Morality of Investment Banking

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Shane Smith
WRD 104-106
18 October 2012

Final Research Essay

Fraud is defined as deceit, trickery, or breach of confidence, perpetrated for profit or to gain some unfair advantage. During the 2008-2009 financial crisis, Goldman Sachs was the definition of fraud. According to the Securities and Exchange Commission, Goldman Sachs marketed and sold complex financial instruments to investors when there was a clear conflict of interest. If Goldman Sachs was able to deceive Abacus 2007-ACI investors so blatantly, then clearly the SEC does not have the regulatory tools to reprimand banks that commit securities fraud. Goldman Sachs is one of the biggest investment banking and securities firms in the world, having approximately $950 billion in assets. Goldman’s business model is to help raise money for their clients through debt offerings, security offerings and other financial instrument offerings. A financial instrument is defined as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. During the mid 2000’s, several money managers and investment banks, most prominently John Paulson, noticed how much debt homebuyers were taking on and that lenders were allowing them to do it. John Paulson, a wealthy hedge-fund manager, speculated that the housing market was inflated and that its crash was inevitable. Paulson needed to find some sort of financial instrument that he could benefit from if his speculation was indeed correct; he solicited Goldman Sachs. Goldman Sachs agreed to help Paulson for a $15 million fee, resulting in the creation of Abacus 2007-ACI. Abacus 2007-ACI is known as a synthetic collateralized debt obligation, or synthetic CDO. CDOs are a form of security that is insured or supported by an asset, in this case, mortgages. This CDO is a derivative, which means that returns from this security are derived from the returns of a collection of assets. According to the American Scholar Journal, “The derivatives market is $600-$800 trillion—about 10 times the $70 trillion output of the world economy” (Quirk 3). Essentially, these mortgages were pooled together to create an investment where investors made money if homebuyers were able to make interest payments and lost money if they defaulted on the loan. A synthetic CDO simply means there is no physical asset to insure the security, but rather a derivation from a physical asset.

Like all bets, on one side there is a buyer and on the other side there is a seller. Buyers of Abacus made money when homebuyers made their interest payments, but there must be another side to the bet. Just like a security, investors had the ability to bet against Abacus. A person who wanted to bet against Abacus took part in something called a credit default swap, or CDS. A CDS is a type of insurance where the purchaser benefits if the assets, or mortgages, default. Goldman Sachs is a market maker, meaning they are an intermediary that markets their self-structured financial instruments to different buyers and sellers. All CDOs have a collateral manager who is in charge of selecting the pool of securities that make up the portfolio. A company called ACA Management LLC was in charge of choosing the securities in Abacus 2007-ACI. Once Abacus was completed, Mr. Paulson bet against the CDO by using credit default swaps. When the housing bubble burst, the majority of the mortgages in the selected pool defaulted. According to the Securities Exchange Commission, “investors suffered losses of up to $1 billion” (Munoz 414). As a result, Paulson bets yielded approximately $1 billion in profits. At this point, it is not very clear why Goldman Sachs committed fraud. If this were actually how the story occurred, there would not be a fraud case; it would simply be a normal series of trades where one party made money and the other party lost money. Unfortunately, this is not what happened. Goldman withheld vital information...
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