Tuesday, April 20, 2010

Smart versus dumb on Wall Street

I have no particular expertise regarding securities fraud, but my preliminary sense of the Goldman Sachs indictment is that it makes a powerful case, as explained by Brad DeLong. The tricky question for me is whether the cherry-picked portfolio here was bad for reasons other than its simply losing ex post because the real estate market headed south, rather than north. This might shed light on the degree to which rational investors ought to have been leery of the investment had they known more about its provenance, leaving aside the fact that they were insanely (but through their own foolishness) betting on continued expansion of the real estate bubble.

Obviously, if there were no further reason for concern, Goldman Sachs could simply have disclosed the provenance, and I agree with Brad that this would have tended to make investors run for the hills. Or they could have actually designed the instrument in the more benign and neutral manner that the disclosure materials suggested.

In principle, there is always a danger that the SEC, if it won this case, would in the future be emboldened to look for something, anything, that hadn't been disclosed whenever investors make a deliberate bet and lose it big-time ex post. But we seem to be very far from such a world. And the all-too-justified sense among investors, given events of the last few years, that Wall Street is a non-transparent sucker's game in which the rubes are perpetually being fleeced by the more knowledgeable is potentially exceptionally deadly to the healthy functioning of our economy.

Even if Goldman Sachs wins this case, they have sent a message to investors around the world regarding exactly how trustworthy they are. Evidently, they have a bridge in Brooklyn that they would like to sell me, and I can't see why any small-time player by their lights (including people with a few spare millions to invest) would want to have any dealings with them for years to come.

But whatever else you think about Goldman Sachs, these guys are smart, not stupid like so many of the other players who brought Wall Street to its knees in the last few years. (Or maybe the point is that the managers owned the firm, and thus weren't inclined, like so many others on Wall Street, to be wildly reckless with the shareholders' money.) They saw where the real estate bubble was heading, and in principle that can help markets to adjust. Better, perhaps, to fleece your customers, who at least have the option of staying away, than to fleece the U.S. taxpayers with "heads we win, tails you lose" bets in which an extra-normal return bespeaks, not "alpha" or the ability to out-perform the market, but rather simply the decision (reflecting both incentives and stupidity) to ignore tail risk.

But sometimes Goldman Sachs' special talent for getting the most out of its customers does harm that resonates more broadly. Their actions in Greece bring to mind a person who observes that his neighbor is feeling despondent, sells him a loaded gun, and then thoughtfully takes out a life insurance policy on the poor guy.

No comments: