Cross of Gold

How the rush to crucify Goldman Sachs is clouding our judgment and distorting public policy.

Imagine that you want to make a bet against a sports team, say the New York Yankees. The Yankees have had a strong run, but, poring over the data, you have come to the conclusion that they're going to start losing. So you go to a bookmaker (in a district where bookmaking is legal, of course) to place a bet. The bookmaker now looks for someone to take the other side of this bet. Once the other party is found, the deal is made. That, in essence, is the transaction that took place in 2007 regarding the future direction of the American residential-housing market, in which Goldman Sachs acted as the bookie, and which the Securities and Exchange Commission now charges was "fraud."

There's so much anger and resentment toward banks these days—some of it quite justified—that anything resembling a defense of them is bound to make people angry. But the rage surrounding the Goldman case can cloud our perspective and distort public policy. We're going through a familiar part of America's boom-and-bust cycle. Having been mesmerized during the go-go years, having unduly lionized and feted industries, firms, and people as they rode the wave, we now want to throw these people to the wolves. We need to step back for a moment and try to understand what happened and learn the right lessons.

Let's be clear: all the facts are not publicly available, and evidence may be presented in court that documents specific misrepresentations and false claims, proving Goldman Sachs's guilt. But much of the public debate has struck me as guided more by emotion than careful analysis. Even if some Wall Street practices strike many people as dodgy, even unethical, that's not the same as illegal. I want financial reform, but I also want our system of government to be characterized by fair play and equal justice—even for people making $10 million bonuses.

There are two core claims of wrong-doing. The first is that John Paulson—the fund manager who wanted to bet against the housing market—was allowed to select the securities he wanted to bet against. This is disputed—but even if it's true, so what? Here's what a routine hedge transaction looks like on Wall Street. Somebody decides to place a bet against some set of stocks or securities. That person approaches a Wall Street firm and says, in effect, "Can you find me someone who wants to take the other side of this bet?" And the firm goes out and finds someone who has the opposite view on those securities. This is how large companies offset the risks to their balance sheet from fluctuating currency, energy, or commodity costs. They often choose the instrument they want to bet against.

Both sides scrutinize the securities on which they're betting. In this case, the main institution that took the other side of this bet was IKB, a large German bank that had whole departments devoted to analyzing just these products—departments many times larger than Paulson's entire firm. Did the Germans know that Paulson was betting against these securities? IKB surely knew that someone was betting against them: otherwise there would have been no transaction. Did IKB realize that the other party thought these securities were garbage? Yes—that's why he wanted to bet against them. Disagreement over the value of stocks or securities is what creates the market.

The second charge is that Goldman Sachs designed a product it "knew" would decline in value. Who knows what was in the mind of the people who put this deal together, but dozens of transactions like this took place in 2005, 2006, and 2007. In most of them, the people who bet the housing market would go up made money, and those betting it would fall—Paulson's side—lost money. Those same kinds of crappy collateralized debt obligations (CDOs) went up in value in 2006. In fact, had this same bet been made nine months earlier, Paulson would probably have lost a huge sum and IKB would have been a winner.

It's easy to say in retrospect that the housing market was obviously doomed to go bust by 2007. But Michael Lewis's latest book, The Big Short, documents precisely the opposite point. He shows that in 2006 and even 2007, almost all the storied names in finance—Lehman Brothers, Bear Stearns, Merrill Lynch—were betting that the housing market would continue to rise. Only a handful of contrarians, Paulson among them, believed the opposite, and many of them had lost money for years on bets that the market would drop. Today it seems clear that Paulson was such a genius that no firm should have gone up against him, but at the time of the Goldman Sachs deal, he was still seen as an oddball.

Thoughtful commentators like George Soros, Roger Lowenstein, NEWSWEEK's Robert J. Samuelson, and Paul Krugman have argued that whether or not Goldman did anything illegal, this kind of casino gambling should be more tightly regulated. I agree. I'm not sure what purpose is served by many of these derivatives. And I'm in favor of most of the proposals the Obama administration has put forward. But it would be a mistake to criminalize retroactively what was standard business practice. New rules going forward are the best avenue for our outrage. In general, regulation by litigation only creates an atmosphere of uncertainty and capriciousness around America's framework of laws and rules.

What this case highlights is that the old Wall Street is dead. Its firms were once partnerships in which the managers were betting with their own money and served as trusted advisers to their clients. The new companies are big players in the markets and have subordinated their advisory functions. But let's be honest: they are also much larger and more lucrative, and have dominated the global financial industry as it has exploded in size over the past three decades. American business has moved away from long-term stewardship. In fact, the basic answer to Michael Lewis's central question—how did the smart money become the dumb money?—is that incentives, including compensation, are wildly skewed toward short-term profits and risk-taking at the expense of a long-term strength.

One can only hope that this crisis and new regulations will make Wall Street firms more responsible. So far most have seemed deaf to the need for new attitudes. That's unfortunate and self-defeating, and it has fed the anger that has erupted over the Goldman case. One thing that will not change, whatever the new rules, is that we can't be sure in advance which securities are "good" and which are "bad." If you doubt this, try an experiment. Pick any asset you think is overvalued today: American stocks, Chinese real estate, Pakistani bonds. Bet against it. Six months from now, you'll be proved either a genius or a fool. But no one "knows" which way things will move in six months. Oh, and to make the bet you'll have to find someone to take the other side, so you'll need someone to handle the deal. Calling Goldman Sachs.