Goldman Fraud Case: The Only Email Worth Reading

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The SEC's announcement on April 16 that it is bringing fraud charges against Goldman Sachs (NYSE: GS  ) has generated a server farm's worth of reporting, commentary, and chatter. However, the truth is that even if the SEC is able to establish that fraud occurred, that aspect of the case is actually a distraction from the broader issues at stake. Don't let the commotion over this case mislead you: Fraud was a minor element in the housing and credit bubble. The problem was not what was illegal, but rather what was sanctioned, and in some cases perpetrated by the government and regulators.

A single useful email
Of the emails that have been released by various parties since the SEC made its complaint public, I have found only one that demonstrates an awareness of the wider problems that led to this crisis. That email didn't originate at Goldman -- employees there had been soaking in the mortgage hot tub for years, so it no longer occurred to them to question whether or not the water was sanitary. Instead, the author was an executive at Paulson & Co., the hedge fund that bet against the infamous ABACUS 2007-AC1 collateralized debt obligation (CDO) and an outsider to the real estate securitization market. This is the available excerpt from this January 2007 email:

Exhibit 1: Paulson employee e-mail

It is true that the market is not pricing the subprime RMBS [residential mortgage-backed securities] wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytical tools nor the institutional framework to take action before the losses that one could anticipate based [on] the ‘news’ available everywhere are actually realized.

In two sentences, this e-mail sums up the root of the credit crisis. The author is absolutely correct in his or her analysis of the exceptional mispricing that existed in subprime securities: Several key constituencies in the securitization market had enormous short-term incentives (primarily financial) to "keep the game going," rather than promote a well-functioning market.

At what price does an AAA rating come?
Credit rating agencies Moody's (NYSE: MCO  ) and Standard & Poor's (a unit of McGraw-Hill (NYSE: MHP  ) ) -- a near duopoly -- were earnings fat fees for rating structured products and anointing them with the highly reassuring AAA rating. This line of business was substantially more profitable than their traditional bond rating activity.

The rating firms received those fees from the underwriters -- investment banks including Merrill Lynch (now part of Bank of America (NYSE: BAC  ) ) or Citigroup (NYSE: C  ) -- who were selling the securities on to investors. Underwriters, who earn fees on a transaction basis, had the same incentive to keep "dancing" (to borrow the immortal expression of Citi's former CEO, Charles Prince). More and bigger transactions produce more fees and larger year-end bonuses for the individuals involved -- the Pied Piper himself couldn't have played a more captivating tune.

An unnamed culprit
As lucid as the Paulson & Co. email is, it does contain a glaring omission, for there was another major culprit in the historic misallocation of capital towards the housing market: The government, acting principally through government-sponsored entities (GSEs) Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) .

Despite being shareholder-owned companies, the GSEs were policy instruments of elected officials who wanted to promote homeownership at all costs, without regard to the consequences. It is no exaggeration to say that "privatizing profits and socializing losses" is a full description of Fannie and Freddie's business model.

Institutional investors failed, too
Investors could have offered a counterweight to these forces and their skewed incentives by refusing to buy toxic securities at inflated prices. Alas, as the e-mail suggests, they lacked the "analytical tools" to do so. That's a euphemistic way of saying they were incapable of valuing the securities they were purchasing, which is how they came to outsource part of their due diligence to a dysfunctional agent, the credit rating firms.

Who's left?
I am in no way opposed to financial speculation, but when the only people left to inject some sense of rational pricing are purely speculative interests (i.e., hedge funds such as Paulson & Co.), you don't have a functioning market. You can't fault a speculator for speculating; it is the other participants that failed to fulfill their roles.

To fix a problem, make sure you understand it first
When lawmakers and regulators try to solve a complex problem, I'm always careful to set my expectations exceptionally low with regard to the result (the problem is -- yet again -- one of incentives). As it is, the folks in Washington don't look ready to surprise me. Instead of grandstanding with Goldman executives, whose primary motivation is to shift blame away from themselves, perhaps lawmakers should spend more time talking to people who proved that they understood the dysfunctions within the real estate finance market.

Between high valuations and slow growth, investors should expect disappointing returns from U.S. stocks over the next several years. Tim Hanson explains how to make more in 2010.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. A member of The Motley Fool's board of directors is the chief operating officer of Paulson & Co. Moody's is a Motley Fool Inside Value recommendation. Moody's is a Motley Fool Stock Advisor pick. Motley Fool Options has recommended a write puts position on Moody's. Try any of our Foolish newsletters today, free for 30 days. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

Read/Post Comments (17) | Recommend This Article (69)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 28, 2010, at 4:50 PM, Momentum21 wrote:

    Nice piece.

    I feel guilty defending GS for some reason and obviously it is political suicide to offer any direct support to them...

    I don't feel bad for them I just don't believe it is a good use of resources to try and find a scapegoat for a problem in our system that was only detected using hindsight.

