Squashing the Goldman Vampire Squid

In the past few months we have learned a number of things about Goldman Sachs.

In February, we found out that it played a central role in helping Greece to hide its government budget deficit from the European Union, the financial markets, and the public at large. Goldman sold complex swaps to Greece in which it paid the Greek government for future revenue streams on items like airport landing fees. This was in effect a loan, but the swap allowed the Greek government to avoid entering the borrowed money on its books as a loan, which would have raised its budget deficit above the euro zone limits. Today of course Greece's financial meltdown is threatening the stability of the euro.

Then, just last month, Goldman was sued for sex discrimination by a former vice-president who claims that she was put on the "mommy track" after taking a maternity leave. She was fired as she was about to start a second leave. (In fairness to Goldman, Wall Street is still for the most part an all-boys club.)

But the big news is Goldman's indictment for putting together a collaterised debt obligation (CDO) from mortgage-backed securities that were expected to fail and then marketing it to its clients as a good investment. The central allegation is that in early 2007, hedge fund manager John Paulson recognised that the housing bubble was starting to collapse.

This meant that many mortgages would go bad. The subprime mortgages, in which homeowners had little or no real collateral, and were facing resets to higher interest rates, were especially vulnerable. Paulson worked out a deal with Goldman in which he would pick the mortgage-backed securities that were put into the CDO. Paulson would then bet that the CDO would go bad, by taking out credit default swaps (CDS) on the CDO. A credit default swap is effectively an insurance policy where the issuer makes up a loss if an asset goes bad.

Goldman was left with the other side of Paulson's deal, finding suckers to buy this huge piece of junk. It would have been hard to find buyers for this CDO if investors knew that Paulson had deliberately constructed it as a piece of junk to short. Therefore, according to the SEC charges, Goldman concealed Paulson's role in constructing the CDO. Goldman allegedly told investors that the CDO was constructed by neutral parties, rather than letting them know that the assets were picked by a hedge fund manager who was taking a short position.

Of course Paulson won his bet, the CDO he put together really was trash. He made nearly $1bn on this particular bet, which involved buying CDS from an insurer, which was backed up by a major European bank. This deal helped to transmit the fallout from the housing crash to Europe, leading to financial crisis there.

In similar deals constructed by Goldman, the insurer was AIG. Of course AIG was unable to pay off its side of the bet, so Paulson or other short speculators on Goldman's CDOs got their money courtesy of the taxpayers, when the government stepped in to bail out AIG. Goldman was also buying CDS to bet against the CDOs it was putting together, although it is not clear that it had bet against this particular CDO. In any case, it clearly profited from the issue since Paulson paid Goldman $15m for its services.

Goldman's conduct in this deal can be framed using an analogy from Phil Angelides, the head of the Financial Crisis Inquiry Commission. Angelides noted that Goldman has bought CDS on the CDOs that it had issued and sold. He compared this to selling a car with bad brakes and then buying insurance on the car. In fact, it looks like Goldman effectively cut the brake lines, sold the car to unsuspecting customers, and then bought the insurance policy.

In fairness to Goldman, there is no reason to believe that they are any less ethical than any of the other big Wall Street actors, just more effective.

All of this should drive home the urgency of both breaking up the big banks and some serious financial reform. The folks who should have been clamping down on this behaviour included then treasury secretary Henry Paulson, who had just left his position as Goldman CEO to take the job.

Even if we put in place a better regulatory structure, as long as financial regulation is just a conversation between friends, it will not be serious. Last year, Rolling Stone columnist Matt Taibbi described Goldman Sachs as "a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money". It turns out that Mr Taibbi was far too generous in his assessment of the huge investment bank. We need to kill the Goldman vampire squid along with the rest of the species, only when we have reduced these monsters to a manageable size can we be confident that they will be effectively regulated.