One of the most significant topics to hit the financial news recently is the SEC’s suit against Goldman Sachs. The issues involved are far from clear, but the basic story is a conflict of interest that was never transparently communicated to investors.
A more detailed explanation begins in 2004 and the years of excess that preceded the credit crisis. During that time, Goldman Sachs profited handsomely by originating CDOs—packages of investments that included sub-prime mortgages, currency trading, corporate bonds, and much more. As everyone knows, these investments turned out to be practically worthless and anyone who bought the mortgage backed CDOs lost their money. The results of these massive losses rippled throughout the financial system with far-reaching implications that continue into the present.
Is it really plausible to believe that none of the parties involved realized the true value of these CDOs, during the time when the market seemed to have an insatiable appetite for them? This is where the story becomes a little more complex and a lot darker. The SEC alleges that Goldman and another sophisticated hedge fund, Paulson & Co., hoped that the CDOs they created would fail. As anyone with a forex account knows, it’s quite possible to profit from either upward or downward movement. Both companies bought significant hedging contracts against the CDOs, essentially shorting them. If the securities did fail, the two companies stood to make a lot of money. The SEC also alleges that they intentionally chose bad securities to make sure that their bets came to pass. Essentially, the whole scam worked something like a sophisticated insurance fraud.
However, none of these securities would have worked unless other investors bought in, and this is the core of the SEC’s allegations—Goldman Sachs intentionally withheld crucial information, giving the impression that these CDOs were sound investments when even they expected them to fail.
All of this leads to a crucial question—how did the company’s actions affect other businesses and their investments? On the most basic level, it’s fairly obvious that Goldman Sachs cheated their investors by not providing them with all of the pertinent information. This was simply a sophisticated form of fraud, since Goldman Sachs benefited from the transactions approximately as much as these investors lost.
When the credit crisis spread, it became everyone’s problem. Financial institutions and individual investors who stayed completely away from CDOs also lost huge amounts of money because of the shady actions of a few. The widening implications were even worse, as almost unfathomable amounts of financial value evaporated overnight. Goldman did profit from their shady dealings, but these profits are negligible compared to the immense losses suffered by the economy at large, or even by other investment portfolios within Goldman!
Therefore, it would be fair to say that the economy at large suffered as a result of one company’s failures. Yet there is a final, more significant casualty of the Goldman scandal which continues in the present. As a result of what happened, there has been a significant loss of trust in financial institutions. It is now clear that implicit confidence in a major bank is naïve. Large financial institutions can be as unscrupulous as individuals, if not more. It will be many years before financial firms are able to reclaim the credibility they had before the credit crisis, and that only introduces more drag into financial and banking markets.
This is where the SEC suit plays a crucial role. If government agencies can prosecute Goldman’s transparency failures effectively, and if clear, rigid requirements are set in place for similar situations, there may be a reasonable hope that the market can work smoothly and with stability. Perhaps the Goldman scandal will even drive governmental policies that require greater transparency and help the markets function better than before. If these things were to come about as a result of what Goldman did, the positive results of the scandal might begin to repay some of the immense losses they produced.
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