    Jack Johnson said it best:

    It was you it was me it was every man

    We've all got the blood on our hands

    We only receive what we demand

    And if we want hell then hells what well have

  • Report this Comment On April 28, 2010, at 6:48 PM, jcder wrote:

    Yes, excellent article.

    I have one objection though. You say that the investors "were incapable of valuing the securities they were purchasing". I don't agree. The purchasers were large institutions, typical "sophisticated investors". Had they used the resources available to them by 1) closely analyzing the offering memoranda of deals in question and 2) building truly sophisticated models to run cash flow scenarios specific to these deals, the investors would have seen the risks they were taking more clearly. Just as the manager from Paulson & Co had suggested, these investors didn't use the "analytical tools" that they could have used to understand the risks that they undertook.

  • Report this Comment On April 28, 2010, at 6:58 PM, ragmaniac wrote:

    If anyone thinks that there may be a possibility to get 'The Powers That Be' to improve our Capitalist social model for the benefit of society: NOT A CHANCE!

    Money is just about the only thing that drives this society. Everyone wants MORE. In our world it is a smart idea to accumulate as much money (and power) as possible. It is the working class, in its never-ending, never realized quest of 'getting ahead,' having the constant hope of some day reaching the Capitalist Holy Grail of Plenty, that is the real fool here, and it always will be, while the robber barons laugh all the way to the bank.


  • Report this Comment On April 28, 2010, at 7:01 PM, loop43 wrote:

    I just retired from the real estate industry this year and in June 2002 when Bush decided to let all people buy a home regardless of being credit worthy. I remember thinking who ever heard of giving mortgages to people without a down payment and also include closing costs. A person could finance it all. No skin in the game. I have sat at many a closing and knew that the buyer would in time lose his home. I live in a small town and we know most of our buyers. In my opinion this is what caused the mortgage meltdown. Nothing else. Hard to understand who thought this could have been a good idea.

    I have been watching the Senate grill Goldman about their role and I find this to be just as stupid. All they were doing was working within the framework that our Federal government established. I am somewhat surprised that Goldman did not just say, Hey, whose idea was this in the beginning?? I guess they are too respectful to say that but I am sure they are thinking that.

  • Report this Comment On April 28, 2010, at 7:25 PM, wesevans wrote:

    Your article is right on. Congress was lobbied(the politicians took money) into passing laws and regulations that were a predictable recipe for abuse and disaster. So congress is at fault. Goldman (Government) Sacks lobbied for the existing rules and were the best at gaming the system and the government they are also responsible. Now that the predictable bubble has burst the senators are posturing and Goldman is the dance partner. All are responsible.

  • Report this Comment On April 28, 2010, at 11:04 PM, Nolte808 wrote:

    To adapt a Buffet saying: if you are making a 'sophisticated' trade with GS and you don't know who the patsy is, then you're the patsy.

  • Report this Comment On April 28, 2010, at 11:16 PM, sshkop wrote:

    "Road to hell is paved with good intentions".

    Our government in its "wisdom" decided to pursue certain policies and in that same "wisdom" decided that the fastest way to achive those is through the market. In that - it was correct: unknown millions got homes that could not and would no otherwise obtain.

    Only the little fact that every government action to "address a problem" invariably creates a few uninteded consequences.

    No - its not "everyone's fault". Remember the goals of each player: business - make as much money as possible in the context of the permissible and lawful;financial firms - optimize financial flows in the economy between all players and maximize profits while doing it; government - set wise policy and successfully implement it through available tools.

    Washington kicked the first snowball, wanting it to become an avalanche with the help of the marget forces and that's exactly what they got. Only nobody in Washington is even capable of seeing 10-20 years down the road. Anyone can see this by listening to the torture of a hearing yesterday.

    That is how the Community Reinvestment and dovetailing set of banking regulations and mandates came into effect and was implemented with complete disregard for the longer-term implications.

    Again, walls steet, or any other business is in it to make money - nothing more and nothing less. Its social responsibility is to exist, hire people, pay taxes, obey the laws and make as much money as possible. "social promotion" is not their role - never was.

  • Report this Comment On April 29, 2010, at 5:18 AM, peretranquile wrote:

    Thanks for another good article .

    Part of the problem was house prices. Median incomes did not keep price with house prices (some say that productivity gains in the economy were creamed off by the financial services industry at the expense of Joe Sixpack). Homeowners remortgaged to improve living standards in the near absence of income increases, encouraged by the financial services industry. A house for sale is only worth what someone will or can pay. House prices had increased over decades, but median incomes had stagnated. So houses for sale were overpriced. No one wanted to see house values going down, not homeowners, not the realtors, not the politicians and especially not the financial services industry who were holding so much property as collateral. So they lent money (with government encouragement) for overpriced houses to people who had either been priced out of the market, or shouldn’t have been in the market, which maintained the illusion of healthy house prices, and kept the dance going for yet one more bonus season.

