The Largest Bubble In The History Of The World

January 26, 2012Investment Managementby David Smith

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Into The Belly Of The Beast (Part 1: How Goldman Sachs Went From Boy Scouts to B
Into The Belly Of The Beast (Part I - How Goldman Sachs Became The Most Hated Bank On Earth)

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There’s a saying in the trade that ‘a rolling loan gathers no loss’. Saving the firm is not the issue. It’s about individualised profit opportunities. With massive executive compensation, you can become fabulously wealthy in two years. But if you get the bubble to hyperinflate, you can keep it running for six or seven years,” said Black.

Black argues that this fraud recipe has been facilitated by the neo-classical view of economics prevalent in the US and Europe. “Unsurprisingly, these were the epicentres of the global crisis. We have created a criminogenic environment through the three Ds – deregulation, de-supervision and de facto decriminalisation through executive compensation.”

The deregulation and de-supervision of the banks is largely a story of Goldman Sachs – and its allies – lobbying government to win the competition in laxity with the world’s other great financial centres.

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“In the US, they argue that jobs will go to the City of London unless we let the banks have their way.  It’s manipulative bullshit and as soon as you accept it as a framing you’ve lost as a regulator. They will do everything they can to reinforce it. They will say ‘There is no alternative, you are naive if you think anything else’.

Goldman lobbied for decades to regulate itself and gradually the restraints on banks were loosened. Banks used to be monitored by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision. Officials probed bank loans and referred suspicious behaviour to the Justice Department.

William K. Black was senior deputy chief counsel at the Office of Thrift Supervision in 1991 and 1992, the last years of the Savings & Loans crisis, which was like the 2007 crisis but smaller. At that time, there were thousands of criminal referrals and hundreds of convictions.

The regulatory controls began to slacken in the mid-nineties when former Goldman co-chairman Bob Rubin served as Bill Clinton’s senior economic-policy adviser. Gradually, the US moved toward a system of voluntary compliance by banks. As a result, referrals by regulators dropped from 1,837 in 1995 to 72 in 2007. 

The next significant year in the loosening of regulations was 2004, when the banks persuaded the US Government to create a voluntary approach to regulation called Consolidated Supervised Entities. One of the most influential figures behind the move was Hank Paulson, Goldman’s then CEO. The banks won the right to lend virtually unlimited amounts regardless of cash reserves. This lax approach led directly to the financial crisis as get-rich-quick investment banks recklessly lent 35 dollars for every one in their vaults.

The Achilles heel to the fraud recipe Black describes is that no one really knows when the bubble will burst. Some of the banks which bet heavy, such as Lehman Brothers, paid the price. But Goldman Sachs - demonstrating once again that its bankers are the most highly skilled on Wall Street - saw the dangers and bailed out in time, making billions of dollars in the process.

In 2005, Goldman began using swaps to limit its exposure to risky sub-prime mortgages. The details of its swaps trades are secret, except for US$20 billion it bought from AIG in 2005 and 2006 to cover mortgage defaults, or ratings downgrades on subprime-related securities.

Goldman’s mortgage traders also bet heavily against the housing market on a sub-prime index in London and by February 2007, Goldman had veered from betting US$6 billion on mortgages to betting US$10 billion against them. 

The swaps contracts, especially the ones with AIG, would net massive profits. When Goldman’s securities lost value in 2007 and early 2008, the firm demanded US$10 billion, of which AIG paid $7.5 billion. AIG suffered an enormous drain on its finances, which led to the taxpayer bailout in 2008 to prevent worldwide losses. Goldman’s payout from AIG’s taxpayers’ money was more than US$8 billion.

But there were massive conflicts of interest as Goldman continued to sell junk sub-prime bonds to clients as AAA rated products despite taking out massive bets against them. The names of the deals Goldman used to clean its books — such as Hudson and Timberwolf — have gone down in banking history.

In the Hudson deal, Goldman claimed to have aligned its interests with its client after buying a US$6 million, but that was a paltry sum compared to its secret US$2 billion bet against the market. In the Timberwolf deal, Goldman kept an Australian hedge fund called Basis Capital in the dark about its counter bets. The fund invested US$100 million in 2007, and almost immediately fell apart financially.  

The most famous example of conflict came when Goldman was paid US$15 million to construct a security but did not disclose that the person paying them, John Paulson, was betting against it. Investors in this Collateralized Debt Obligation (CDO) lost US$1 billion, while billionaire investor John Paulson made US$1 billion.

William K. Black regards Goldman’s behaviour as fraudulent.  “The Levin report said they misled their clients and misled Congress. Mislead is another word for deception which is the core principle distinguishing fraud from other crimes. It’s a betrayal of trust, but selling mistakes to customers is actually the standard policy of investment banks. It’s actively pushed from the top.”

A huge bullhorn comes on and tells them ‘shift the following crap onto your customers’,” he said.

Cohan disagrees with Black, however.

“The Levin report was damning, but the problem is not what’s illegal, but what’s legal. It was really unethical to continue selling the mortgage- backed securities throughout 2007 whilst making huge bets against the market. But they didn’t do anything illegal, and the reason they didn’t is because they wrote the rules and laws by which they lived.”

”They are a perfect embodiment of the values of American society – of freewheeling Darwinian capitalism,” he said.

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The consequences of investing in Goldman’s trashy products were drastic for many funds. One of the worst hit was California’s public employees’ retirement system, known as CALPERS, which bought US$64.4 million in sub-prime mortgage-backed bonds from Goldman in March, 2007, by which time Goldman was busy betting the other way. By July, CALPERS listed the bonds’ value at US$16.6 million, a drop of nearly 75 percent.  

“Goldman would argue they were not betting against clients, but that these funds are counterparties,” said Suzanne McGee.

“Goldman would say ‘they know the game and we don’t have the same fiduciary duty to maximise profits as we do to our shareholders, or to clients who ask us to invest their money’. It’s important to understand that Goldman Sachs’ best customer at the end of the day is itself.”

David Smith,

EconomyWatch.com

Read Part Two Of Our Feature On Goldman Sachs where we look at Goldman’s networks of power in Europe. We consider the ways in which Goldman is using the same dangerous financial products, which caused the 2007 crisis to bet against Europe’s floundering economies whilst at the same time governing, or advising those countries. Finally, we ask what can be done to reduce Goldman’s power.

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