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Monday April 19, 2010 - 15:22:38 GMT
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Goldman CDO Lessons

Friday’s news of the SEC charging Goldman with fraud over how it marketed a synthetic CDO sold to RBS and IKB (among others) without full disclosure of the advisor who helped put the mortgages in the CDO (selected BBB subprime mortgages) has generated every news outlet and talking point in the market since the news broke. 


While Goldman has denied any wrongdoing and vowed to fight the charges (had it not we would have been reading of a settlement), the question involved has devolved into a legal discussion and this is probably best left to securities lawyers and not crack Wall Street journalists, bankers and TV talking heads.  I certainly can’t conclude anything about any illegal activity in this CDO trade. 


But what I think is being glossed over is the ethical question about an intermediary bringing together two customers with asymmetric information and stacking the deck in favor of one customer over another – Paulson over RBS, IKB and others who bought Abacus.  Moreover, the deal was underwritten by ACA, a derivatives insurer, that was allegedly led to believe that Paulson (the hedge fund), actively involved in selecting the subprime MBS (vintages, ratings, deal size) was a buyer of the product.  Maybe RBS and IKB (and other investors) would not have done anything differently had it known Paulson’s roll and position…it was after all pre-crisis and how many had a clue about Paulson’s subprime acumen. 


But this is all about doing what is right, and sometimes doing what is right is not suspending the ethical rules of the road to just to create a likely fatal accident…which yields a handsome “return”.    By all accounts Paulson was very upfront about his exposure (presumably his contact with ACA was through Goldman) and indeed did nothing wrong.  However, as Seeking Alpha  noted today Paulson shopped the deal to Bear Stearns around the same time and its mortgage desk said no thank you (Goldman made $15mln in fees) as it did not cut the ethical mustard.  How ironic…Bear refused high fees based on a different ethical standard we are led to believe assuming the (WSJ) reporting is accurate.  And this fits any normal distribution of any characteristic…some are more ethical in a population and some are less ethical. 


To many the Abacus deal also shows that Goldman engaged in customer arbitrage…exploiting the unsophisticated customer for the benefit of the sophisticated customer…surely an allegation that could be applied to a number of financial institutions.   One would think that if Goldman as an institution knew that the chance of Abacus becoming worthless was very high (Torre email suggest as much) that it would be the obligation of the institution not to sell it to another customer down the institution’s food chain or pop chart.


Just because the law is not clear on issues in finance does not mean firms should exploit legal vagaries to simple make fees or profits (capital gains) and this applies to many institutions.  Even Paulson at some point should have had the moral responsibility to alert officials (suspect he did and no one would listen…subprime is contained) to the extent of the problem…where was his op-ed in the WSJ?   No laws were violated perhaps but if we could have avoided this meltdown we would have better off…benefitting on betting on the meltdown is okay but fanning the fire of the meltdown to enhance those bets raises serious ethical questions especially when it involves willful withholding of critical information.  Moreover, the more these ethical lapses are exposed the greater the risk that a/ the public loses confidence in the banking system – households and firms – which is key to a well functioning capital market and b/ invites heavy regulation. 


Don’t get me wrong, sound ethics can’t be legislated into place…the customers must demand it as a prerequisite for doing business.  Clearly the financial industry has serious ethical issues to address ahead and the customers of the financial system have some serious recalibration of standards to demand from financial firms ahead.  Unfortunately legislatures will not wait for the laws of nature to sort this out and after 2008 we know that the system left to its own threatens far worse than creative destruction.


David Gilmore




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