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Op-Ed BatteryPark.TV, April 22, 2010
One of the key defenses used by Goldman Sachs in the SEC fraud case is that sophisticated institutional investors purchased the mortgage derivative product it sold, known as Abacus, and should have known better. “Mom and pop” investors were not scammed. Goldman Sachs is correct (although they may still be guilty of not disclosing the little tidbit about the hedge fund Paulson & Co. choosing the composition of Abacus as it simultaneously shorted the product).
How were these “sophisticated investors” duped so badly? For that matter, how did Merrill Lynch, Lehman Brothers, Bear Stearns, Citigroup, etc. all get stuck owning so much toxic debt?
Herd mentality creating a false sense of security is the fundamental reason most of Wall Street, the Fed Chairman, the Treasury Secretary, the President of the United States, and the rest of the world, were all caught off guard. Goldman Sachs was unquestionably the smartest firm with the best reputation at the time and was leading the way in creating various types of derivatives related to mortgages. The lesser firms followed Goldman’s lead.
In 2007, BatteryPark.TV attended a Citigroup conference at the Waldorf Hotel. One of the speakers was from a prominent private equity firm. He commented how surprised he was at the demand for CDO products and how little the “sophisticated investors” cared about the quality of the mortgages. They just wanted instruments to help them make hedges in their portfolios, he said.
This conference took place more than a year before the collapse of the markets but not many prop-traders at the Wall Street banks seemed to heed the warnings. Ironically, Citigroup, host of the conference, would later become decimated and nearly liquidated by the bad CDO debt on its books. Only a $45 Billion government bailout saved them (of which, $20 B is still owed).
Like all bubbles, many people actually trading the CDO’s knew better, but were lured into the risk because everyone else seemed to be doing it. Their highest supervisors condoned the behavior. How could such incompetent traders within Wall Street banks be allowed to “prop trade” such risky derivatives? Warren Buffet called derivatives, “weapons of mass financial destruction”.
In a previous commentary (A Case to ban Prop Trading), the perverse incentives of Wall Street that reward cronyism more than competence are described. As a result, people with little to no experience with derivative trading in real hedge funds were put in charge of the purchasing and trading of these complex financial instruments. The same people are under immense short-term pressure to make profit regardless of future risk. As a result, Wall Street broker dealers practicing proprietary trading were the biggest suckers in the game purchasing the junk that Goldman Sachs was selling. Meanwhile, Goldman was going short on the mortgage market taking an opposite bet to the banks buying its products (e.g. the Abacus tranche of CDO’s).
One of the main components of the “Volcker Rule” that may become part of the final financial regulatory bill supported by President Obama will be a ban on “prop trading” by banks. It seems prudent to separate the trading of equities and derivatives from the unqualified executives working at the hybrid Wall Street/bank firms. They have proven their incompetence many times over the years.