Throwing Goldman Sachs to the Lynch Mob – Politics as usual, but hardly rule of law

As a part of its 18-month long inquiry into the causes of the financial crisis, Senate Homeland Security and Governmental Affairs Investigations Subcommittee on Tuesday summoned Lloyd Blainkfein and several other senior Goldman executives to answer for their role in causing the financial crisis.

According to the subcommittee, it has chosen to investigate Goldman Sachs  merely as “case study”, and yesterday’s oral exam was generically titled “Hearing On Wall Street and The Financial Crisis: The Role of Investment Banks”. It appears, however, that the subcommittee members were not primarily interested in the general issues pertaining to what role Investment Banks may have played in creating the credit bubble leading to the financial crisis (although that too is addressed, and Blankfein concedes that they and others “failed to… sound the alarm that there was too much lending and too much leverage in the system). Rather, it seemed the subcommittee wanted to pick a fight with Goldman Sachs over the bank being a little too successful at hedging its positions during the financial crisis, and over the fact that it at times were selling assets that some of its clients were buying (and vice versa). Specifically, the subcommittee claims that Goldman Sachs acted unethically and contributed to the financial crisis because of:

(3) Shorting the Mortgage Market. As high risk mortgage delinquencies increased, and RMBS and CDO securities began to lose value, Goldman Sachs took a net short position on the mortgage market, remaining net short throughout 2007, and cashed in very large short positions, generating billions of dollars in gain.

(4) Conflict Between Client and Proprietary Trading. In 2007, Goldman Sachs went beyond its role as market maker for clients seeking to buy or sell mortgage related securities, traded billions of dollars in mortgage related assets for the benefit of the firm without disclosing its proprietary positions to clients, and instructed its sales force to sell mortgage related assets, including high risk RMBS and CDO securities that Goldman Sachs wanted to get off its books, creating a conflict between the firm’s proprietary interests and the interests of its clients.

(From exhibit 1 in the exhibits list for the hearing)

Let me see if I am getting this right:

1) Goldman Sachs is being subjected to a congressional lynch mob because they managed their risk relatively well. In response to what they saw as increased risk related to RMBS and CDO assets they aggressively and successfully hedged their long positions in those markets with equivalent short positions, at times so much that they were net short overall. I always thought managing risk well was something very good for a bank to do, but apparently aiming for gambler’s ruin is a more “ethical” strategy. As The Economist points out, Lloyd Blankfein “must have wondered if Goldman would have been better off from a public-relations point of view by incurring giant losses”.

2) Goldman Sachs acted like a greedy, unethical bastard because it let clients decide for themselves what assets they wanted to buy or sell at a given time and price regardless of what positions the bank held itself, and because it sold assets it wanted to get rid of to clients who wanted to buy them. Now, it takes two parties who agree on a price to make a transaction, but it seems the subcommittee subscribes to the notion that Goldman alone decided which securities its clients would buy or sell at a given time and price. Furthermore, it does not matter if a certain client would not have been willing to buy a certain security if they had known Goldman was short that security, as long as the client also knew at the time of the transaction that Goldman’s positions were confidential. The fact that Goldman might be short the given security is necessarily a consequence of  the known fact that the bank’s positions were kept secret, and something one can only expect clients to take into consideration. If the fact that Goldman might be short a security a client is planning to go long would make a client uncomfortable about making the trade, she should not do it. If the fact that Goldman might be short a security doesn’t matter that much for the client, then who cares?

It doesn’t take a government-skeptic with paranoid tendencies to see that this “case study” is a politically motivated attempt at making Goldman Sachs commit to a round of Maoist-style self-criticism because lawmakers are in need of recession-scapegoats. While such a lynching may give some satisfaction both to the senators on the committee, as well as their disgruntled voters, it hardly sheds a lot of light on the causes of the financial crisis. It will certainly make the Volcker rule more likely to pass, though, and also provides some pretty strong incentives for investment banks to improve their public relations. Goldman would perhaps have been better off had they heeded The Epicurean Dealmaker’s prescient warning about the possible consequences of having an approach to PR comparable to that of the Mouth of Sauron.

Of course, none of this makes it okay to drag a firm through the mud just because it has been doing very well when many others have been doing badly. I recently wrote an article on how, in North Korea, the government executed a senior communist party economist found guilty of treason after a currency reform he was named responsible for failed and led to an economic crisis. Just like Goldman Sachs, he was a much-needed scapegoat. In the article, I wondered ironically how the West would have looked if one was act more like North Korea and charge senior finance executives for treason in the wake of the financial crisis. Sadly, it almost appears as if the Americans are intent on showing us.