Americans who watched the financial system implode in the fall of 2008, sending our economy and the global economy along with it to the very brink of an outright economic depression, have since learned that the crash on Wall Street was largely self-induced by Wall Street itself. It set up a casino of boundless side wagers on a financial novelty — securitized packages of risky-to-toxic mortgages — and let all comers bet giddily on each other’s side bets, under the guise of unregulated and heavily leveraged credit-default swaps, until some bets finally had to be called and the casino balloon burst.
But fraud didn’t enter the lexicon officially used to describe these shenanigans until last Friday. Then, some 19 months after the crash, the Securities and Exchange Commission charged Wall Street’s iconic and now most powerful investment bank, Goldman Sachs, with fraud in precisely the type of trading that lies at the heart of the financial crisis.
The suit charges that Goldman Sachs Group Inc. deceived clients by selling them toxic mortgage securities that were secretly designed by a prominent hedge fund investor, John Paulson, who then bet against the investment through credit-default swaps, along with Goldman Sachs. The lawsuit named a Goldman Sachs’ vice president, Fabrice Tourre, as the collaborator who packaged the securities in an investment instrument called Abacus 2007-AC1. The vehicle was one of 25 such instruments created by Goldman Sachs so it and some of its clients could vote against the then-high flying housing market, the lawsuit claimed.
Mr. Paulson was no incidental investor. He reportedly earned an estimated $3.7 billion in 2007, mainly by betting against the housing market. He was not named in the lawsuit, however, nor was Mr. Tourre’s assistant.
The lawsuit claimed that Goldman Sachs had told investors that the funds they were to invest in would be selected by an independent manager, but that the firm then allowed Mr. Paulson to select the Abacus securities that ultimately failed. It alleged that Goldman Sachs subsequently sold the securities packages to a range of investors, including pension funds, insurance companies and foreign banks, which ultimately lost billions of dollars.
Goldman Sachs, of course, has asserted that the lawsuit is groundless, and that its decision to take positions against the market and some of its clients was a typical hedge for risk protection, and not a wrongful attempt to game its clients by taking short positions against their investments.
That, of course, remains to be seen as the lawsuit goes forward. The more potent aspect of this lawsuit is that it, at last, officially reveals the questionable circumstances of the egregious use of unregulated derivatives like credit default swaps, which allowed third, and fourth and further multiples of market players to stack side bets merely on the speculative value of the choices of real investors in real securities.
Credit default swaps could be, and still are, taken as a form of insurance, from another third party. American International Group, known as AIG, underwrote such credit default swaps at numbers that vastly exceeded its reserve funds. It subsequently received federal bailout loans of some $185 billion — the largest of the bailout loans — to meet all the calls on the credit default swaps it wrongly issued in this unregulated market.
Yet Wall Street is now lobbying vigorously against regulation of derivatives and other measures to improve transparency and fair rules for the banking and investment industry. But as the SEC lawsuit shows, it is past time for Wall Street’s unacknowledged abuse of its trading power and the unregulated use of derivatives to be examined for what it actually is — and the free-for-all casino that it eventually became.
Republicans who are still contesting the need for robust and thorough financial reform bill, as proposed by Democrats and the Obama administration, should reconsider their opposition. The new SEC lawsuit reveals more than enough to prompt serious oversight. Anything less, after the man-made, market-rigged debacle of 2008, would be a travesty.