BUSINESS CLASS: The Gold, the bad and the ugly

This week our travels take us to Wall Street, where investment banks are being cast as terrorist cells, star fund managers are being demonised and where regulators are looking at things they shouldn't.

It's taken a while, but finally the GFC has a villain it can put a face to. Well, several villains, really; with Goldman Sachs being cast as the evil HQ of the investment banking universe, "Fabulous" Fabrice Tourre as the young Goldies henchman, drunk on power and greed, and John Paulson, whose previous role as the smartest investor ever is fast mutating into that of mercenary fund manager who cashed in on America's mortgage debt misery.

The US Securities and Exchange Commission, perhaps a touch distracted back in the winter of 2007-08, has seen fit to charge Goldman Sachs and Tourre, the vice president it has deemed "principally responsible", with securities fraud, last week alleging that they "structured and marketed a synthetic collateralised debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS).

The charge continues to claim that Goldman "failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO"... because they were, ahem, rubbish.

From the outside, it doesn't look too flash. But what's the feeling among the business folk of the interwebs?

"If the SEC case is true, this was a scam – nothing more, nothing less," writes Will Hutton in The Observer. "This is a used car salesman flogging a broken car he's got from some wide-boy pal to some driver who can't get access to the log-book. Except it was lionised as financial innovation."

"Beneath the complexity, the charges are all rooted in the same phenomenon – deception. Somebody, somewhere, was knowingly fooled by banks and bankers... Along the way there is a long list of so-called 'entrepreneurs' and 'innovators' who were offered loans that should never have been made."

But The Business Insider's Henry Blodget isn't so sure the SEC really has a case. After every market crash, he says, regulators re-evaluate standard industry practices, and some are criminalised in hindsight.

"It may be that the SEC now decides that in every case like this, the BUYERS of CDOs should have been told everything that might have influenced the security selection process and who was betting against them." If so, he adds, this would be highly unusual. (Almost as unusual as senior SEC employees spending hours surfing pornographic websites on government-issued computers while being paid to police the financial system. But that's a different story...)

"When you buy a stock, you have no idea who is selling it to you. You do know (or should) that the entity selling it to you thinks you are a fool. That entity may be Warren Buffett – or it may be your idiot day-trader neighbour."

As for failing to mention to ACA that Paulson had taken a short position on the CDOs, Blodget says that "with CDOs like the one in question, there is ALWAYS a short side and a long side: The buyers of the CDO knew that someone was going to be betting against them." Or they should have.

And Alvaro Vargas Llosa from the Washington Post Group (via The Australian) agrees; vigorously. "What Mr Paulson did – generate a product so he could bet against a blatant bubble – was an island of common sense amid a sea of insanity. What Goldman did – brokering a deal between informed sellers and buyers - is what a broker/dealer does. What Mr Tourre did – market the product – was his job description. What ACA did – select subprime mortgages and acquire the product believing the bubble was sustainable – is what Mr Paulson, who had been preaching in the wilderness against it, and Mr Tourre realised was crazy. What IKB did was continue to bet on the mortgages of people with scant creditworthiness.

"Who would you rather have on Wall Street," Vargas Llosa asks, "those who fed the bubble or the prescient minds who acted against it?"

But beyond the arguments over job descriptions, "the law", and codes of practice – arguments that are definitely worth having – the broader debate over Goldman has become one of morality which, as Business Spectator's Stephen Bartholomeusz has pointed out, becomes problematic.

"The concept of morality simply doesn’t apply to Wall Street investment banks. They exist to make money, largely but not exclusively by acting as intermediaries," says Bartholomeusz. "They are, if anything, amoral institutions whose reference points tend to be the law and their own codes and relatively narrow notions of ethical behaviour rather than broader community concepts of good and evil."

Nevertheless, the broader community, including those who've lost their homes and almost all of their good will (if indeed they ever had any) towards banks, is judging, and it's judging from the post-GFC world – and that is something Goldman's lawyers will need to take into account.

"We now know that Paulson was right about the housing market and the buyers of the CDOs were wrong," says Blodget. "This colours a lot of dialogue on the issue, but it is important to remember that it was NOT KNOWN at the time.

"We now know that housing was a gigantic bubble. It's easy to forget that this was not obvious at the time." And while it might now seem like Goldman knew the housing market would collapse, he says, "in fact, at the time, it would have seemed like Goldman was making a risky bet that the majority of people would have thought was foolish. (The great trades always strike most people this way)."

Ditto for Paulson, who is "now viewed as one of the smartest investors in the world... At the time, he was a nobody."

But whether or not Goldman is guilty, says George Soros in the Financial Times, "the case has far-reaching implications for the financial reform legislation Congress is considering."

"This is a clear demonstration of how derivatives and synthetic securities have been used to create imaginary value out of thin air. More triple A CDOs were created than there were underlying triple A assets. This was done on a large scale in spite of the fact that all of the parties involved were sophisticated investors. The process went on for years and culminated in a crash that caused wealth destruction amounting to trillions of dollars. It cannot be allowed to continue."

So get ready, Wall Street, for some "monstrous" financial regulation – 1933-style.