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.
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.