Let us harken back to the sub prime crisis, which quickly evolved into the Great Recession.And, which we warned about in our From the Northwest Quadrant blog, providing even the most recalcitrant investment managers sufficient time to sell all of these securities (though few did).
If you want to win at the sub prime crisis, why not have inside information?
Know about both sides of the trade at all times. And that goes beyond the alleged information shared between hedge fund maven Paulson and Goldman, while the Abacus CDO was being used to calculate profits.
Why not own the servicers and/or originators of subprime mortgages?
Then, you would know more about the underlying mortgages, their initial state and their ongoing performance, before anyone else on Wall Street. As we have read, this was the case for some investment banks.
Why not shield this inside information from potential investors by providing average statistics as a guide?
We have done an analysis, the investment banker would say, and the average FICO score of the pool is 720.
Of course, they do not tell you if the range of scores is 710-730, or if you have got one quarter of the pool with very low FICO scores offset by the remainder with very high FICO scores. Or, they do not bother to tell you how the FICO scores, themselves, can be gamed.
Or, how about, our analysis shows an average Loan to Value at origination of 77%.
Could that really mean that a quarter of the pool are LTVs of 100% and three quarters are at LTVs of 70%, before the heart stopping dives in real estate values we have seen?
Some investors, looking beyond the average statistics and doing their own detailed, independent research saw trouble coming in subprime years before it actually occurred. They wanted to short subprime, but, at first, there was no investment product or derivative available to them to do so.
That is where some of the large investment banks come in, developing tools like derivatives, CDOs and the like, at break neck speed and finding investors still ready and willing to take the long end of the subprime bet…including themselves.
Some investment banks were caught relatively unaware about how bad things would get and were slow to realize that the short end of the subprime bet would prevail. For Lehman and Bear Stearns, that approach contributed to their demise. For Goldman, coming to this realization allowed them to profit from the short end.
Back to the SEC charges:
Did Goldman commit fraud by not revealing the way in which Abacus was structured? Although determining fraud will be left to the courts and Goldman has always stated that it always operates within the law, it is likely we will discover that Goldman acted unethically.
Did other investment banks act in a similar fashion - effectively using inside information - to shape their opinion and investment philosophies about subprime? Of course, they did. It is pretty hard not to use what you hear from each side of a trade in making a case for the risk/reward position of your firm.
However, was there other inside information - beyond trading facilitated by investment banks - that was illegally used to fashion the firm’s investment stance? For that, we will rely upon the courts. However, the obvious ethical problems remain.
Investment managers owned by investment banks or broker/dealers always tell us there is a legal firewall between the bank and the manager and, this is undoubtedly true. However, the issue here is not legality but how ethically the firm acts. Do you want to deal with a firm (either as an investment manager or as a firm that your manager trades with) that acts unethically? And, where do you draw the line?
Hopefully, the SEC case against Goldman will not solely be discussed from a legal standpoint.
Caveat emptor is what comes to mind when dealing with investment managers, broker/dealers and others in the investment space.
And, as we have been saying for some time, you must spend time understanding the motivation of the group on the other side of the trade as well as their business model for generating revenues.
With the SEC action against Goldman, things may seem to have gotten a whole lot more complicated in the financial markets. But, it really has been like this for a very long time.
The question remains: How will you now practice caveat emptor? And will that practice prove up to the task?
