Lloyd Blankfein is the chief executive officer of Goldman Sachs, the world’s most powerful investment bank. Last November, Lloyd was interviewed by the UK’ Sunday Times. It went something like this: “So it’s business as usual then, regardless of whether it makes most people howl at the moon with rage? Goldman Sachs, this pillar of the free market, breeder of super-citizens, object of envy and awe, will go on raking it in, getting richer than God? An impish grin spread across Blankfein’s face. Call him a fat cat. Call him wicked. Call him what you will. He is, he says, just a banker “doing God’s work”.
Well, it now appears that God was a fraudster, according to the US Securities Exchange Commission (SEC). The SEC has charged GS of defrauding investors by recommending they invest in a securities portfolio while they secretly organised with a hedge fund to ‘go short’ (i.e. bet on the price falling) the very same portfolio.
The SEC charge is that Fabrice Tourre, a 31-year-old vice president at Goldman Sachs, knew that the Paulson hedge fund firm had helped select the assets backing a collateralized debt obligation called Abacus 2007-AC1, even as Paulson planned to bet on it failing. The SEC says Tourre misled a collateral manager, ACA Management LLC, and an investor, IKB Deutsche Industriebank AG, about Paulson’s role.
“Marketing materials for Abacus 2007-AC1 were false and misleading because they represented that ACA selected the reference portfolio while omitting any mention that Paulson, a party with economic interests adverse to CDO investors, played a significant role in the selection of the reference portfolio,” the SEC argues.
What does this mean in layman’s terms? It means that GS set up a security instrument called a Collateralised Debt Obligation (CDO). CDOs contain a bunch of mortgage-backed securities, which, in turn, are based on different home mortgages – some with very good credit-worthy borrowers and many with sub-prime mortgages, namely with borrowers who will almost certainly default if the housing market collapsed.
The trick with CDOs is that even if they were 90% composed of sub-prime securities, because the likes of GS made them up, they were deemed by the ratings agencies who vet these products for buyers as triple-A (namely hardly any risk at all). So the CDOs were rated very safe but in fact contained very risky securities.
The likes of GS and other investment banks could get away with this as long as home prices kept rising as they did between 2002 and 2006. As soon as they stopped in 2007, sub-prime borrowers started to default and all the securities in these CDOs became worthless.
In his brilliant new book, The Big Short, Michael Lewis (the author of another great story about financial trickery in the 1980s, Liar’s Poker) shows how the likes of GS set up the scams. Before 2007, GS and other investment banks were selling these CDOs like the blazes and they were making lots of money for their clients who bought them (usually other investment banks and rich individuals, often from Europe).
But then GS realised that these CDOs were gong to turn sour in early 2007 as the property bubble started to burst. As Lewis puts in his book, “Goldman Sachs did not leave the house before it began to burn; it was merely the first to dash through the exit – and then it closed the door behind it.” And close the door, it did.
The SEC’s evidence shows that GS executives knew that CDOs were turning bad but they still went ahead and set up more CDOs. GS called these latest ones Abacus and invited their clients to buy them. But apparently, at the same time, GS worked with John Paulson, a top hedge fund manager who wanted to ‘go short’ on these CDOs, not only to pick out the bad CDOs, but actually to construct the worst possible CDO so that shorting it would make the most money!
The SEC charge is that GS did not tell potential investors that the Abacus CDO had been constructed with the help of a hedge fund that wanted to short it. Indeed, GS told investors that it had asked a completely independent investment company, ACA, to choose the securities going into the CDO. So the SEC reckons that GS lied to its clients and then ripped them off.
The Abacus CDO was even more exotic than other CDOs. It was a ‘synthetic CDO’, made up not of mortgages, not of mortgage bonds, but insurance premiums on mortgage bonds called credit default swaps (CDS). How exotic can you get. The owner of this CDO became a huge insurer of mortgage bonds, without knowing the quality of the bonds, let alone the quality of the mortgages behind them. If these mortgages turned sour, the CDO owner was liable to almost unlimited liabilities or payouts to those insuring against default.
