When Is a Hedge Not a Hedge?

In his column this morning Paul Krugman comments on the fraud suit against Goldman Sachs:

The main moral you should draw from the charges against Goldman, though, doesn’t involve the fine print of reform; it involves the urgent need to change Wall Street. Listening to financial-industry lobbyists and the Republican politicians who have been huddling with them, you’d think that everything will be fine as long as the federal government promises not to do any more bailouts. But that’s totally wrong — and not just because no such promise would be credible.

For the fact is that much of the financial industry has become a racket — a game in which a handful of people are lavishly paid to mislead and exploit consumers and investors. And if we don’t lower the boom on these practices, the racket will just go on.

I’m not versed enough in the intricacies of securities fraud to determine whether what Goldman Sachs did was in fact fraud. It sounds very much like the “Magnetar trade”, the creation of risky instruments with, apparently, the specific intent of shorting them.

It seems to me that a lot hinges on who knew what when and what their intentions might have been. When shorting your own instruments is a method of mitigating risk, that would appear to be benign. However, when you create a complicated financial instrument primarily so that you can take a short position on it, making more money on the short than could conceivably have been made through the instrument, that certainly sounds like a colloquial definition of fraud to me.

But Dr. Krugman is probably wrong that pending legislation can solve the problem. I note that Goldman Sachs was indicted under present law and apparently that wasn’t enough to discourage the practice. The incentives are huge and the likelihood of discovery relatively small.

Besides, we’re dealing with intelligent actors who are likely to respond with strategies to get around anything that Congress is likely to come up with. As I’ve said before I think we need to deal more with the incentives. So, for example, commissions should be paid based on the performance of any instrument throughout its life rather than solely based on current year sales.

11 comments… add one
  • PD Shaw Link

    I’m not sure what to make of the Goldman Sachs complaint, but a couple of things stand out. (1) It’s being reported that Paulson shopped this idea around to other banks and only G.S. bit. That suggests that this deal isn’t necessarily representative of the banks or the cause of the crisis. (2) It appears to be about disclosure to the customer. That leaves me wondering whether a legalistic dislcosure in the sales documents would have shied many customers away. I.e., it can be possible that Madoff was a crook and also that many of his victims should have known better.

  • Drew Link

    I think you are on to the real issue, PD.

    As I understand it, in the Magnetar trade the Magnetar hedge fund saw a market opportunity to buy the riskiest tranche of banks CDO’s and relieve them of a portfolio problem. Then Magnetar set up separate short bets against the position. But if they lost, and the housing market had held on longer, they could have been wiped out. Think what you might about the beta of the transaction, its was Magnetar’s right to make, and legal.

    The Goldman issue appears to be a separate one – to your point, PD – that doomed to fail (by design) derivative based securities were sold to customers, while Goldman simultaneously shorted them. Goldman will undoubtedly argue that the investors were sophisticated and should have done their diligence. Buyer beware.
    But it sure is a good political tool to point out Goldman are schmucks.

  • Drew Link

    As for dave’s concluding paragraph.

    “Besides, we’re dealing with intelligent actors who are likely to respond with strategies to get around anything that Congress is likely to come up with.

    Absolutely, and always has been the case. In addition, the cushy relationship (read: bailouts) between big time street firms and Washington pols was well documented in the book I recently cited here, but which was pooh-poohed.

    “As I’ve said before I think we need to deal more with the incentives. So, for example, commissions should be paid based on the performance of any instrument throughout its life rather than solely based on current year sales.”

    Oh, you mean like my comp, (!!) based upon the investment gains we make over 3-7 year periods. But as we all know, Private Equity is a bad word these days.

  • PD Shaw Link

    One of the things that stood out to me in the Magnetar piece was the presence of shame and remorse. Most commentors don’t seem to think those concepts exist anymore. At least for purposes of informal controls, I don’t think it’s a bad idea for the worst culprit to be singled-out. The government is signaling that Goldman Sachs was excessive in fiduciary risks to its clients.

    A hundred years ago such a red letter would be significant. The Barings Bank never completely recovered from its bailout during the Panic of 1890; they were labeled as leaners. But today, does such signaling discourage as many customers as it encourages?

  • Drew Link

    PD –

    When Wall Street investment banks were partnerships, as you well know, the risks in the positions and actions taken by a partner who could bind the firm mattered. Today, not so much. This is a byproduct of going public, and also the inferred government guarantee.

    The concepts of shame and remorse, not to mention the key concept of fiduciary duty, are actually alive and well in some circles. They certainly are in PE in general. And at my firm. Remember, stock brokers, investment bankers etc are just that: commissioned brokers. They are not principals. (At least not in their transaction oriented businesses. ) They do use their balance sheets more in the trading and PE arms.

    That all said, I’m not a lawyer, but creating and selling securities designed to decline, while having their firm take proprietary trading positions on the opposite side seems like fraud to me. If not, I hope there is a special place in hell for the perps.

  • sam Link

    What Drew just said (well, a bit ago). The killer for me was that GS allowed this Paulson dude to design the CDO, and in so designing, he included things, read dogs, he believed were doomed. And then he shorted it. BTW, Felix Salmon went over the pitch document and, according to him, there’s no mention or Paulson’s — or any third-party’s — input at all. My Dante is really rusty, but wasn’t there a particular circle of hell reserved for folks who do stuff like this?

  • sam Link

    BTW, and the real, real, real killer for me was the fact for Paulson’s short scheme to succeed, a whole lot of folks — read SUCKERS — had to go long. And GS did nothing, nada, zip, to prevent these people from losing their shirts, pants, coats, everything. Sons-of-bitches.

  • steve Link

    According to Yves Smith (?), The Fab guy had told ACA that Paulson was long $200 million in the CDO. I am struck by the fact that the narrative is a bit confused still. Need to let all the facts sort out.

    Steve

  • sam Link

    Here’s one of the best accounts I’ve seen. It’s from the website interfluidity (highly recommended site): Goldman-plated excuses.

  • Drew Link
  • PD Shaw Link

    I like Tom Maguire’s piece, but it probably is also worth emphasizing that the Paulson scheme is at the tail end of the bubble. The deal is closed April 26, 2007 and within 6 months, 83% of the portfolio had been downgraded. I believe that is classic end-of-the-bubble misconduct that occurs when the pressure to maintain the inflated profits and questionable decisions are made.

    Also, recommend Professor Bainbridge’s update on his thoughts.

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