An Analogy for the Goldman Fraud

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Friday, April 16, 2010 at 2:31 pm

I’ve been reading the Securities and Exchange Commission’s civil charges of Goldman Sachs and one of its vice presidents carefully. It’s a complicated case dealing with complicated financial instruments, but I think there is a handy analogy to explain it in layman’s terms.

Let’s say that you are buying a house in a foreign country where you do not know much about the real estate markets and therefore prices are fairly opaque to you. You decide to hire a real estate broker to help you find and buy a house and to act as a guide to the market. You know that real estate brokers sometimes represent the person selling a home as well as a person buying a home, but also know that your broker has a legal responsibility to act in your best interests and disclose as much about the house as possible. Ultimately, the broker makes money on the deal, but does not have a direct financial interest in the house.

So you meet with the broker, who shows you a plain apartment in a plain apartment building. You decide to go for it. He says he will hire an independent home inspector to appraise the home, to make sure it is sound and to help you determine your bid. The process moves forward, you buy the house and pay the broker his fee.

But just months later, you find out that the neighborhood is drug-addled and the apartment filled with leaks. You try to sell the apartment, but can only do so at a 90 percent loss. It turns out that the third-party independent home inspector had been hired by the seller; that the seller had made a bet with a bookie that the price of the house would go down; and that the broker knew it — he let them overvalue your house.

In this analogy, Goldman is the broker. Paulson is on the short side of the trade, and behind the home appraiser. The analogy is by no means perfect — collateralized debt obligations are more complicated than houses. But it goes to show that the issue here was that Goldman had a responsibility to disclose pertinent information to the buyer, and it did not.

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Anon
Comment posted April 16, 2010 @ 7:48 pm

“Your broker has a legal responsibility to act in your best interests”

Not to excuse what the GS people are accused of doing here, but I don't think this statement is true with respect to the GS employees selling the CDO to investors. Typically a person in that situation would not have a legal obligation to act in the buyer's best interests.

The allegation is not that GS failed to live up to a fiduciary obligation to the purchasers of the CDO tranches, it is that (a) they did not make adequate disclosures about how the CDO assets were picked, and (b) thery made actual misrepresentations about that same subject. (Sins of both omission and commission, I guess.)


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