Goldman Sachs Essays

Goldman Sachs Essays Goldman Sachs Essay Goldman Sachs Essay The Goldman Abacus Fund: Ethics You Can Count On Or Ethics That Don’t Add Up Set Up Imagine a physician is on the golf course with one of his colleagues, who happens to be a cardiologist. Somewhere on the back nine the cardiologist begins to tell the physician about one of his patients, a 52 year old man with blood pressure of 145/99, who is 40 lbs. overweight, chain smokes, and enjoys 7 to 8 martinis a day. In spite of medications, in the words of the cardiologist, the patient is â€Å"a ticking time bomb. The first physician asks for his friend’s patient’s personal information, and after the golf game, goes to see his State farm agent, where he takes out a 1 million dollar life insurance policy on the ‘time bomb† guy. Are the actions of the physician ethical? Taking out such a policy is of course illegal, as the doctor does not have what is known as an insurable interest. But assuming the doctor took no steps to encourage th e man’s death, under the theory of rational egoism his actions would be justified. Furthermore, as macabre as the doctor might seem in betting on the death of another human being, Sternberg would consider his actions to be within the realm of ordinary decency. In 2007, amid historic economic development, a scenario emerged similar to the one just described. Although the players and events were quite different, the same philosophical question was raised: is it ethical to benefit from someone else’s demise. Living in a society riddled with envy and resentment, many onlookers thought so. Two parties in particular did not. They were John Paulson Co. , a hedge fund company established in 1994, and Goldman Sachs Co. a global investment banking and securities firm founded in 1869. The Events The story has its beginnings in 2005 when 49 year old Paulson, a man with a Wall Street reputation of mediocrity, hired an out of work analyst, Paolo Pellegrini. Pellegrini’s job was to crunch numbers on a befuddling trend which â€Å"everyone† seemed to be maki ng money on except Paulson (Zuckerman). After a year’s worth of late nights, Pellegrini determined that not only were housing prices soaring independently of interest rates and well beyond the pace of inflation, but that when the bubble did pop, it would send home prices down more than 40%. : When Pellegrini showed his charts and figures, Paulson couldn’t believe his eyes. Finally the housing market boom made sense to him. What also made sense to him was the market’s inevitable crash. Paulson had to find a way to make money on this prediction. Initially Paulson and Co. bought large lots of credit default swaps, which in effect were insurance policies against â€Å"risky† subprime mortgage debt (Zuckerman). Paulson was paying up to an 8% premium to guarantee against the default of mortgages he didn’t even own. Paulson and Co. spent months accumulating these mortgage insurance policies before deciding that the process was too slow. Paulson needed another way to short the housing market, preferably one with great leverage. A collateralized debt obligation seemed to be the perfect means to Paulson’s desired end. To understand how Paulson was able to make a $15 billion profit on his market prediction, a closer look at the 3 main financial instruments used is needed. Residential Mortgage Backed Securities (RMBS), Collateralized Debt Obligations, and Credit Default Swaps are all financial instruments used by both commercial and investment banks. RBMSs are bonds which are backed by a pool of residential mortgages. These bonds have different ratings based on the default risk of the varied prime and subprime mortgages. Even though the initiating bank may continue to service the loan to the homeowner, the mortgage itself will likely end up being sold again and again, often being pooled as an asset base to compose a RMBS. Collateralized Debt Obligations are securities collateralized by debt. Basically, a CDO is where a financial institution bundles a bunch of debt and sells it as a package to other financial institutions (Stephen D. Simpson). CDOs commonly take RMBSs a step further by packaging a series of them into one portfolio. The CDO collects cash from the pool of bonds it contains, and from this cash, distributes interest and principle payments to the CDO’s investors. If the underlying securities fail (as in the case of a defaulted subprime mortgage), the investors lose the money they put into the CDO. In the case of the Goldman Sachs Abacus deal, rather than a cash-based CDO, a synthetic CDO was packaged. A synthetic CDO differs from a CDO in that it does not own the underlying asset (portfolio of bonds). Instead it uses credit default swaps to mimic the risk associated with the assets (bonds) listed in the portfolio. A credit default swap is a means to achieve risk transfer from the bond holder to another party. When a bond holder buys a CDS, he is buying insurance against the bond defaulting, by paying a series of premiums to the CDS seller. In the event of default, the CDS seller must compensate the bond holder with the face value of the bond. Back in 2006, these vehicles were viewed as free money. Many economists and banking institutions believed the U. S. had reached a period of indefinite, sustained growth, meaning the likelihood of mortgage default, even at the subprime level, was low. The top banks, with presumably the most savvy, sophisticated money managers in the world, took advantage of this by heavily participating in these high leverage instruments. In 2005, senior traders from Bear Sterns to Goldman Sachs shared the sentiment that the housing market was solid and in no danger of collapse. By December of 2006 however, though not going public with its stance, Goldman decidedly turned bearish on the mortgage industry. Early in 2007, Paulson approach Goldman requesting that they structure a CDO with (allegedly) the inclusion of 123 hand-picked RBMSs which