Starting in late 2006, Goldman Sachs made trades that would pay off if the housing market tanked. Was this a massive bet that the housing market was going to crash, as Goldman's critics maintain? Or was it merely a hedge, an attempt by the firm to reduce its risk, as Goldman claims? This debate, which has raged for more than three years, has lately taken on a new significance. Sen. Carl Levin, D-Mich., stops just short of accusing Goldman's top executives of perjury for describing the position as a hedge in their testimony before the Permanent Subcommittee on Investigations, which he chairs. Goldman, for its part, says its executives were telling the truth.
To my mind, the perjury question is a distraction. Any claim that Goldman lied to Levin's subcommittee will probably be hard to prove, and, anyway, the subject obscures more fundamental questions about Goldman's behavior. The evidence that Goldman misled the government is murky. The evidence that Goldman misled its customers, on the other hand, is fairly compelling. And if that is indeed the case, then there are suitable remedies.
It was just over a year ago that top Goldman executives appeared before Levin's subcommittee. Plenty of people were already outraged by the fact that Goldman had established its short position while continuing to sell securities backed by subprime mortgages to its clients. At the hearing, CEO Lloyd Blankfein and CFO David Viniar both said that the short position was simply an attempt to reduce risk. Goldman "didn't have a massive short against the housing market, and we certainly didn't bet against our clients," said Blankfein. "Rather, we believe that we managed our risk as our shareholders and our regulators would expect." Vinair said: "We were primarily, although not consistently, short, and it was not a large short."
Yet emails the subcommittee released made it clear that individual traders at Goldman were quite bearish on the housing market and were seeking to profit from a downturn. In January 2007, a trader named Jonathan Egol wrote: "the mkt is dead." Two other Goldman traders, Michael Swenson and Joshua Birnbaum, bragged in performance reviews about the "extraordinary profits" they'd made and about a plan to not just "get flat, but get VERY short." In late 2007, Birnbaum wrote in a draft presentation (which argued that the mortgage traders should be compensated even more richly than Goldman traders usually are) that "the shorts were not a hedge." Yet another Goldman trader described the position as an "enormous directional short."
Then, this past April, the Levin subcommittee released a 639-page report alleging that Goldman's Structured Products Group, which was a trading desk within the larger mortgage department, "twice amassed and profited from large net short positions in mortgage related securities." (The quotation is from an accompanying press release.) The subcommittee says that in 2007 Goldman Structured Products Group produced more than $3.7 billion in revenues. At a press conference, Levin said, "Goldman clearly misled their clients and they misled Congress" in their 2010 testimony. He said that he wanted federal prosecutors to review whether to bring perjury charges against Goldman executives.
Over the last few months, the drumbeat has gotten steadily louder. In early May, Attorney General Eric Holder told the House Judiciary Committee that the Justice Department was looking at the sections of the subcommittee report that dealt with Goldman. In mid-May, Levin told the Financial Times that there was "real hope" that law enforcement authorities would act on the report. (He said he was "not going to judge whether they [Goldman executives] committed perjury," but they "obviously spent a lot of time parsing words.") Long-time financial services analyst Dick Bove wrote in a report that "pressure on the Justice department to bring a criminal lawsuit against Goldman [appeared to be] building to a high pitch." And the Manhattan District Attorney has subpoenaed Goldman.
Goldman stuck with its previous position, saying that the firm didn't have a "massive net short position because our short positions were largely offset by our long positions, and our financial results clearly demonstrate this point." Apart from that, the firm stayed quiet. Sources tell me the bet was that this would all blow over. When it didn't, Goldman launched a counteroffensive. A Wall Street Journal story cited "people familiar with the situation" saying that the subcommittee had "drastically overstated" Goldman's bet due to "sloppy" math. A New York Times piece pointed out a mistake in the subcommittee report that made the mortgage department's bet look far more important to Goldman's overall results than it really was.
The subcommittee can point to lots of evidence to bolster its position that Goldman was making a big bet against the housing market. But Goldman has one obvious defense: Its mortgage department didn't net large gains because Goldman took losses on the billions in mortgage-related products that it held in inventory. (Just as a clothing store has to have an inventory of merchandise to sell its clients, so does a securities firm carry inventory.) The losses on that inventory, the value of which declined precipitously as the crisis began, mostly offset the wins from the negative bet.
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