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L’affaire Goldman

What’s at stake: The Securities and Exchange Commission filed a civil lawsuit against Goldman Sachs for securities fraud on Friday, charging the bank with creating and selling mortgage-backed securities that were intended to fail. According to the complaint, Goldman let John Paulson, a prominent hedge fund manager, select mortgage bonds that he wanted to bet against because they were most […]

By: Date: February 22, 2010 Topic: Finance & Financial Regulation

What’s at stake: The Securities and Exchange Commission filed a civil lawsuit against Goldman Sachs for securities fraud on Friday, charging the bank with creating and selling mortgage-backed securities that were intended to fail. According to the complaint, Goldman let John Paulson, a prominent hedge fund manager, select mortgage bonds that he wanted to bet against because they were most likely to lose value and packaged those bonds into the “Abacus” investments, which were sold to investors like foreign banks and pension funds. As those securities plunged in value, the Paulson hedge fund made money on the negative bets, while the Goldman clients who bought the investments lost billions of dollars. Meanwhile, other nations seem prepared to get in on the investigative action, and Goldman’s board could come under pressure.

Unethical, illegal, neither or both?

Felix Salmon writes that the SEC may be trying to cure unethical behaviour by treating it as illegality. The lawyered-up SEC, if it finds a deal it considers odious, will go to great lengths to find a way in which that deal is illegal. Salmon does not doubt for a minute that Goldman’s behaviour was more unethical than it was illegal. Goldmanites never stop talking about how they always put clients first, but because the U.S. has a rules-based rather than a principles-based regulatory system, that’s not an explicit regulatory requirement.

Paul Krugman argues that we are now seeing are accusations of a new form of fraud. Most discussion of the role of fraud in the crisis has focused on two forms of deception: predatory lending and misrepresentation of risks.  We’ve known for some time that Goldman Sachs and other firms marketed mortgage-backed securities even as they sought to make profits by betting that such securities would plunge in value. This practice, however, while arguably reprehensible, wasn’t illegal. But now the S.E.C. is charging that Goldman created and marketed securities that were deliberately designed to fail, so that an important client could make money off that failure. That’s what Krugman would call looting.

Mark Thoma notes the case against Goldman Sachs is not air tight, and law professors have been busy figuring out how the company might defend itself against the charge that it failed to disclose all the relevant information about the CDOs it was selling. One idea noted by Erik Gerding is that so long as investors knew what assets were in the CDOs they purchased (as opposed to who constructed it), they had all the information they needed to make an informed decision.

Could regulation or monitoring of these financial instruments have prevented such behaviour?

Wolfgang Munchau argues that the Goldman Sachs story raises two questions for regulatory reform, the first is the role of the shadow banking system itself, and the second is the freedom with which banks can create complex structured products. He offers no opinion on the case itself, but makes the point that there is a strong case for a much more hands-on regulation of the shadow banking system, but says the best and most practical way forward is to outlaw certain financial products, such as naked CDS. If naked CDS had been banned, synthetic CDOs, and other produce whose main purpose consisted of defrauding investors, would never have been possible.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.


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