The recent recession and financial scandal brought to light many unethical, illegal, and quasi-legal practices of the major investment firms. One example of this was the Goldman Sachs securities fraud case, in which the firm was accused of creating and selling bundled mortgage investments in an instrument that was intended to fail and which the company' bet against' with a desire to make a profit (Storey & Morganson 2010).
The government's case against Goldman Sachs concerned Abacus 2007-AC1, one of 25 investment vehicles specifically created to allow its clients to "bet against the housing market" (Storey & Morganson 2010). This "initially protected Goldman from losses when the mortgage market disintegrated and later yielded profits for the bank" (Storey & Morganson 2010). Ironically, one of the initial marvels of the credit crisis was the degree to which Goldman appeared to emerge unscathed, in contrast to its rivals.
"Goldman told investors that the bonds would be chosen by an independent manager," but instead allowed John A. Paulson, "a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst," to select mortgage bonds, despite his personal interest in their losing value (Storey & Morganson 2010). "Goldman then sold the package to investors like foreign banks, pension funds and insurance companies, which would profit only if the bonds gained value," which of course they did not (Storey & Morganson 2010).
Goldman initially said that it had lost money in the transactions overall and had acted with transparency. "The firm said the losses in the deal came from the overall collapse of the mortgage market, not from the way the deal was structured" (Storey & Morganson 2010). But "when Goldman sold shares in Abacus to investors, the bank and Mr. Tourre disclosed only the ratings of those bonds," not Paulson's interests in seeing the creditors default (Storey & Morganson 2010). By the end of 2007, Mr. Paulson's credit hedge fund was up 590%" (Storey & Morganson 2010). In the official SEC statement, detailing the civil suit it was stated: "the product was new and complex but the deception and conflicts are old and simple…Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party" (Delaney 2011:2; SEC Charges Goldman Sachs with fraud in structuring and marketing of CDO tied to subprime mortgages). Although the credit default swaps were a new financial instrument, the nature of Paulson's 'betting against' the assets he was selling was a conflict of interest.
It should be noted that Paulson was not the subject of the lawsuit, but rather Goldman itself because Sachs Vice President Fabrice Tourre was principally responsible for creating ABACUS 2007-AC1. "Tourre structured the transaction, prepared the marketing materials, and communicated directly with investors. Tourre allegedly knew of Paulson & Co.'s undisclosed short [selling] interest and role in the collateral selection process" and had a responsibility to inform investors and police those conflicts (SEC Charges Goldman Sachs with fraud in structuring and marketing of CDO tied to subprime mortgages, 2010, SEC). In addition, he misled "ACA Management LLC, a firm managing 22 CDOs with assets of $15.7 billion" by "indicating that Paulson & Co.'s interests in the collateral selection process were closely aligned with ACA's interests. In reality, however, their interests were sharply conflicting" (Delaney 2011:2; SEC Charges Goldman Sachs with fraud in structuring and marketing of CDO tied to subprime mortgages, 2010, SEC). The worse the failure of the assets, the more Paulson would profit.
Paulson effectively 'stacked the deck' against the success of ACA. "Paulson's selection criteria [for Abacus] favored [residential mortgage-backed securities] that included a high percentage of adjustable rate mortgages, relatively low borrower FICO scores, and a high concentration of mortgages in states like Arizona, California, Florida and Nevada that had recently experienced high rates of home price appreciation" (Delaney 2011:2). Paulson was not simply lucky in betting against the failure of ABACUS 2007-AC1; rather the security was specifically engineered to fail.
"John Paulson picked those lousy underlying assets for the Abacus CDO so that he could bet against them by purchasing 'credit default swaps' -- insurance policies that pay out if borrowers default" and the uniquely 'bad' instrument would not have existed without the agency of Goldman Sachs (Delaney 2011: 3). There was no 'risk management' -- one of the hallmarks of intelligent and conservative investment in the creation of ABACUS 200-AC1. All of the assets within ABACUS were of the worst kind, with the highest-risk borrowers, without any safe assets to effectively protect investors. This was unusual and not standard business practices. Moreover, ABACUS was highly-rated as a non-risky asset by Goldman, despite all evidence to the contrary that even a layperson who had investigated the asset could have detected, had Goldman acted with transparency.
Regarding the alleged harms done by Goldman, it was not simply the persons who trusted Paulson who were harmed. Rather, the "creation and sale of synthetic CDO [credit default swaps] s helped make the financial crisis worse than it might otherwise have been, effectively multiplying losses by providing more securities to bet against. 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" (Delaney 2011:4). Many people got 'burned,' including ordinary consumers whose retirement accounts and other assets were decimated in the credit crisis. The fallout from Goldman's actions ratcheted up the fear in the financial community and caused lending to freeze and slowed the world economy down to a crawl as a result. Many workers lost jobs who had nothing to do with the housing crisis and never took out a subprime loan. Although the economy would have been hard-hit, given the inevitability of the defaults in the poorly-policed subprime market, credit default swaps and a lack of transparency amplified the problem.
Eventually, Goldman Sachs agreed to pay $550 million to settle the fraud suit brought by the SEC, and the government decided to settle rather than to press the matter further (Goldfarb 2010). Although $550 million may seem like a great deal of money to an ordinary individual, to Goldman such a sum was relatively trivial, and likely written down to the cost of doing business, rather than a serious rebuke and testimony to the fact that it needed to improve its ethical standards. Goldman issued a statement that it 'regretted' the actions it took, and as part of the settlement conceded to the government's main contentions regarding its wrongdoing. But this only represented "a tiny fraction of its $13 billion in annual profits" (Goldfarb 2010).
Given the expense of bringing the case to trial, the government's actions are understandable to a point. But the trivial sum extracted in the settlement hardly even amounts to a 'slap on the wrist' regarding Goldman's lack of ethics. Even more inexcusable is the lack of regulation that the government has exercised over Wall Street, even in the wake of the credit crisis. Four years later and "the Justice Department has yet to convict a single high-profile banker" (Koba 2012). The major piece of financial reform, the Dodd-Frank Bill of 2008, "created an Office of Credit Rating at the Securities and Exchange Commission (SEC) to regulate credit ratings agencies like Moody's and Standard & Poor's" and the Consumer Financial Protection Bureau (CFPB), to protect consumers from 'unscrupulous business' practices by banks" such as what occurred in the case of Goldman's actions (Koba 2012).
However many analysts, including the chair of the Dallas Federal Reserve Bank believe that Dodd-Frank did not go nearly far enough. "You…