by David Dreman
Although there were many players, Goldman Sachs was the superstar, according to the findings and e-mails that were released publicly by the various Senate and House committees investigating the crash and meltdown. Goldman’s research in finding the worst groups of subprime or Alt-A mortgages in the marketplace was outstanding. It could then short them to its clients or other buyers, making a killing when they dropped. To get the maximum odds, it wanted to discover not only the poorest issuers of this junk—and there were dozens of them—but the absolutely worst issues each had put out.
To do this, its analysts scoured through every series of mortgages of each bad issuer with a high credit rating. Overall, their detailed research covered thousands of individual series of mortgages. Which of each poor issuer’s mortgages, for example, had the worst “Ninja” series, combined with a high rate of negative amortization or other debilitating options, to give Goldman a strong possibility of higher default rates, regardless of how high a credit rating they had been assigned? Dozens of other tools were used by Goldman’s highly sophisticated multimillion-dollar-plus research and trading teams. All were out to bag their regular clients or any other potential victim who showed enough life to sign a derivative contract. Goldman was not alone; many of the banks noted above played an identical game, but unquestionably this firm was the champ.
One of its biggest wins was AIG. Goldman and a syndicate of bankers bought credit default swaps, which effectively resulted in their shorting mainly AAA-rated but very poor quality subprime mortgages to AIG, the buyer. The giant insurance company’s losses were so huge that it was on the brink of bankruptcy. The New York Fed, then under Timothy Geithner, stepped in and paid the syndicate of banks 100 cents on the dollar, or $62 billion in all.*90 The inspector general of TARP, Neil Barofsky, stated that the Fed, using taxpayers’ money, had overpaid Goldman and the rest of the syndicate by tens of billions of dollars, but that is another story.*91
Goldman was bearish on the subprime market and watched it begin to turn down in the fall of 2006. The company wanted to get out of its remaining inventory quickly. The market for subprime was becoming increasingly illiquid, and the sale of its inventory would be difficult and probably go at a sizable discount. What to do? Easy: sell to its own clients. As Table 15-1 shows, Goldman sold six issues totaling $6.5 billion, all from its own inventory, to clients. The six new issues of subprime mortgage pools were quickly brought to market in late 2006 and early 2007. Five had AAA ratings on 70 percent to 80 percent of the overall issue.
Goldman knew that the ratings would collapse because of the poor quality of the holdings, since it had been instrumental in getting high ratings on many of them from the rating agencies and had researched them all thoroughly. The largest issue was Hudson Mezzanine, which, although subprime, contained 72 percent of supposedly AAA mortgages. The issue dropped more than 50 percent in less than a year, and Goldman made major money on its sale, while its clients lost a big chunk of their own investment.
In early 2007, as the subprime market began to crumble, Goldman moved quickly to increase the sale of its toxic inventory to clients. Hudson Mezzanine was followed by two more deals, Anderson Mezzanine 2007-1 and Timberwolf 1. In total these two underwritings raised $1.3 billion. What did the clients buy in the “synthetic” packages? Naturally, more of the lethal inventory that Goldman wanted to bail out of. “Boy, that Timberwof [sic] was one shitty deal,” wrote Thomas Montag, formerly the cohead of the global securities business at Goldman, according to the Levin subcommittee.29 To sell it, the head of Goldman’s Mortgage Department, Daniel Sparks, sent out a mass e-mail promising its sales force “ginormous credits” for disposing of these tainted securities.
The Hudson Mezzanine 2006-1 deal was rated AAA, the highest credit rating that Moody’s gives, although it had a major slug of subprime instruments in it. The subprimes were quickly downgraded, and investors lost the majority of their capital, as Table 15-1 shows. Look at row 3, which shows the highest credit rating for the issues in early April 2010, prior to their being sold to Goldman clients. Of the six issues, all of which contained sizable AAA portions, credit ratings had been entirely withdrawn by Moody’s for two, Hudson Mezzanine and Timberwolf 1. Three others, Long Beach Mortgage Trust 2006-A, Anderson Mezzanine, and Abacus 2007-AC1, were lowered to low junk ratings; only GSAMP 2007-FMI, although downgraded significantly to Baa2 by Moody’s, was just barely above junk status. Finally, the underwritings were downgraded very quickly by the credit agencies, the average time being remarkably short—six months.
Obviously, given Goldman’s sterling record for integrity in the recent past, it would be hard for any of us not to accept the statements of Goldman’s CEO, Lloyd Blankfein, made at the various congressional committee hearings, that Goldman had not been using its formidable research and marketing clout to its benefit against that of its clients. It would be even harder not to accept that a good part of the $11 billion in bonuses Goldman paid out for its 2008 year in early 2009 could not have come from its subprime businesses. Blankfein testified to the committees that the firm had lost money there.*92 Where it had come from was never quite answered.
Subsequently, in mid-2011, Blankfein and other officers hired criminal attorneys when the United States began a probe of matters raised by the Senate’s Permanent Subcommittee on Investigations. The subcommittee report accused Goldman Sachs of misleading clients about complex mortgage-related investments. The subcommittee chairman, Senator Carl Levin, also alleged that Blankfein had misled Congress.30 Other lawsuits have been filed on a number of highly rated issues Goldman sold or shorted to its clients from its inventory in this period. The odds played by Goldman short selling to its own clients seem above those of the hypothetical casino in the chapter’s opening paragraph.
