In Defense of the SEC's Case Against Goldman Sachs.

sec_logo.jpgAlready, there is plenty of independent push-back against the quality of the SEC's case against Goldman Sachs. As someone whose initial reaction was that this is a very hard case to prove, I don't necessarily disagree. But the arguments that people are making about the SEC's case seem to miss the forest for the trees.

For one, everyone seems to be taking at face value the claim that Goldman wasn't warned about the suit or given a chance to settle. However, the SEC says talks began with Goldman about this case last summer and the firm did receive a chance to settle. I'm not sure why everyone is presuming that Goldman Sachs is telling the truth in this disagreement, but we'll find out as the case moves forward.

Second, while the timing of the case's announcement certainly raised eyebrows, it's hard to see how SEC Chair Mary Schapiro, a regulator formerly derided as an industry stooge, became a partisan demagogue overnight. It's also very strange to see people, some of whom have complained extensively about bipartisan inaction by regulators, get worked up about the commission's partisan vote to launch the case. Now the SEC is actually doing something, but the problem is that they're not following Marquess of Queensberry rules?

As to the case itself, as Sebastian Mallaby writes,

[T]he SEC asserts that Goldman, and specifically its young mortgage whiz, Fabrice "Fab" Tourre, tricked ACA into believing that [hedge funder John Paulson] meant to bet on the mortgages' soundness, not the other way around. This is the nub of the case, and if there's proof that Goldman or Tourre was dishonest, the SEC could yet emerge with its reputation intact. But none of the e-mail fragments quoted in the complaint comes close to being a smoking gun.... What the complaint does show is that ACA believed Paulson was a buyer, not a seller; and the really intriguing mystery is how ACA could have been so dumb.

So Mallaby says that taking advantage of a fool isn't illegal. But Goldman's defense so far is that they only dealt with "sophisticated investors." The really intriguing mystery here isn't how ACA "could have been so dumb," but why they thought Paulson was betting on the mortgages' success. That seems well worth an SEC investigation to me, and I'm not sure why looking into that is irresponsible.

Consider the complaints about the case from President George W. Bush's SEC Chair, Harvey Pitt: The SEC is going after the "premier firm" on Wall Street. The audacity! These parties are too sophisticated for SEC protection. He'd better check with Mallaby about that. They investigated for a year and a half. Too quick? And he repeats the partisanship and no-warning canards. I don't know too much about Pitt's background, except that he was the SEC Chair during the Enron scandals; perhaps his list of objections to the SEC's current case explains why Enron was such a debacle.

Whether or not the SEC can specifically prove that Goldman Sachs misrepresented these complex securities, the case is important simply because it tells us exactly what happened during the financial crisis: Artificial, complex securities were created in shadowy circumstances by people who may or may not have understood them and used them to drive a massive housing bubble. When they failed, taxpayers had to bail them out. This is the same kind of deal that led to the AIG bailout; the insurer is even considering a lawsuit against Goldman because of these new revelations.

Here's the real nub of the case: There are still many questions surrounding the specific deal in the SEC case and deals like it; the SEC -- in charge of making sure the public and investors are protected from financial malfeasance -- could not gain sufficient understanding of the situation after 18 months of private discussions with Goldman Sachs, and filed a civil suit because it had reason to believe fraud occurred and wished to find out the truth. The commission is doing its job, nothing more.

Update: Via Clusterstock's Joe Weisenthal, I see that Pitt actually worked for Paulson in 2008, while these deals were ongoing. It wasn't disclosed at the Daily Beast; I have inquiries out for more information. 

Update to the update: The Daily Beast runs the following Editor's Note: "An earlier version of this article neglected to note that Harvey Pitt has done work for hedge fund manager John Paulson, who helped Goldman Sachs develop the product at the center of the SEC’s case but has not been sued in the matter.  We regret the error. Mr. Pitt noted: “I had no involvement in these transactions nor with the SEC's decision whether, and whom, to sue. My article doesn't mention Paulson or discuss its role, other than to paraphrase the SEC's allegation.”

- Tim Fernholz

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