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A blog on financial markets and their regulation
I wrote a column in the Financial Express on what the securities fraud case against Goldman Sachs tells us about the economic function of investment banks.
Regardless of its ultimate outcome, the SEC’s case against Goldman Sachs alleging securities fraud has already transformed the debate on financial sector reforms in the US. More importantly, I believe the case has raised disturbing questions about the economic function performed by investment banks in modern financial markets.
At the centre of the SEC case is the Abacus deal that Goldman brought to market in early 2007. The structure was created at the request of the hedge fund, Paulson & Co, which wanted to bet on the collapse of the US housing market by taking a short position on subprime securities. Goldman created synthetic subprime securities through the Abacus vehicle and sold these to the German bank, IKB. Paulson took the opposite (short) position on these securities.
The prospectus of Abacus highlighted the role of a reputed CDO manager, ACA Management, in selecting the portfolio of subprime assets underlying the Abacus deal and gave full details of this portfolio. But the 196-page prospectus did not mention the fact that Paulson had played a role in selecting the portfolio. This non-disclosure is a key element in the SEC case against Goldman.
In addition, the SEC alleges that Goldman misled ACA about Paulson’s intentions. Apparently, ACA believed that Paulson intended to buy the equity (first loss) piece of Abacus and was, therefore, motivated to exclude truly bad assets from the portfolio. In reality, Paulson planned to take a short position in Abacus and wished to stuff it with the worst possible assets.
It is difficult to predict the outcome of the SEC case because there are few precedents for invoking the anti-fraud provisions of US securities law in similar situations. The SEC might be in uncharted waters here, but it is pursuing a civil case where the standards of proof are lighter. Moreover, Goldman would certainly not relish having to defend its unsavoury conduct in a jury trial.
It is true that during the crisis the SEC acquired a reputation for incompetence (for example, Madoff and Stanford), which makes people sceptical about the Goldman case as well, but the new director of enforcement, Robert Khuzami, whom the SEC hired last year, has a formidable reputation from his days as a federal prosecutor.
Interestingly, Goldman in its defence thinks of itself more as a broker-dealer in complex derivatives and less as an issuer or underwriter of the Abacus securities. Broker-dealers have no obligation to disclose the identity or motivations of either counterparty to the other. It is true that Goldman could have achieved the same economic effect as Abacus by intermediating a credit default swap (CDS) between IKB and Paulson, but that is not what it chose to do. It chose to issue securities in which a CDS was embedded.
I am, however, less interested in whether the SEC wins this case or not. I am more concerned about the role of investment banks like Goldman in modern financial markets. In an ideal, perfectly efficient market, buyers and sellers would deal with each other directly through an electronic limit order book without any gatekeepers or intermediaries. In reality, intermediaries are needed to solve the problem of information asymmetry where one side knows a lot more about the transaction than the other.
It follows that the value added by an investment bank is measured by the extent to which it reduces information asymmetry. Otherwise, it is only exploiting oligopolistic rents or earning the rewards of excess leverage made possible by implicit ‘too big to fail’ guarantees.
From this perspective, the major banks of the 19th century or early 20th century like Rothschilds, Barings or JP Morgan did serve an economically useful function. Academic studies have shown that sovereign bonds underwritten by these major banks during that period had significantly lower default rates than other sovereign bonds (Flandreau, et al, 2009, The End of Gatekeeping: Underwriters and the Quality of Sovereign Bond Markets, 1815-2007, NBER Working Paper 15128).
Similarly, financial historians tell us that 19th century investment banks like JP Morgan played a critical role in bridging the information asymmetry between US railroads and their British investors. To their contemporaries, rich and powerful bankers like the Rothschilds and the Morgans were among the many ugly faces of capitalism. But the hard facts show that while they did not claim to be doing God’s work, they did do something useful.
The Abacus case makes one wonder whether modern investment banks do play any such useful role. The Goldman defence asserts that sophisticated investors like ACA and IKB were capable of looking after their own interests and did not need help from Goldman or anybody else. If there are no information asymmetries to be resolved or if modern investment banks have too little reputational capital to resolve them, then it is not at all clear what economic function they perform in today’s highly liquid and sophisticated markets.