When Investments Sound like Cruise Missiles: United States v. Goldman Sachs

Today, the United States Securities and Exchange Commission filed a civil suit against Goldman Sachs for fraud.

Yes, f-r-a-u-d.

The decision is a landmark one for the SEC, which up to this point has yet to file suits against firms whose financial instruments depended upon the fate of the housing market, and more specifically, the bursting of the housing bubble in 2007.

The financial instrument in question, the ABACUS 2007-AV1, sounds more like a weapon of war (think F-18 Hornet, the super-fighter plane, or the MGM-1 Matador, a nuclear-capable cruise missile) than any money-based product. Yet those analogies are eerily perfect: with these devices deployed, Goldman Sachs was in a position to benefit from the downfall of the housing market. The interests of the society at large became antithetical to their own interests. Problem is, Goldman Sachs used fraudulent practices to stack their own deck.

The process worked like this: Goldman Sachs had many loans on their books. Some were good (they would, most likely, be paid back in full and on time), and some were bad (the most likely outcome was that the debtor would not be able to pay back the loan). Goldman and its friends picked from among all those loans the very worst of them--the loans most likely to fail. They then offered these investments as bets to other hedge funds, banks, etc., except GS told these clients that the loans had been randomly chosen by an independent third party, which led the other clients to believe they had a better chance of profiting than was actually the case.

Let's put this in simpler terms. I hold a deck of cards in front of you and say, "I bet you $5 that the random card you chose will be a red card." You, thinking the chance you have of winning is 50/50, agree to the bet. Only I've done something nasty, I've filled the deck with red cards, and there's only one black card left. Inevitably, you will probably pull a red card, and I will win. This was Goldman Sach's strategy.

While these are not the kind of strategies that make the financial system, as a whole, melt down, they are indicative of a kind of mindset that clearly pervaded--and pervades to this day--the Wall Street crowd. In Krugman's taxonomy, these investments would be just the type he would insist on curbing, without trying to minimize banks' overall size. A first step?