There was no meeting of minds at Tuesday's US Senate grilling of Goldman Sachs CEO Lloyd Blankfein and his colleagues. The Senators seemed more concerned with criticising Goldman's overall trading practices than with proving specific wrongdoing in the now-infamous Abacus transaction. Although Blankfein's air of injured innocence was a bit much, I found myself agreeing with him just a little bit more than I expected.
Let's home in on the real issues by looking at how bond/fixed income businesses work. We can start with trading in an existing bond issue. If a dealer sells a bond from its inventory to a client, there's a clear implication that the two parties to the transaction have differing views as to the value of that bond. Obviously enough, the buyer thinks it's going to be worth more than the seller (the dealer) does. Provided the sides are more or less equal in status (i.e. as long as Goldman isn't selling bonds to your grandmother), even the senators seemed to accept that this is perfectly reasonable business, though one or two of them did seem to waver a bit.
Now consider a "new" bond issue -- a corporate borrower, or a CDO, or whatever. When the dealer agrees to raise funds for a borrower, it usually "underwrites" the deal. This in effect means that it writes a cheque to the borrower for the amount of the bond issue, taking on the risk that the bonds won't be sold. If the market moves against it, the dealer may lose money before it manages to sell the bonds. To protect itself, a dealer will normally hedge its position by "going short" (i.e. selling) an equivalent amount of an existing bond issue. In the US, this would normally entail selling US government bonds. As the new issue bonds are sold, the dealer then progressively unwinds the hedge by buying back the bonds it shorted. Note (and this is crucial in examining Goldman's behaviour) that this is only supposed to protect the dealer against movements in the underlying bond market. If the new issue has been wrongly priced and can't be sold, the dealer may still end up taking a loss.
Much of the Senate questioning focused on this issue of hedging. Blankfein argued that it was normal practice, as indeed it is. The senators accused Blankfein of keeping its "short" positions in place even after it had sold its new issues, which means in effect that it was betting that the bonds it had just sold would decline in value. Blankfein's response was that it designed and marketed securities that would allow its clients to "express" their views of the market. As long as the securities were accurately described to the clients, it should really be of no interest to the clients whether Goldman shared their market view, and hence Goldman had no duty to disclose whether it was betting the other way, by not unwinding its short.
The senators had a lot of trouble with this, but as long as we are talking about trades with institutional buyers, I think Blankfein's position is defensible. But that's only true if we are talking about overall market movements, which a traditional hedge is intended to protect against. The serious accusation now levelled against Goldman by the SEC, which the senators kept losing sight of in my view, is that its short positions were not simply hedges: they were outright bets against securities that had been designed to fail.
The essence of the SEC's Abacus case, named after a particular housing-related security dreamt up by Goldman, is that it stacked the deck. Allegedly, a well-known short seller, John Paulson, was allowed to influence the selection of mortgages that went into the pool of assets that lay behind the Abacus securities. Paulson then slapped on a very large short position against the new issue, by using credit default swaps (CDS) rather than by selling US treasuries, and duly cleaned up when the Abacus deal entirely predictably went into the tank. The accusation against Goldman, which the company of course denies, is that it did not properly disclose the role of Paulson to the Abacus buyers.
The use of CDS is quite different from the standard practice of hedging a new issue by shorting bonds. CDS are a bet against a specific issue, not simply a form of insurance against movements in the underlying market. By failing to keep that distinction clear, the senators made things rather easier for Blankfein than they might otherwise have been. I wouldn't say they failed to lay a glove on him, but by and large he was a lot calmer and more cogent than his accusers. The SEC may, of course, be a rather tougher opponent when its case comes to trial.
And while all this was going on....hedge funds and other short sellers have potentially turned Greece's debt problems into a full-blown sovereign debt crisis and are getting ready to do the same to Portugal; the ever-alert ratings agency S & P has reduced Greece's debt to junk status; and the Republicans, egged on by Wall Street lobbyists, are stalling President Obama's plans for financial sector reform. We seem to have forgotten nothing of the recent credit crunch, but sadly we haven't learned anything either.
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