In the end, John Paulson, with the help of GS, made $1bn on just one Abacus CDO going bust at the expense of buyers like the UK’s RBS and Switzelrand’s UBS, who were stupid enough to buy it. GS made millions in fees and commissions in setting up the Abacus CDO and getting investors to buy it.
The SEC has exposed this scam as a probable criminal fraud. But the operations of GS and other investment banks with CDOs and other weird investment instruments was a giant scam at the expense of the whole econ0my and eventually brought the whole house of finance capital down in 2008.
In my book, The Great Recession, I describe in Chapter 47 how GS in particular completely escaped the consequences of this scam, thanks to the US government. Indeed, the whole ugly story of the activities of Goldman Sachs and other investment banks before, during and after the credit crunch and the Great Recession beggars belief.
GS and other banks at the height of the boom sold billions of bundled mortgage-backed securities, usually composed of sub-prime mortgages that were going to default and be worthless in any housing slump. Pension funds, insurance companies and stupid European banks bought loads of this stuff. But from the beginning of 2007, GS began to bet against these same securities that it was selling as low-risk and bona fide. As one government regulator subsequently said: “it was like selling cars with faulty brakes and then buying an insurance policy on the buyer of those cars”.
And who sold GS such an insurance policy in the form of these credit default swaps (CDS)? None other than the biggest insurance company in the world , American Insurance Group (AIG). AIG usually sold boring car or buildings insurance as well as life insurance. But it set up a division that specialised in selling insurance on ‘financial instruments’.
AIG was prepared to sell CDS on mortgage-backed bonds to all and sundry – it was money for old rope, it thought. And for a while it made huge profits from its financial credit division. By the end of 2007, AIG had issued $527bn in CDS, of which $78bn was written on just those CDOs that GS and others were selling. So AIG became liable to most of the losses that could happen if the US property market collapsed. And it duly did. As home prices dropped and sub-prime mortgages defaulted, the value of the mortgage-backed securities dropped and those who had insured against such an event (GS and others) with CDS then demanded payouts from AIG. AIG’s huge profits disappeared and soon it found it could not even meet the insurance payouts.
In the great financial crisis of September 2008, when the investment bank Lehman Brothers went bankrupt, so did AIG. But there was a difference. The US government decided to bail out AIG with taxpayers’ money to the tune of $85bn (and more later). Why did it do this? The answer soon became clear.
If you insure your car against a crash and then the insurance company goes bust, you don’t get paid. GS and other banks had insured against losses on the very mortgage products and CDOs they were selling to others. When they went bad, they wanted AIG to pay up. But if AIG went bust, they would get next to nothing. So the government bailout, led by people who had worked only short time before as executives in Goldman Sachs, enabled AIG to have the funds to pay GS and others. Indeed, GS got paid $14bn in CDS insurance – or 100c on the dollar. GS did not lose a penny while everybody else took a hit – particularly small investors and of course the taxpayer – you and me.
That was not the end of it. The government then handed more billions to GS and other banks to prop up their balance sheets and allowed them to borrow more in the bond markets with a government guarantee. GS got $29bn that way, JP Morgan got $38bn and Bank America another $44bn.
And now we have the final scam in this period of recovery after the Great Recession. The likes of GS and the other big banks can now borrow money from the Federal Reserve at next to nothing and are invited to buy government bonds paying out 4% of more every year – it’s a risk-free (at least so far) way to make more money. The banks don’t want and don’t have to lend to small businesses who need to invest or people who want to buy a home – that’s much too risky. No, they can just buy government bonds or even better speculate in the stock market with taxpayers money.
This is an even bigger con than the outright fraud that the SEC says happened during the crisis. GS and the other banks are now making billions in profit every quarter and paying out all those huge bonuses to the top executives and traders that set up all those rotten CDOs that are the subject of the SEC’s probe.
But then as Lloyd Blankfein says, he is doing God’s work.