel much sympathy for the European banks that lost money, but Goldman still comes off like a dealer plying a junkie with a fix, aware that it's bad junk that will cause an ugly crash before long.
Yet the entire Wall Street bailout was based on the premise that Wall Street's arcane financial activities are vital to the overall economy. That included the TARP funds that went directly to Goldman and all the other big banks, plus less visible efforts by the Federal Reserve, FDIC, and other parts of the government to provide guarantees and cheap money to the banks and make sure they got healthy again. Goldman Sachs, for instance, is now classified as a commercial bank, like the ones that take deposits and offer checking accounts to ordinary consumers. This allows Goldman to access cheap loans from the government and make money lending it at higher rates, even though Goldman has no branches where Joe Six-Pack can walk in and open an account with $100.
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If Goldman and its ilk were funneling money into businesses and other ventures that helped generate economic growth and create jobs, all that government support might seems like money well spent. But the more we learn about Goldman, the more it seems like a private money-making club that's disconnected from the overall American economy. There's nothing illegal about that. But there's no lingering illusion about what this does for the rest of us. What's good for Goldman is good for … Goldman, and not necessarily anybody else.