Since last Friday’s announcement by the SEC, much has been discussed regarding the accusation of fraud against Goldman Sachs (GS).
As is the case in the media’s world of sound bites, some of the press accounts have been misinformed and many of the opinions have had little relationship to the facts of the case and/or are being offered by individuals without any legal experience or background.
At the core of the complaint is that Goldman Sachs sold a $2 billion synthetic collateralized debt obligation (CDO) product, Abacus 2007-AC1, which was linked to the performance of a package of subprime residential mortgage-backed securities. The SEC has alleged that Goldman failed to disclose to investors important information about the CDO — most importantly, that Paulson & Company, a hedge fund that bet that the pool of mortgages would decline in value, helped design the product (with ACA Management) in late February 2007 and took a short position against the CDO.
The best and most straightforward summation of the case being made by the SEC was detailed in an article written in the Wall Street Journal over the weekend by former TheStreet staffer, lawyer and friend, Jamie Heller.
I have no clue how the case will be decided or how it should be decided. I am not a lawyer, and I suspect that it is a far more complicated suit than many have stated or assumed.
I am more concerned with the direct and indirect market and economic ramifications.
The announcement already has had an immediate market impact. Time will tell whether the market is much more vulnerable to Friday’s news. I really don’t know, but, gun to my head, I think it has already been discounted. I do feel strongly and I can say with some confidence that Friday’s SEC charges will not have any bearing on near-term economic growth expectations.
What I believe to be significant is that the Goldman suit reminds us how different conditions were in the last cycle of credit and why, in its aftermath, it will be so different this time.
Goldman Sachs’ Abacus product and similarly structured unregulated derivative products, such as the sprawling shadow-banking industry and the rapidly growing securitization markets that proliferated in the past decade, were symptomatic of a moment in time. The liberal extension of credit over the past 15 years was unique in history and had never previously been so munificent, but it was followed by the sharpest recession since the Great Depression. With the deep recession, lower stock and home prices and rising unemployment, it shouldn’t have been surprising that a populist backlash against the wealthy and large corporations ensued. We witnessed the electorate’s primal scream in the Presidential election in 2008, in the Massachusetts Senatorial race, in the Tea Parties of 2009-2010 and with the SEC accusation on Friday.
The death of shadow-banking, securitizations and structured products ushers in the age of populism.
So, what are my specific observations and takes from Friday’s SEC move against Goldman Sachs?
Firstly, both the subprime mortgages that were originated and packaged into a synthetic CDO as well as Abacus itself should never have existed. The mortgages and the CDO were at the tail end of the past cycle’s acid trip on credit. They were cycle-ending events that wreaked havoc on the economy and the capital markets and nearly bankrupted the leading financial institutions around the world.
Similar to other structured products, Abacus was the outgrowth of a steroid-induced world of financial and economic make-believe. Worldwide economic growth (especially of a consumer kind) was exaggerated and likely borrowed from future growth. Among many other culprits, this hyperbole was abetted by:
* an unregulated shadow-banking industry (e.g., Countrywide Financial);
* a permissive, complicit and conflicted ratings industry (Moody’s and Standard & Poor’s);
* Wall Street (in its “heads I win, tails I win” compensation programs), which stuffed financial weapons of mass destruction into municipalities, insurance companies, other countries and down its own throat;
* the government, which liberalized the wide scope of activity and leverage of bankers; and
* a too-generous Fed.
Secondly, the SEC suit is another example of the type of public outcry we should continue to expect in the years ahead. This outcry stems from the growing perception of an ever widening schism in the U.S. between the haves (the Goldmans) and the have-nots (the rest). Never before have the wealthy and large corporations been held in such contempt by the average American. This holds with it huge implications for further populist policy initiatives and even (as we witnessed on Friday) litigation. The gloves are now off and the outgrowth of populism is higher taxes and more burdensome and costly regulation (likely aimed at hedge funds, banks, Wall Street, etc.).
All these factors hold the promise, in the fullness of time, of reducing the upside to equities and of containing economic growth.
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