Betting against clients

Was Goldman complicit in making the housing crash a lot worse than it might have been? A report in the NYT is certain raise new questions about who knew what, when - and what they did about it. The story details how the bank profited by betting against the same mortgage-related securities (known as collaterized debt obligations, or CDOs) that it was selling to clients. The Goldman folks, you see, believed that the housing market would crash, while its clients - some of the most sophsticiated investors in the world - were looking for vehicles to ride the housing wave. This allowed Goldman to make money two ways: Selling the CDOs and then profiting on their bet that they would collapse. Now, their actions are being investigated by the SEC, Congress and others. One big question: Was Goldman bundling especially risky mortgage products that had the biggest chance to fail? From the Times:

"The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen," said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. "When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else's house and then committing arson."

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The creation and sale of synthetic C.D.O.'s helped make the financial crisis worse than it might otherwise have been, effectively multiplying losses by providing more securities to bet against. Some $8 billion in these securities remain on the books at American International Group, the giant insurer rescued by the government in September 2008. From 2005 through 2007, at least $108 billion in these securities was issued, according to Dealogic, a financial data firm. And the actual volume was much higher because synthetic C.D.O.'s and other customized trades are unregulated and often not reported to any financial exchange or market.

There is, however, another side to this. The Business Insider's Henry Blodget says that what Goldman did was "just an everyday reality."

Wall Street firms like Goldman sit between buyers and sellers, and they also buy and sell on their own behalf. Every single transaction these firms conduct entails a conflict of interest: Everyone is always making bets, and someone is always winning and losing them. It's just not obvious until later which party that is. The way we suspect Goldman viewed its behavior in the housing scenario above is as follows:

--Clients are desperate for products with which to bet on the housing market

--We can help our clients by creating those products and get paid handsomely for doing so.

--We're negative on the housing market, so we can use the products bet against the housing market. If we're right, we'll make some money there, too.

There's more to keep in mind: The Goldman clients might have quickly resold the CDOs to other investors ("We're not talking about mom-and-pop buy-and-hold investors here," Blodget writes). Also, Goldman was not hired to manage money for these clients - it was strictly a product dealer. Most importantly, Goldman could have been wrong about its housing bet - in which case, the bank would have lost big-time. The process of making and losing money is not a morality play - it's simply a means to an end. You might be outraged at what Goldman did, but it's not all that different from what goes on in the financial world every day (assuming that the bank didn't deliberately mislead those clients). Forget the conspiracy theories - the collapse was the inevitable result of investors at all levels (that's you and me, bud) who were looking for higher and higher returns and simply assumed that the good times would never end. Warren Buffett had it right when he said, "people don't get smarter about things that get as basic as greed."

By the way, Calculated Risk points out that much of the Goldman story had been reported more than a month ago by McClatchy Newspapers reporter Greg Gordon. The headline: "How Goldman secretly bet on the U.S. housing crash."