Will Ken Lay's Ghost Haunt Goldman Sachs?

♠ Posted by Emmanuel in at 12/03/2007 01:20:00 AM
Off-balance sheet financing...creative accounting...close connections to the White House...hyping junk as "good as gold" while selling it on the side: do these activities sound familiar? Of course they are--those were the symptoms of Enronitis that plagued the eponymous firm earlier in the decade. The late Ken Lay, Dubya's "Kenny Boy," was headed for the clinker before his untimely demise over such shenanigans including calling Enron stock a "bargain" while unloading it near the peak of the Enron hysteria.

Fast forward a couple of years and now we have one Goldman Sachs. The investment banking powerhouse is a giant not only on Wall Street but also in Washington. Many current and former Bushites, like Treasury Secretary Hammerin' Hank Paulson, are Goldman alumni. The firm was also Bush's fifth largest contributor during the 2004 presidential election. Meanwhile, the fate of subprime junk issued by Goldman and other Wall Street firms is the subject of endless chatter from here to Norway. Recently, Goldman Sachs surprised many in the financial community by reporting sizeable profits while the rest of its Wall Street brethren were eating dirt. The reason? The firm has been heavily shorting mortgage-backed securities. From an earlier report in Fortune:
Much of the focus is on Goldman's trading revenue, which totaled a spectacular $8.23 billion, up 70% on the year-earlier quarter. Part of that increase was due to a bold bet that made money if mortgage-backed bonds and financial instruments tied to mortgage values fell in price. Of course, because of the credit crunch, they did plunge in value, netting gains for Goldman that the banks said "more than offset" the losses it saw on the mortgages it was holding.

So what's the problem, you ask? It turns out that Goldman Sachs was, at the same time, one of the biggest issuers of mortgage-backed securities during recent years, including those with Paulson at the helm. Shades of Key Lay, again. Pump it up to others and bet on a price tumble at the same time. Fortunately for Goldman with its most recent earnings, its gains betting on mortgage security-related junk taking a tumble outstripped losses on those that it held. However, these activities raise the very same question posed by prosecutors to Ken Lay: why did you do the "pump and dump"? That's the question being asked by Ben Stein in a recent New York Times feature. Also, Goldman Sachs research is busy trumpeting a doomsday scenario over subprime which of course benefits the firm if more believe it:

But what leaps out at me from this story is that Goldman Sachs was injecting dangerous financial products into the world’s commercial bloodstream for years. My pal, colleague and alter ego, the financial manager Phil DeMuth, culled data from a financial Web site, ABAlert.com (for “asset-backed alert”), that Goldman Sachs was one of the top 10 sellers of C.M.O.’s for the last two and a half years. From the evidence I see, Goldman was doing this for years. It might have sold very roughly $100 billion of the stuff in that period, according to ABAlert. Goldman was doing it on a scale of billions even when Henry M. Paulson Jr., the current Treasury secretary, led the firm.

The Goldman spokesman would not comment on this except to note that other firms sold C.M.O.’s too. The point to bear in mind, as Mr. Sloan brilliantly makes clear [in this Fortune article], is that as Goldman was peddling C.M.O.’s, it was also shorting the junk on a titanic scale through index sales — showing, at least to me, how horrible a product it believed it was selling. The Goldman Sachs spokesman said that the company routinely shorts the securities it underwrites and said that this is disclosed. He noted candidly that Goldman is much more short in this sector than usual.

Here is my humble hypothesis, even after talking to Goldman: Is it possible that Dr. Hatzius’s paper [forecasting subprime gloom] was a device to help along the goal of success at bearish trades in this sector and in the market generally? His firm says his paper, like all of its economists’ work, was not written to support any larger short-trading strategy. But economists, like accountants, are artists. They have a tendency to paint what their patrons, who pay them, want to see...

Now, obviously, Goldman Sachs does many fine deals and has many smart, capable people working for it. But it’s not the Vatican. It exists to make money for the partners and (much farther down the line) the stockholders. The people there are not statesmen. They are salesmen.

To my old eyes, the recent unhappiness about mortgages and Goldman’s connection with them are not examples of sterling conduct. It is bad enough to have been selling this stuff. It is far worse when the sellers were, in effect, simultaneously shorting the stuff they were selling, or making similar bets...

Here is a query, as we used to say in law school: Should Henry M. Paulson Jr., who formerly ran a firm that engaged in this kind of conduct, be serving as Treasury secretary? Should there not be some inquiry into what the invisible government of Goldman (and the rest of Wall Street) did to create this disaster, which has caught up with some Wall Street firms but not the nimble Goldman?

When the Depression got under way, the government created the Temporary National Economic Committee to study just what had happened on the Street to get the tragedy going. Maybe it’s time for an investigation of just what Wall Street and Goldman did to make money as they pumped this mortgage mess into the economic system, and sometimes were seemingly on both sides of the deal. Or is Goldman Sachs like “Love Story”? Does working there mean never having to say you’re sorry?

It's going to be interesting if Goldman Sachs and Co. are investigated. Yes, Goldman may claim "research independence," but there's something underhanded about having your research arm literally trash products you've marketed--and make a gain by doing so. Making fools of your clients does not strike me as a wise long-term strategy for building customer loyalty. Clearly, there are many conflicts of interest issues at play. But that they are Goldman Sachs' interests may be a game-changing fact.