Goldman Sachs was not the only investment bank that was flagged by the House and Senate subcommittees in the 2010 hearings for this type of trading. Investigations are also being carried out at the time of this writing on Morgan Stanley and Citigroup. Goldman has also made a large settlement with the SEC entailing a payment of $300 million as a fine and $250 million as restitution to the institutional investors involved.
Not only did Goldman and probably many other banks not share the information about those investments with their clients, as was their fiduciary responsibility, but, as we have seen, they actually sold those securities to the clients. Though doing so may not be have been illegal, it certainly seems to have been a breach of ethics that is unforgivable to most. Just as bad, the firm and many others sold tens of billions of dollars’ worth of low-quality mortgage-backed securities to their clients in new underwritings when they believed the subprime market was on the verge of collapse. An underwriter has the fiduciary obligation both to provide his clients with his views on the state of the market and to sell them securities he believes are very solid. Goldman and many other firms did neither.
Ironically, in the financial panic beginning in September 2008, there was a run by investors on their assets at Goldman Sachs and Morgan Stanley. The firms were saved only because the Fed transformed them into banks and extended major credit to them, as it was also forced to do with Citigroup. The bailout provided more capital to many of the major domestic banks involved as well. Most of the banks that had been instrumental in causing the crash came out whole, while all too many Americans suffered badly.
Are there lessons here for you as an investor? I think there are several. First, the banks resisted financial reform at every step, in spite of the bailout and the damage they caused. Financial reform will help, but, as noted, it’s not perfect; nor has the SEC taken aggressive steps on the matter of conflict of interest—and this seems surprising when it is all over smaller investment firms for even minor technical infractions.
You should stay away from complex products offered by investment firms and banks. If you stick to contrarian strategies, you will be much better off over time. Also, with products not regulated by the SEC, take underwriting ethics with
a grain of salt regardless of what you buy. The underwriters at banks and investment banks certainly do.
Chapter 16
The Not-So-Invisible Hand
ADAM SMITH, THE father of free-market economics, wrote about an “invisible hand” in his magnum opus The Wealth of Nations, published in 1776. The invisible hand, which guided resources and capital to where they would be most productive, is one of the best-known images in economic literature. In Smith’s words, man “neither intends to promote the public interest, nor knows how much he is promoting it . . . He intends only his own gain . . . led by an invisible hand to promote an end which was no part of his intention. . . . By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”1
Smith was, of course, the major figure in the development of laissez-faire economics, the purest form of free enterprise. He was strongly opposed to monopolies and cartels and warned repeatedly of their “collusive nature,” which would fix “the highest prices which can be squeezed out of buyers.”2 Smith also warned that a true laissez-faire economy would quickly become a collusion of business and industry against consumers, which would scheme to influence politics and legislation. So things seem to have turned out pretty much as Adam Smith foresaw.
The last few decades of the twentieth century and the first decade of the twenty-first were a time of economic experimentation for the United States—not at the command of big government or as the result of a clamor for change by the general public but as a result of the great American belief in the power of free markets. This faith was amplified by many leading economists and financial professionals and championed by both Republican and Democratic administrations from at least the time of Ronald Reagan.
Intrinsic to that faith in the market is trust in the operation of an “invisible hand” to guide buyers and sellers to the best possible outcomes. Whether it is housing, autos, construction equipment, goods at Wal-Mart, or products available from online retailers, the market mechanism adjusts supply and demand to reach fair prices, equitable distribution, and socially beneficial results. At any rate, that is the basic theory.
But is the invisible hand currently all that, well, invisible?
In short, some market participants are greatly tempted to “help” the invisible hand reach outcomes favorable to their own personal interests and wallets. This is the sort of anticompetitive behavior and market monopolizing that has been resisted with only partial success in the U.S. economy for generations.
Adam Smith clearly understood the dangers of monopolies and the necessity of their regulation—unlike our Mr. Greenspan, who as we saw in the preceding chapter, despite his reverence for the master, seems to have been more influenced by the school of absolute economic freedom espoused by Ayn Rand. Ironically, the founder of laissez-faire theory would be likely to side with the old trust-busting policies of Teddy Roosevelt in addressing these problems. We saw where Mr. Greenspan stands on this one.
Though the era of unfettered deregulation now seems over, one debate between the invisible hand and the helping hand, if you will, remains as fiercely fought as ever. That is the issue of “free trade.” A cause célèbre of long standing, it’s now an issue amplified by the concerns of a global economy, and how it plays out in the years ahead will have a formidable potential to enhance or disrupt every investor’s holdings, whether domestic or foreign. When it comes to investing, there’s no doubt that it’s a global world, with an unprecedented level of interconnectedness among the major economies.
Given the world we must deal with, there are two subjects that should be of particular concern for all investors in trying to protect their investments in the global economy. These are the investment implications for the future of free trade (with the related conundrum of fair trade) and the ominous signs of future inflation, the monetary dragon that can never be permanently slain.
