Goldman case all too usual in Financeland
The specific details and complexities of the SEC’s case against Goldman Sachs (GS:NYSE) may or may not lead to a conviction. As a shareholder, I certainly hope my management team is right when they say the SEC’s complaint is “wrong both in fact and law”.
Standing back, though, the informational one-sidedness of the Paulson/Goldman/Unwitting Pension Fund transaction are not unique in the slightest. On a daily basis, business transactions are conducted where one side has substantially more information than the other.
In the Paulson/Goldman case, the accusation is that client Paulson asked investment bank Goldman to pick certain mortgage-backed securities that Paulson wanted to short, and then Goldman would find someone to take on the other side of the trade. According to the SEC, Goldman’s vice-president misrepresented the quality of the assets in the mortgage pool as he tried to get pension funds to acquire the long end.
Paulson appears to have had a high level of knowledge into the circumstances of the assets underlying the mortgage pool, while the other half of the trade didn’t. The SEC made much of the fact that the Goldman VP is alleged to have advised the pension funds that an independent consulting firm had played a role in the choice of which mortgage CDOs went into the deal.
When you bore down on the key elements in this scandal, it is pretty clear that one side of the transaction appears to have done substantially more due diligence than the other. Goldman may have referred to some arms length consultant, but I’m not sure how that excuses the buyers from doing their own due diligence.
According to Michael Lewis’ excerpt in the recent Vanity Fair, one could assess the performance characteristics and quality of the individual mortgage CDOs if you did your homework.
Around our shop, we are regularly given the chance to enter a situation that another lender is looking to exit from. Unlike our favourite “growth capital” deals, there are also lots of debt re-fi opportunities to sift through where you sometimes have to wonder. In those cases, the other lender is the “seller”, and we’re the “buyer”.
They have far more information about the historical performance of the business and management team than we do. They know how the business has performed against budget, and perhaps what messages the customers are sending about the future. They know why they got into the loan at the outset, what they were told would happen, and how that all went.
Imagine a circumstance where we didn’t try to validate the investment merits of the deal ourselves, and just accepted the fact that the Agent on the deal told us that the 2010 / 2011 financial forecasts were “conservative”. And that a consultant had analyzed the deal for the Agent and pronounced that the assets were valued appropriately at that particular point in time.
If we lost money down the road because we’d stepped into the departing lender’s shoes and things didn’t go as planned in the business, and we didn’t do our own due diligence homework on the merits of the opportunity, does that make the Agent’s actions worthy of SEC charges?
News to me.
MRM
Good post Mark.
I’d only add that failing to conduct sufficient due diligence is certainly the investors (buyers) fault and there’s no excuse for it. And loses stemming from such lack of research are deserving. However, GS is also certainly at fault in this case (if the allegations are true)simply because of the lack of transparency on the Abacus CDO they “sold” to the pension funds in regards to Paulon’s involvement. This situation is, IMHO, at the root of the problem in the investment industry today. It’s a wild west environment: create any product you can sell (even if you know it is a bad investment), market it those most gullible and make a ton of money on the involved fees. Heads the manufacture wins, tails they win. That’s fine if we’re talking about vacuum cleaners or electric razors (where the buyer can access quality and price easily). But with more complicated purchases that are long-term in nature (think medicine, tax, law, investing) buyers need to know that the advice providers are held to some standard of competency and ethics that allow the buyer to have comfort in knowing their best interests (a fiduciary relationship) is being taken into consideration. Yes, people have to be responsible for themselves, and caveat emptor, etc. But the regulators (at least in the retail chain) need to acknowledge clients put on a lot of faith in their advisors and this combined with the asymmetry of information and substantial moral hazard (commissions) that exists causes many, many people to lose lots of money over years of bad (high fee) investing. In regards to the GS/Pension fund/Paulson situation, all players where sophisticated, so I know it’s less meaningful. But GS’s actions (if true) are rampant in the retail chain as well and needs to be addressed. In a nutshell, creating and selling investments known to be terrible “products” to unsuspecting buyers should not exist. By eliminating commissions the moral hazard would be avoided and bad products (sold with short-term commission thinking) would disappear. The compensation arrangements would be a performance fee or “trailing” compensation tied to the life of the investment, etc. My two cents…
I don’t think it’s easy to write this off as a case of failed due diligence. GS is alleged to have marketed the product as a product desgined to succeed where in fact it was a product designed to fail.
Thanks for stopping by Keith.
I’m not saying that there was no misrep. That’ll come out via the court trial. My comment was more generic: lots of deals close every week where one side has materially more info than the other. And that’s the guy who usually wins out.
MRM
Fair enough and agreed that information asymmetry is wildly common. The link below is an interesting look at GS’s stance. Roughly paraphrased, it doesn;t deny Paulson’s involvement but says that since you knew more or less what was in the portfolio, it doesn’t it matter who picked it:
http://dealbook.blogs.nytimes.com/2010/04/19/the-goldman-defense-caveat-emptor/
Even if there was formal compliance with whatever disclosure obligations were in place, did GS design and sell the portfolio in bad faith?