I remember the moment when I realized that Goldman had gone from being the darling of Wall Street—the firm everyone pointed to as the best run, with the best internal risk controls—to something very different. Last summer, in response to a little piece I wrote for a New York Times Dealbook blog discussion, a commentator referred to Goldman as the embodiment of evil, or something to that effect. I couldn’t imagine what he was talking about. Within a few weeks, I began to understand, as rumors surfaced about Goldman profiting from its customers’ subprime losses and being a multibillion dollar beneficiary of the government’s AIG bailout.
After many months of rumors, the SEC has charged Goldman with violating the securities laws by misleading the investors in synthetic collateralized debt obligations (CDO’s). With a CDO, investors invest in an entity that holds bonds issued by a variety of companies. A synthetic CDO doesn’t actually hold the bonds, but achieves the same effect by holding financial instruments (usually, credit default swaps) that are linked to the same kind of bonds. As I understand it, based on a quick reading of the SEC complaint, the SEC alleges that Goldman didn’t tell investors that John Paulson, a hedge fund manager who helped to determine the contents of the synthetic CDO, had placed large bets that the underlying subprime bonds would decline in value. Paulson was picking bonds that he viewed as likely to default.
I personally have somewhat conflicting reactions to the scandal. First, if the allegations are true, Goldman deserves to be punished for hiding key information about the packaging of the synthetic CDOs. Although the losers in these transactions seem to have been large institutions, that’s no excuse for withholding key information about how the investment portfolio was selected. But second, I suspect that part of the reason for charging Goldman is a distaste both for synthetic CDOs and for the fact that Goldman benefitted from the subprime crisis. I’ve never understood the rationale for synthetic CDO’s and have doubts about their benefits. But as long as they’re legal, I don’t think banks should be punished for having profited from them.