    “We got your pay increase, but we’ll lend it back to you so that you can pay interest on a house that is more expensive than it oughta be ‘cause we don’t want to write down our collateral and take a hit in our bonus. We’re decent human beings – really.”

  • Report this Comment On April 29, 2010, at 9:51 AM, Big50Shooter wrote:

    I also applaude you on the great article Alex!!!

    I agree with you 110% regarding these credit-rating agencies responsibility for the crisis that unfolded... What they did cannot be charactized by any other term than "FRAUD"!

    As far as I am concerned, not enough has been done to make them accountable for their actions either!!! That is why I no longer trust what they have to say, and no matter what the TMF says about their viability, I will NEVER invest a dime with either of the aformentioned agencies....

  • Report this Comment On April 29, 2010, at 11:54 AM, rhutmacher wrote:

    Excellent article, and I agree that the thought of the government actually helping the situation would be surprising. The government is already working on the next housing bubble by giving away ridiculous tax credits to consumer that purchase a house. The Fed is also helping in this next bubble by keep rates as low as possible. False incentives are what caused the last housing bubble, what makes this one different? Consumers that would not have been able to purchased a home otherwise are doing so now because of these government incentives. Same thing that happened ten years ago

  • Report this Comment On April 29, 2010, at 12:04 PM, texbudda wrote:

    The reason we are in this mess is because clinton not George Bush deceided to give everyone a home. People were buying houses (arm) and buying way over their heads, with no thought as to what would happen (IF) the interest rates went up , they didn't care its just give it to me now take some responsibility folks for YOURSELF the government is not your keeper and not your friend. You are in this alone TAKE RESPONSIBLITY FOR YOURSELF . I'm tired of working to support people who whine and cry because they got caught with their britches down . And no I do not have a bunch of money thanks for letting me get this off my chest . buy what you can pay for and stop living beyond your means

  • Report this Comment On April 29, 2010, at 3:58 PM, TLMKJ wrote:

    At the very least, if we're not going to put these people in jail (that include the CEOs, the politicians, the mortgage brokers, the people who lied to get their loans), a list of these people should be created and circulated so at least we can treat them like the lepers they are. Remember the scarlett letter. It's time to bring it back and brand these folks so we never get !@#$'ed by them again!

  • Report this Comment On April 29, 2010, at 4:00 PM, tdubs1957 wrote:

    One of the more interesting questions is how the rating agencies haven't been called before committee to explain how these CDO's were able to maintain such high ratings and why the underlying bonds holding the subprime mortgages were able to get AAA ratings. Goldman is not blameless. However, they played the market based on their belief that the housing market was in the tank. It is what investment banks do with cash they have on hand, hedge against reversal of their positions.

  • Report this Comment On April 29, 2010, at 10:24 PM, TMFAleph1 wrote:


    In fact, the very same Senate subcommittee that grilled Goldman Sachs held a separate hearing on the role of the credit rating agencies in the credit crisis. The hearing, which included representatives from these firms, took place last Friday.

    Of course, there was infinitely less hoopla and media coverage at that time compared to the Goldman hearing. Rating agency analysts are much less satisfying punching balls than investment bank traders -- they earn a lot less money, for one thing.

    Wall Street and the Financial Crisis: The Role of Credit Rating Agencies

    Permanent Subcommittee on Investigations

    Friday, April 23, 2010

    09:30 AM

    Dirksen Senate Office Building, room G-50


    Alex D

  • Report this Comment On May 02, 2010, at 11:55 AM, Spears40 wrote:

    I got a nice E-mail from Sen. Levin patting himself on the back on what a great job he did on uncovering the culprit in Wall Street who caused the problems; Goldmen Sachs and friends. I returned his message requesting that he investigate the real culpits of the problem: Fanny Mae and Freddy Mac and the people running those programs. I than asked him "Do you really think that the people is this country are that stupid to think Wall Street was the only problem." Then I reasured him that he again not get my vote for re-election along his partner Sen. Stab them All.

  • Report this Comment On May 04, 2010, at 1:19 PM, tricity100 wrote:

    Fannie and Freddy are NOT the culprits. The banks have wanted to get rid of them for years as with social security, medicare, and all New Deal programs.

  • Report this Comment On May 11, 2010, at 6:33 PM, TMFAleph1 wrote:


    You wrote:

    "To adapt a Buffet saying: if you are making a 'sophisticated' trade with GS and you don't know who the patsy is, then you're the patsy."

    Paulson & Co. was part of this same sophisticated trade with Goldman Sachs. Were they a patsy, too?

    Buffett also said recently:

    "Now, I don't hire them for investment advice or services. People do. They have got a big investment advisory business, but I don't pay them for that. What I do do is frequently is I trade with them. When I buy something from them, they may be selling it for a customer. They may be shorting it to me. You know, it's not their responsibility to manage my money. I could hire them to manage my money, if I want to. But I don't. And I often buy something from them that my guess is that they are shorting to me. But, you know, that's the name of the game."


    Alex D

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