Paulson believed to be most likely to default (Quinn). He also asked Goldman to help him find another party who would take the other side of his desired market position. Goldman agreed, was paid $15m in fees by Paulson and Co. , and Abacus was born. Goldman assigned 29 year old a junior bond trader named Fabrice Tourre with managing and promoting Abacus to investors. Tourre approached IKB Deutsche Industriebank, who expressed interest only if a third party choose the RMBS. As such, Goldman enlisted ACA management to choose the RMBS which would compose Abacus. At this point, Tourre allegedly led ACA to believe that Paulson was going to invest $200M into Abacus. Thinking this, ACA also directly invested $42m into Abacus and took on the role of insuring $909M worth of credit default swaps; (unknown to ACA, Paulson was on the other side). With a third party (ACA) now selecting the RMBS, Tourre convinced IKB to invest $150M into Abacus. Ultimately these were the events which led the SEC to file charges against Goldman on April 16, 2010. The Outcome A year after Abacus was assembled and marketed, Paulson’s prediction came true. 99% of the CDO had been downgraded, rocketing the value of the credit default swaps he bought. John Paulson netted $1bn. n what Gregory Zuckerman of the Wall Street Journal would call â€Å"the perfect trade. † IKB lost nearly its entire investment of $150M. ACA Management lost $841M. When the dust settled, eyebrows were raised and eventually charges were filed. Goldman was charged with fraud in structuring and marketing of a CDO which was secretly intended to fail. The fraud charge alleged that Goldman allo wed Paulson to strongly influence ACA in selecting the RMBS which would make up Abacus. The charge also alleges that ACA was deceived to think that Paulson had an interest in the CDO’s success rather than failure. Paulson was not charged and has maintained that ACA â€Å"had sole authority over the selection of RMBS in the CDO (Quinn). The Facts ACA Management was both the portfolio selector and the largest investor to Abacus. Owned by one of the largest banks in Europe, ABN Amro, ACA management specialized in CDOs and portfolio selection. Put another way, they knew exactly what they were getting into, they just happened to be wrong. Paulson had been unsuccessfully â€Å"betting against† the housing markets since 2005. During 2006-2007 insurance against defaulting mortgages (CDS) became extremely cheap. During the period, many banks were selling CDS to collect what they saw as low risk insurance premiums. ACA was to collect $1,545,300 in premiums per year through insuring Abacus. Paulson’s role in Abacus was not made clear to investors, but the anonymity he maintained is both legal and commonplace on Wall Street. All the players at the table were among the most sophisticated banking institutions in the world, which could not be better equipped with experts to perform the due diligence of investigating a prospective investment. Ethical Analysis In a 2009 Rolling Stone article, Matt Taibbi accused Goldman Sachs of being â€Å"a great vampire squid wrapped around the face of humanity,† Goldman he states, was the cause of the housing bubble through creation and use of financial instruments such as CDOs and CDSs (TAIBBI). The dramatic description hardly instills an image of ethical behavior. But is it true? Taibbi has it backwards. The Housing and Community Development Acts of 1974, 1982, and 1987 had been making mortgages easier to obtain long before the 1994 invention of Credit Default Swaps, (although the first CDO was issued by Drexel Burnham Lambert in 1987) (Frej). It is because we live in a society where there exists too much envy and resentment that media figures such as Matt Taibbi point the finger at those who succeed, and scream â€Å"hey, that’s not fair! † When people defaulted on their home mortgages, it was not because of Paulson or anyone else making money. It was because of their own greed and desire. People acted like children giving in to the impulse to grab the â€Å"shiny object† i. e. large mortgage, when in fact it was their responsibility to perform due diligence and conclude whether or not such mortgages were financially feasible. Was it unethical for Goldman/Paulson to benefit by means of others’ demise? Just as in the opening example of the patient who was certain to die, so too were historical numbers of mortgages destined for foreclosure. And while wealth creation is not a zero sum game, equity trading often is; every buyer needs a seller. ACA management and IKB were trying to profit by knowingly taking risks. They lost. For Goldman and John Paulson, it was â€Å"just business. † There were no intentions beyond profit maximizing, nor did they act in any unfair or unethical way. Goldman and Paulson did their best to maximize the long term value for their investors in a business designed around risk. In the end it was Paulson and Company’s countless hours of research and study which led them to the decisions they made. Had anyone else done the same, they likely would have gained similar compensation. This would be in line with Sternberg’s principle of distributive justice. Conclusion There has been recent talk from the likes of Warren Buffet to Barack Obama about the evils of complex financial instruments. They say CDOs and CSOs should be banned or at least controlled with more regulation. This is a much too simple solution to the problem of financial responsibility. If CDOs and CSOs get banned, another instrument with the same potential effect (good or bad), will be right around the corner. Living in a period of record government hand-outs, it is no wonder people think everything either is free or obtainable with minimal effort i. e. mortgages. Financial responsibility must be taught at an early age, whether at home or at school. The path away from any future financial crisis will be seen when people have an understanding of money and make gains through distributive justice.