Washington Versus Wall Street

In my book, The Future of Hedge Fund Investing, I had written that, "after the financial crisis of 2008, politicians will be clamoring for more regulation. The important thing for the regulators to understand is that they need to impose the right regulation and not regulation for the sake of it.”

Unfortunately, the media headlines seem to suggest that the financial regulation being proposed is being driven more out of fear and political interests rather than being an educated response to the crux of the problem. In this article I will concentrate on SEC’s case versus Goldman Sachs and in the subsequent articles will tackle some of the other regulations being discussed in the US Congress.

The crux of SEC’s charge against Goldman, released on April 16, 2010, was that Goldman Sachs structured and marketed a synthetic collateralized debt obligation (CDO) linked to the performance of subprime residential mortgage-backed securities and that Goldman Sachs failed to disclose to investors that a major hedge fund, Paulson & Co., had taken a short position in this CDO.

Since this story has broken and the ensuing Senate hearing, I have seen every journalist and news anchor, with zero working knowledge of derivatives or the investment banking industry, weigh in with rhetoric and invective against Wall Street with no regard to the form or function of the investment banking industry.

I worked on Wall Street as a derivatives structurer, marketer and trader for several years, so I will try to explain the Goldman transaction. Professional investors like pension funds, hedge funds, banks, corporations, etc. whose job is to increase or decrease risk to interest rates, currencies, stocks, bonds, real estate, etc. come to investment banks with their complex problems looking for a solution.

Banks like Goldman Sachs have derivatives departments whose job is to study these problems and devise products to arrive at a solution. Often these solutions require structuring complex derivatives transactions. Despite the very few highly publicized derivatives debacles, in most cases derivatives transactions have provided solutions which have mitigated large risks and thereby reduced volatility in the markets.

Once a bank devises a derivatives transaction and trades it with their client, the bank de-facto gets the other side of the risk on that trade. Now it is the trader’s job to hedge this risk, as his job is to protect the bank’s balance sheet and financial health. The trader might keep some of this risk in his own book and might ask his marketing department to sell the rest to willing investors.

In my 10 years on Wall Street working at several different banks, both domestic and European, at no point is the bank under any obligation to disclose to the buyer or seller, the origin of that risk. In most cases it would be impossible to pinpoint the origins of that risk as it gets pooled together with other transactions. Furthermore, in most cases the buyer of the risk would not even care, as they might be buying that risk to hedge something else in their portfolio or to just express a view on the markets.

This is exactly what transpired in the Paulson, Goldman and IKB trade. Paulson, a no-name hedge fund in 2006, approached Goldman Sachs with a problem where they wanted to take an exposure to the downside of the subprime residential mortgage market. Goldman structured that transaction, kept some of the risk for their own books and sold the rest to willing buyers.

Another important point to realize is that these sophisticated derivatives transactions are not done with retail clients. They are solely done with institutional clients who are supposed to have professionals who have the knowledge to ascertain the risks in these trades properly. In the US, such professionals have to take several exams to get certified.

The major buyer of the risk in this particular case was a German bank, IKB. But unfortunately the media and the Senate made it seem that Goldman Sachs and other investment banks devise derivative transactions to swindle unsuspecting ‘mom and pop’ investors. That is simply incorrect and nothing more than hype.

Once we put political agendas and journalistic ambitions aside, we can start to focus on the true nature of the problem. The housing bubble was fueled by very low interest rates and investors clamoring for high yield products without paying attention to the risks involved in those transactions.

Retail as well as professional institutional investors dropped the ball in conducting proper due diligence and got swayed by the allure of high returns. People suspected that the housing market would eventually crash, but everybody wanted to play one more round at the roulette table. Eventually the bets went sour.

Instead of blaming the investment banks, investors should start taking responsibility for their own actions, while politicians and journalists should start promoting the importance of due diligence.

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