Goldman, Fraud, and Philosophy

A number of you have may be wondering why the Goldman fraud case is worth following in close detail. So in this rare Sunday morning edition I will explain why I, for one, believe that the SEC case against Goldman represents a sea change for us all.

The most intriguing implication of the case is what it means for the role Wall Street plays in the economy.

As I have said here before the social purpose the banks play is to move capital around the economy. They collect it from people who have excess cash and allocate it to people who have a need for cash above their own ability to generate it. The simplest way of doing this is to make a loan. Other ways are to help raise equity or debt in the money markets.

The reason we tolerate banks in this intermediary role is that the have access to sources of money and information that we do not. Their presence saves us all the task of gathering that information ourselves. In effect we ‘economize’ our own costs by relying on the banks. Since we cut our costs through this reliance we free up cash, some of which we use to pay the banks for their services, and some of which we simply pocket.

So the banks make the economy more efficient by acting as middlemen in the gathering and disbursing of cash.

They add to this value by building up their expertise in risk management. This skill allows them to identify opportunities for the cash they gather. They then are more able than the rest of us to channel cash towards the best, or most profitable, ways invest.

So the banks play a crucial role in making sure that society’s spare cash ends up going to the projects and other uses where it will have the greatest impact.

This is what I mean by Wall Street’s social purpose.

The bankers don’t set out to be socially useful, but if they play their role properly they end up that way.

This simple model is the time honored description of banking.

And it went horribly off track in the last ten years.

The Goldman case tells us that the bankers at Goldman – and their various shadow bank associates – decided that they stood to make more profit, not by channeling cash towards constructive projects – lending to a company so it could build a new factory – but by channeling it into toxic assets that they knew in advance would collapse in value.

This was a total perversion of the hostoric role of banking.

The idea was to shovel cash into rotten assets and then to insure against the loss in value of those assets.

For the scheme to work well Goldman needed partners and customers.

Its partners shared in the scheme by helping collect the necessary toxic assets. In the case being pointed to by the SEC these assets were sub-prime mortgages. The primary partner was Paulson a huge hedge fund.

Between them Goldman and Paulson built a securitized asset whose value resided in the collateral of its underlying mortgages. That’s why you see the phrase ‘Collateral Debt Obligation’ or CDO crop up in this case. The problematic asset is also sometimes referred to as a ‘Residential Mortgage Backed Security’ or RMBS.

Forget those silly acronyms and focus on the philosophy adopted by Goldman and Paulson: they had determined they could make more profit by selling an asset they knew was going to prove to be worthless. Instead of the profit motive motivating constructive use of capital, it motivated a destructive use.

In a sense both Goldman and Paulson were acting very smartly: after all they were not the idiots who made the bad mortgage loans. They were merely exploiting what they saw as the imminent collapse in value of those bad loans.

Their fraud is not that they took advantage of the bad lending of the banks who had made the bad loans, but that they sought to profit from their ability to move those bad assets into a CDO and then sell it on to unsuspecting customers – traditional customers of Goldman – who would not have known the danger they had put themselves into.

So instead of acting as a positive intermediary, Goldman set out to the exact opposite: to profit by moving losses onto its customers balance sheets.

Paulson made billions from the collapse in the sub-prime market by betting against it. This is not illegal. Indeed it is very smart.

Goldman made billions also. But no it appears that it did so by deliberately misleading its own customers.

RBS the near failed UK bank alone lost almost $880 million from the deal the SEC is focusing on. It was one of many such losses that drove RBS into the UK government’s hands. British taxpayers have a particular interest in the Goldman case – they ended up bailing RBS out.

Another Goldman customer sold down the river was a German bank, and now we hear that the German government is thinking of launching its own law suit against Goldman.

The perversion of the normal socially positive role played by the banks into the cynically negative one directs our attention to the way in which wall Street has innovated over the last few years. It has invented all sorts of tricks in with which it can inoculate itself against lost value. Some of these tricks allow it to exploit its own customers. More to the point, they allow Wall Street to gain more from a downturn and from lost asset value, than from working hard to locate positive and constructive uses for the cash that flows through its hands.

Wall Street has become the anti-social actor its critics often argue it is. It not only gains when Main Street loses, but it now seeks to ensure that Main Street fails in order to make that gain. It sets out to undermine the economy for its own private gain.

Anyone who studies economic theory will realize that this perversion of value also undermines the long standing view first articulated by Adam Smith that the accumulation of selfish acts ends up producing a socially beneficial outcome. This is the central premise upon which free market economic theory rests.

Now we all have to re-think that premise: Goldman’s pursuit of its own self-interest did not contribute to a socially beneficial outcome. On the contrary, it undermined it. The American economy ended up being devastated by the cynicism of Wall Street. Billions upon billions of capital was destroyed by schemes like the one the SEC is examining. That lost wealth has left the economy short.

By eschewing the hard work of searching for positive uses for capital Goldman betrayed its role as a socially beneficial actor. It fell prey to the cynicism and negativism of Ayn Rand’s ‘anything goes’ philosophy. Rand’s simple minded lunacy has misled many people through the years. Her denial of social values as separate properties of society outside of private interests, was a thought of supreme simplicity and blindness to reality. It led Margaret Thatcher to make the statement that ‘society doesn’t exist’ – only private citizens exist. This extremist vision of the ‘individual’ as the sole actor on the social stage infested policy thinking in both the UK under Thatcher and the US under Reagan and Bush.

And it leads inevitably to the kind of self-serving cynicism that informs the thinking at Goldman and Paulson when they set out to defraud Goldman’s customers.

This is why the cure for all that ails our economy requires a thorough cleansing of Wall Street. Indeed if we are to save our version of capitalism at all we need to eliminate the scourge of Randian cynicism that undermines it through its portrayal of social values as antithetical to a person’s ability to pursue self-interest.

Banking needs to be built upon trust.

Trust is a socially constructed value: it belongs of all of us. It is not private property. We trust one another. We rely upon each other to behave within socially accepted norms. Without the collective identification of trust the individual possession of trustworthiness is meaningless.

For banking to return to its socially beneficial role we need to restore a philosophical balance between the roles and responsibilities of society and its individual actors.

Goldman’s exploitation of its own customers is a tragic example of what happens when we lose that balance.