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The Alpha/Beta Debate: Goldman vs. The World

The Goldman hearings debate rages on as Institutional Investor's Imogen Rose-Smith (Alpha) takes Goldman’s side, while her colleague Julie Segal (Beta) makes a case for the investor.

Alpha/Beta Blog

On April 16, the U.S. Securities and Exchange Commission filed a civil fraud suit against Goldman Sachs over the synthetic collateralized debt obligation Abacus 2007-ACI which, the commission alleges, was put together by Goldman in consultation with Paulson & Co, the New York-based hedge fund that was betting against the U.S. housing market using credit default swaps.

Goldman, the SEC alleges, did not inform clients of the hedge fund’s involvement in the deal. The mortgage CDO tanked within a year as the subprime mortgage market collapsed. Holders (including Goldman, execs there are at pains to point out) lost money, and Paulson made history.

Last week Goldman’s top brass, and Fabrice Tourre (AKA the Fabulous Fab), the 31-year-old London-based junior banker who put on the trade, faced an uncomfortable, combative grilling before the Senate Permanent Subcommittee on Investigations. Institutional Investor staff writers Imogen Rose-Smith and Julie Segal debate the issue.

Imogen Rose-SmithImogen (Alpha) — I’ll take Goldman Sachs’ side of this.

It’s the story of the frog and the scorpion. Goldman, like any bank, is a scorpion. The frogs (buyers in this metaphor, I suppose) can hardly be surprised when they get stung. Is it really a shock that a bank might have been selling less then stellar products to clients? Or that some hedge funds got treated well, or even better, than others? Goldman made $15 million in fees off this deal after all.

It’s worth remembering that John Paulson was not the hedge fund sensation he is now. He was a not very well known manager with a view on the mortgage market — a view which many, including presumably the people buying mortgage CDOs in April 2007, didn’t share. Caveat emptor.

The extent that the Securities and Exchange Commission does have a case appears to center on the question of disclosure. Did Goldman adequately disclose the involvement of a hedge fund manger — forget about which fund it was since, as I said, Paulson & Co back then did not have the power to impress that it does post-mortgage crisis — in this deal? What claims did they make to clients about what they intended to hold on their balance sheet?

It is also curious that the SEC was split on bringing this action. On the one hand, given its bad rap of late, the Commission desperately needs a win, suggesting that it would be foolhardy to bring such a high profile case unless it thought it was watertight. On the other, this is the SEC we are talking about. An II hedge fund 100 manager I was speaking to the other day indicated that he thinks the SEC’s case is extremely weak.

Obviously Goldman has been shocked by the sheer vitriol aimed toward them from main street and, by extension, politicians. I think Goldman was genuinely unprepared for how much the resentment against Wall Street would be directed at them. And clearly they have made a PR hash of this whole thing. But I wonder if they won’t lose the war and win the battle.

To me, the focus on Goldman and Paulson, a few of the highest profile names in finance right now, obfuscates some of the more challenging questions this whole economic crisis has brought up: Where (yet again) were the ratings agencies in all of this? How much responsibility do investors have to take for making bad decisions? Should Dick Fuld face criminal prosecution? I believe the entire industry would benefit from a better SEC. But I have yet to be convinced we have one.

Julie SegalJulie (Beta) — Now let’s talk about investors.

Yes, IKB, the German Bank and one of the buyers of the Abacus deal, is a grownup. Goldman wasn’t selling Abacus to you or me or even John McCain. These investors are supposedly sophisticated and employ their own teams to do due diligence on everything they buy. It goes without saying that investors need to up the level of skepticism in their buying decisions and examine how they were left holding such lousy deals. Goldman is a market maker that has no legal fiduciary duty to its clients. Leave that job to their investment managers (who are clearly winning in a post-2008 world, but that’s another blog).

This case is the inevitable outcome of the firm that Goldman has morphed into over the last decade: from advisor to advisor/trader. It’s clear now that you can’t do both. Even if Goldman is not selling to mom ‘n pop, they can’t dump deals they called lousy in emails into the laps of their clients. Full disclosure should have included Paulson’s role and view but also perhaps the internal emails sent by Fab to his superiors and his girlfriend. If Lloyd Blankfein says clients should trust Goldman, as he told his panel of questioners earlier this week, then he needed to tell clients absolutely everything about the products that he is creating.

The conflicts on Wall Street aren’t new, especially in the fixed income world where little is traded on transparent exchanges or cleared through clearing houses. But what is new is the level of sophistication and complexity of products. Goldman had access to the underwriters that wrote the mortgages, they unfortunately had power over the ratings agencies, they had first hand knowledge of the data supporting Paulson’s view, and they had a relationship with ACA, the third party that was to solely pick the securities to go into Abacus.

Without this level of access, investors, even the most sophisticated, were at a disadvantage. And remember, many of these sophisticated investors are overseers of public and corporate pension plans around the world. They may not be mom n’ pop, but they certainly represent them. These clients wanted AAA securities, they didn’t want a security with an explosive hidden inside it. Whether Goldman or the SEC wins in court remains to be seen, but what’s clear is that Goldman’s model of taking all sides to a trade has to change. Its clients will force it to change.

Imogen Rose-SmithImogen (Alpha):

The argument you’re making is, basically, a moral one. I can see the case for moral outrage that Goldman was selling (allegedly) products it knew were shoddy to clients. But the legal case?

There is nothing illegal in me selling you a security that I think is rubbish. And how many emails do you think go round a bank (obviously less now) saying such-and-such deal is a lousy deal? We learned this in the dot.com crash. It happens all the time. Just because Fab Fab thinks the deal sucks doesn’t mean that so-called sophisticated investors agreed with him.

And that, too, is my point.

If these guys are such sophisticated investors that they can, say, invest in hedge funds which the SEC is protecting the likes of me (poor, I like to think, not unsophisticated) from investing in, then they need to start using their brains. Or we need to have a very serious discussion of what a sophisticated investor really is. You can’t be sophisticated in the good times and a poor, naïve dupe when things go wrong. You want to play with the big boys — and everyone knew Goldman Sachs was one of the best at playing the game — then that’s fine. But don’t cry about it when you get skinned alive.

Julie SegalJulie (Beta):

After the hue and cry, investors may ultimately learn the meaning of market maker. If the testimony leads to smarter investors who do their own due diligence and don’t rely on bankers, monoline insurance companies or ratings agencies to bless their purchases, then perhaps Fab Fab’s juicy emails will be all to the good. Unfortunately, though, bubble and bust investors — whether the big guy or the little guy — make the same mistakes over and over. They’re looking for something that is too good to be true whether a housing market that never goes down or Internet companies that can reach unreachable highs.

The Alpha / Beta blog is devoted to news and insights about the alternative investment (Alpha) and the traditional asset management (Beta) industries. Institutional Investor staff writer Imogen Rose-Smith covers hedge funds, private equity and their investors. Julie Segal is an Institutional Investor staff writer covering money managers and pension funds, foundations and endowments.

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