How Goldman Sachs' "Wonderful Life" Magnified Toxic Risk

Last Updated May 4, 2010 4:13 PM EDT

To hear CEO Lloyd Blankfein tell it, Goldman Sachs (GS) is just the modern version of America's most benevolent banking icon, George Bailey. During his recent interview with Charlie Rose, Blankfein used It's a Wonderful Life to explain how the mortgages that Goldman purchased and repackaged allowed local bankers to lend more money to the community, while at the same time safely spreading that risk.

Except that new data from the Senate Committee hearings shows that the risk was in fact magnified until it threatened to topple the global economy.

The data from the Senate investigation looked at a pool of mortgages called the Soundview Home Loan Trust. Of this multi-billion dollar pool, a single risky slice, known as Baa2, was valued at $38 million. But that same slice of mortgages was referenced -- in other words, wagered upon -- by 30 different debt pools.

"There was a limited number of similar bonds," Darrell Duffie, a finance professor and derivatives authority at Stanford University, told the WSJ. "So they are likely to show up in multiple deals." The result was that when the mortgage market went belly up, investors were on the hook for $280 million in losses, or roughly seven times the value of the original assets. It was this kind of magnification that allowed the relatively small subprime mortgage market to destabilize the global economy.

These mortgages, mostly from Florida and California, made their way into deals all around the world, including Abacus, the transaction at the center of the SEC's case against Goldman. This kind of trading is now the subject of a debate that, for simplicity's sake, I'll call the casino conundrum.

As my colleague Cait Murphy has written, there were plenty of legitimate scenarios in which Goldman was short, or helped clients short, the housing market. But many opponents of the coming financial regulation go further. Award winning financial writer Clifford Asness believes that these kind of side bets actually make the system safer. "Consider the case of John Paulson and the now infamous Goldman Abacus deal," Asness wrote on the popular financial blog, The Big Picture.

The tough case seems to be speculator-on-speculator side bets. In this case somebody will win and somebody will lose. First, I appeal again for the rights of free people to put their money where their opinions lie. Just because somebody will be wrong doesn't reduce this right. But, second, this activity still makes society itself better off. If these "side bets" encourage more research, more time and energy, into figuring out whether the current price is too high or too low, they themselves can make prices more accurate.
This argument is Econ 101: the more opportunity for rational actors to participate in a free market, the more rationally, and safely, the market will behave. The problem with this line of reasoning -- putting aside the fact that in the Abacus deal, one party didn't know the true influence of the other -- is that these side bets did more than just influence the prices of the underlying assets. By allowing multiple speculations on the same pool of debt, they also created mountains of new risk.

The fundamental free right of Americans to invest as they please needs to be regulated when it threatens society as a whole. And as the crisis clearly showed, complex securities did not go hand and hand with better research. Unlike George Bailey, the people who created, bought and swapped these products were far removed from the realities of the American homeowner.

Image from Takara Tomy Toys

  • Ben Popper

    Ben Popper writes at the intersection of culture and technology. His work has been published in the NY Times, Washington Post, Fast Company, Rolling Stone, The Atlantic and many others. He lives at