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Commentary By Nicole Gelinas

Is Goldman Sachs Guilty of Fraud?

I apologize for breaking the radio silence on financial reform, but I listened to the debate between Will Cain and Andy McCarthy, and I’m with Will on this one.

Some Goldman Sachs supporters argue that in selling its “Abacus” derivative instrument to European investors, Goldman did not have to disclose that John Paulson, who would benefit if the instrument lost value, had a hand in choosing the specific mortgages that would determine whether it did well or did poorly.

This follows from Goldman’s claims before the Financial Crisis Inquiry Commission that it is a neutral market maker — that is, when one party wants to bet that a financial instrument will increase in value, and another wants to bet that it will decrease, Goldman serves as the disinterested matchmaker in the middle.

This argument would be reasonable enough if Goldman were just doling out Apple stock or Exxon bonds. Yeah, if you’re buying the security, you can be pretty sure that someone else is selling it — but knowing that the other person thinks it will go down while you think it will go up doesn’t deter you.

When it gets down to the granular level of customization involved in the Abacus instrument, though, the market-maker argument starts to disintegrate. If European investors just wanted mortgage bonds, they could have bought straight-up mortgage securities. But the investors desired Goldman’s specific expertise and the expertise of Goldman’s hand-chosen “independent” consultant, ACA.

Unbeknownst to the poor Europeans, according to the SEC, market expertise was working against them. Paulson, with Goldman’s cooperation, was expressly and intricately designing the instrument so that it would perform more extremely than a run-of-the-rill, even high-risk, subprime-mortgage investment.

The Europeans wanted exposure to mortgages and even to high-risk mortgages, but there is no evidence that they wanted exposure to an instrument that was systemically designed by someone with a great interest in magnifying all potential risk on the way down.

Intense customization makes other parts of the argument less tenable, too. The “Fabulous Fab” — the Goldman employee who faces a civil-fraud charge — knew from Goldman’s trading desk in designing and selling Abacus that the mortgage market was faltering. As someone from Goldman’s “structured product correlation trading desk” e-mailed Mr. Fab at the time, “the cdo biz is dead we don’t have a lot of time left.”

Now, it’s okay for a neutral market maker to help all of its customers benefit from trading information; in fact, that is sort of the point. If you’re selling an Exxon bond and Goldman knows from its own data that the market for the bond is plummeting, Goldman can still use that information to help you get the best price. If you’re buying the bond and the market is plummeting, the job is easier.

In this case, though, the European investors likely thought that they were benefiting from Goldman’s expertise in customization and its position as a market maker. It seems dubious, at best, for a market maker, unbeknownst to the buyer, to allow a short seller to help systemically design a financial instrument so that it will intensify all losses — while at the same time seeing from its internal market information that such losses look increasingly likely.

And this all has a great deal to do with derivatives reform. Requiring financial firms to trade derivatives on exchanges would discourage this level of customization — and that is not necessarily a bad thing. Yet only one Republican, Chuck Grassley of Iowa, voted for public derivatives trading yesterday in committee. Democrats are wobbly on this in the details, so it’s important for Republicans to see how important it is.

Financial markets are supposed to be markets — where investors can watch financial instruments trade and compare volume and price information on different investments and on the same investments over time. The goal should not be for financial institutions to hoard valuable information by making sure that no single financial instrument looks exactly like another. They are not snowflakes.

This piece originally appeared in National Review Online

This piece originally appeared in National Review Online