Correction Appended: April 26, 2010
The biggest bummer to arise from the allegations that the revered and feared Wall Street puppet master Goldman Sachs had played us all for patsies is this: the dial on the Wall Street capital-formation machine, the engine that was supposed to be the driving force of the greatest economic system on earth, was purposely set to junk worthless, synthetic junk.
The civil fraud case the Securities and Exchange Commission filed in mid-April against Goldman is based on a single deal, called Abacus 2007-ac1. The investment bank created it so hedge funder John Paulson could line his pockets with cash when the value of American families' most prized asset crashed. But on Wall Street in the late aughts, polyester financing was in fashion everywhere.
Morgan Stanley had the so-called dead-Presidents deals, named Buchanan and Jackson. Another Morgan deal, one called Libertas, defrauded investors in the U.S. Virgin Islands, according to a lawsuit. JPMorgan Chase played procurer for Magnetar, a hedge fund so artful in profiting from the meltdown that Northwestern's Kellogg School of Management praised it last year in a case study. A firm run by Lewis Sachs, until recently a top Treasury Department adviser, and UBS, until recently a tax-cheat favorite, created junky bonds that investors who bought them now claim were going bad even before the deals were closed. Bank of America too is being sued for a deal that was set up by its Merrill Lynch subsidiary with a manager who is now under investigation by the SEC.
In the end, it was in fact all one big scam predicated on rising housing prices. Certainly, greedy consumers played a minor role in feeding the frenzy. But the Street made sure that those of us who are not members of its elite club remained the suckers.
Why didn't we find out about these deals sooner? Because they were encapsulated in one of Wall Street's most opaque investment creations ever: synthetic collateralized debt obligations, or CDOs. Synthetic CDOs are derived from mortgage bonds hence they are derivatives but they don't actually hold assets, although you can invest in them as you would in the real thing. And you can also short them, as you would a stock, using insurance contracts called credit-default swaps, or CDSs. In the Goldman case, the investment banks and hedge funds that concocted the CDOs allegedly loaded them with the equivalent of toxic bonds and then bought CDSs for themselves, figuring the CDOs would lose value. They did, which left the unsuspecting investors and counterparties who swallowed the CDOs including supposedly sophisticated banks such as the Netherlands' ABN Amro Bank and Germany's IKB wondering what happened to their money.
On the surface, these deals look complicated. They are. But the alleged fraud at the heart of the case against Goldman and its CDO dealings is one of the simplest and oldest forms of deception: lying. According to the SEC, Goldman told one group of investors they were buying a AAA-rated (by lapdog ratings agencies, but that's another story) high-yield investment put together by an independent firm called ACA Management. But the SEC says the person really picking the collateral was Paulson, an investor whose only interest was: Paulson. What Goldman allegedly sold, like any good snake-oil salesman, was a worthless, well-packaged fake.
Only now, in the wake of the SEC suit against Goldman, are investors beginning to suspect they were hoodwinked. According to Thomson Reuters, Wall Street firms underwrote at least $119 billion worth of these deals as the housing market began to crumble, from 2006 until the music stopped. And this number could be low. Many of these deals never get counted, because they are private transactions and not traded on an exchange.
All the firms that set up these deals, and the hedge funds that bet against them, contend they did nothing wrong. A synthetic CDO is at its core a trade, meaning it has a long and short position, and grownup investors are free to take sides. In response to the SEC suit, Goldman says it didn't set up investments to fail and it didn't mislead its clients. It plans to fight the charges aggressively. Some have even argued that these synthetic deals were good for the economy, because they didn't boost lending at a time when the housing market was already overheated.
The reality is that Wall Street's CDO synthesizer set one of the economy's largest sectors off in the direction of creating nothing but waste pure economic waste. These CDOs didn't help anyone afford a house. No cars were purchased. No one got a loan to go to college. These CDOs were the last stop in a vast transfer of wealth from a large group of American mortgage holders to a much smaller group of already rich traders who profited as the CDOs failed.
Certainly, the folks who lied to get mortgages, and the banks who helped them, deserve what they get. Still, as most of us worked hard to cobble together a down payment for a house in an ever rising market or put money into our still-damaged-from-the-dotcom-bust investment accounts in order to send our kids to college or retire, we assumed the financial system was working its invisible magic to help make all that possible. In fact, just the opposite was going on. Wall Street was busy chartering buses to nowhere, so our jobs and savings could be driven right out of town.
How the Culture Changed
It is easy to think that Wall Street has always been the place for the corrupt and the greedy and that this is nothing new. But that's not really accurate. Of all the causes of the financial crisis, one of the biggest was a power shift on Wall Street that left the traders in charge and the bankers who had traditionally run everything from Broad Street to Maiden Lane sidelined.