Would Financial Reform Have Stopped Goldman's Scheme?

The Goldman Sachs fraud case has been instantly and officially dubbed a momentum changer for the financial-reform bill in the Senate, an exemplary news peg for the legislation along the lines of the Anthem Blue Cross insurance rate hike in the run-up to health-care reform. On Friday, Tim Carney asked whether or not Sen. Chris Dodd's bill could prevent a fraud like the one Goldman allegedly undertook. While there is nothing in the law that makes lying about the quality of your products illegal -- that's already illegal -- what the bill does in a number of areas would make the scheme less likely to work and more likely to be detected. So...

  1. Goldman needed the raw material for their synthetic CDO, a collection of securities made from mortgages taken out by folks across the country, largely from unregulated independent mortgage lenders. The Dodd bill would create a Consumer Financial Protection Bureau to write new rules about industry practices that would makes these loans less likely to default, including prohibitions on loans that don't require the borrower to have an income or are negatively amortizing. While it's unclear how much of the investment vehicle included sub-prime loans, we have to assume it's quite a bit since hedge funder John Paulson, who helped design it, wanted loans that would fail. With the Dodd bill, he'd have fewer to pick from.
  2. The next step in the fraud is selling the designed-to-fail financial product to investors as a sound investment while sneakily buying insurance against it's failure so the bank wins at both ends. (That's the specifically illegal act in question). Right now, that insurance against failure -- credit-default swaps -- is bought between two institutions, with no real transparency. The only people who know about it are those involved in the deal. While it's not illegal to buy CDSs -- although it might be nice to make it illegal for people without an insurable interest in something to buy insurance on it -- you'd imagine questions would be asked if Goldman was taking an aggressively short position on their own product, betting it would fail.

    The derivatives language in the Senate right now would require derivatives like CDSs to go through regulated central clearinghouses. It also envisions them being traded on transparent exchanges. That way, not only do market participants and regulators have a picture of the deal that Goldman is making and asking questions about the quality of the products the firm is betting will fail, you also have someone monitoring their counter-party's ability to pay. That means, outside of the fraud situation, if those bonds fail, you (ideally) won't have to bail out AIG. The clearinghouse is responsible for ensuring that the firm has enough money to pay off its losses, otherwise other clearinghouse participants are liable.

  3. Consolidated supervision and the systemic risk council may play a role here as well; besides eliminating regulatory arbitrage, you are forcing regulators to a take a big-picture rather than institution-by-institution approach. That means they'll be sharing data and looking at broader trends. While before the crisis each agency mainly fretted about its aspect of the bubble -- the Fed and interest rates, the FDIC and local bank mortgages, nobody and independent mortgage brokers, the SEC with investment banks, etc., now they'll have a picture of the interplay between these markets that firms like Goldman straddle. The strategy they used to make money requires understanding of a macroeconomic trend, and regulators will be better positioned to pick up on it.

So while this bill can't forbid what's already been forbidden (lying about your products) it does make it harder for conditions to exist where this kind of bet will work, and also easier for regulators to see these deals in action rather than after the crisis passes. Incidentally, do read Brad Delong's excellent economic analysis of Goldman's alleged crime.

-- Tim Fernholz

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