The Case for Free Trade
Naturally, Adam Smith was a strong believer in free trade. He opposed the efforts of Alexander Hamilton, our first secretary of the Treasury, to put up barriers to protect the United States’ infant industries in the early 1790s, as he was convinced that the country would benefit more by the open export of cheap agricultural commodities, where it had a strong comparative advantage.3
The law of comparative advantage has been the core of free-trade belief for almost two hundred years. It was first put forward by David Ricardo, an English economist, in 1817.4 Ricardo used the example of England and Portugal to illustrate his thesis: Portugal can produce wine and cloth more cheaply than England. But in England wine is very costly to produce while cloth is only moderately more expensive. Even though it’s less costly to produce cloth in Portugal than England, it is cheaper still for Portugal to produce more wine and trade that for English cloth. Portugal then has more of both. England also benefits from this trade because its cost of producing cloth is still the same but it can now get wine at a cheaper price, coming out better on the deal. Thus each country can gain by specializing in making the products in which it has a comparative advantage, and trading that good for the other.5
Free trade has been one of the most debated topics in economics for the last two hundred years, on economic, moral, and sociopolitical grounds. A recent survey in this country showed that as many as 65 percent of those surveyed were against it. Surprisingly, in high-income groups the percentage is even larger.6
In the last few decades, numerous new theories have come out that favor or disfavor free trade. The law of comparative advantage has been challenged, even by numerous new hypotheses that favor free trade. Paul Krugman writes: “Free trade is not passé, but it is an idea that has irretrievably lost its innocence. . . . There is still a case for free trade as a good policy and as a useful target in the practical world of politics, but it can never again be asserted as the policy that economic theory tells us is always right.”7
Are We in a New Era of Free Trade?
There is one area where the invisible hand continues to face fewer restrictions in this country, even though it sometimes functions poorly. That is free trade. Ricardo’s thought, which was true in his time, was that the masses in the Far East and other remote, underdeveloped regions would never be a part of the international labor force. In any case, even if they could be, the cost of shipping raw materials to them and finished goods back to Europe would make the final prices prohibitively high. In the last six decades, however, technology and skilled labor in those nations have turned what was true in the early nineteenth century upside down. Ease of transportation, highly skilled and educated workers, and easy movement of machinery to any country have dramatically lowered the costs of production in Asia and elsewhere.
The result is that higher-wage countries such as the United States are at an enormous disadvantage relative to their low-paying counterparts. In 2008, the average U.S. hourly pay was $18.00. When benefits of $3.60 an hour, including the Social Security tax of 6.2 percent, are added, the average U.S. working hour costs the employer about $22.90. Compare this figure with the average wage in China in 2008 of $2.00 an hour, in Indonesia of $.65 an hour, in India of $.41 an hour, and in Thailand of $1.67 an hour.8
The cost of one hour of labor of a Chinese employee is less than 9 percent of the cost of a U.S. employee. In fact, the Social Security tax on the average U.S. hour worked is almost two-thirds of the average Chinese worker’s wage and more than three times the average Indian worker’s wage. Taking this a step further, in a perfectly competitive world, if there are 150 million workers in the United States and two billion in China, India, Indonesia, and other low-wage Asian countries, the average wage for an American worker manufacturing the same product would have to drop very sharply to be competitive: from $22.90 an hour to a small fraction of this.
This is a worst case scenario, as many jobs obviously cannot be exported, but unfortunately, it contains far more than a grain of truth. It is the reason we are outsourcing millions o
f our best jobs abroad and will continue to do so in the future. Ricardo could not foresee the future, and most contemporary economists have not focused directly on this problem, which has a number of thorny aspects.
To begin with, American consumers, along with those in almost all countries, want lower-priced goods of equal or even higher quality. This demand fueled the rise of Wal-Mart from a start-up forty-five years ago to the largest chain in the country today. The Wal-Mart revolution has spread to thousands of other businesses in dozens of sectors, all of which must make or sell low-cost products.
Second, low-cost foreign labor allows many businesses to stay competitive with foreign firms. The U.S. auto parts manufacturers were at a competitive disadvantage for years because their foreign counterparts could supply parts at lower prices. The American Big Three had to force a good number of suppliers to open plants in Asia or be dropped. Building plants abroad was the way to survival for many hundreds of industrial companies.
Increasing cost pressures on other industries, plus the natural desire to increase profit margins, have also led U.S. business to use lower-cost services abroad. India, where English is the second language and often the first, is a natural provider of these services. Customer service is provided there for dozens of companies, from United Airlines’ reservation, departure, and arrival information to American Express’s credit card information to hundreds of other companies’ customer service help lines. All displace American jobs at significantly lower wages. But the range of services can also be much broader and more sophisticated: U.S. firms needing software engineers can get the work done for about $10,000 a year in some cases, against the annual cost of $80,000 to $90,000 for a U.S. engineer. Brokerage firms can ship over the daily processing in some departments after the market closes and receive the completed results early the next morning. A good deal of routine accounting can also be e-mailed to India, with the completed work returned promptly at a much lower labor cost.