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In Defense of Goldman (Kind Of)

Okay, it's easy and fun and often appropriate to dish - or in Senator Carl Levin's (D-MI) mellifluous phrasing, "crap" -- on the fat-cat bankers. Believe me, I have no sympathy for the people, flush with fabulous paychecks and an inflated sense of entitlement, who did so much to destroy the nation's wealth, housing market and self-confidence.

But there are good reasons to crap on the financial industry, and bad ones. And what we have been seeing in the hearings by the Permanent Sub-Committee on Investigations is a lot of emphasis on the latter. This matters for two reasons. One, if you do not identify the right problems, you are not going to come up with the right solutions. And two, the ignorance betrayed in so many of the questions and commentary has to give pause.

New forms of regulation are certainly required. For a start, I think bank leverage caps should be lower and capital ratios higher. I think the mission of Fannie Mae and Freddie Mac should be clarified. I think there is a case for requiring banks and mortgage brokers to keep a piece of each mortgage generated; having skin in the game is a good incentive to evaluate risk, and not just to sell it on. I believe that people should only be able to hedge against products they control; without that kind of connection, such transactions are pure speculation.

And I don't think any of this needs to be complicated. It's not a matter necessarily of more rules, but of smarter, more consistent ones. Given the spectacle on Capitol Hill, I am not confident that this crew can deliver them.

To wit, the questioning of Goldman executives. (Disclosure: I bought Goldman shares several years ago and still have them.) I am not pre-judging the matter one way or the other. There is too much we don't know, although it has to be said that a lot of what we now know - ie, about Goldman's opinion of many of its clients -- is ugly.

But I do know some things that many of our nation's political elite apparently do not.

1. Short-selling is not evil. In 2007, Goldman CEO Lloyd Blankfein wrote in an email that Goldman "made more than we lost because of shorts." And John Paulson, the hedge fund founder who helped Goldman create the now-infamous Abacus fund, made $1 billion when the housing market collapsed because he bet against risky ARMs and interest-only mortgages. Senator Claire McCaskill (D-MO) asked in disgust, [Paulson] "was just looking for a place to score on a bet, wasn't he?" (See video)The short answer, so to speak, is: Yup.

In fact, it's the kind of bet that traders have been making since they gathered under the buttonwood tree at 68 Wall Street in 1792 to create the first American stock exchange.

And there is nothing wrong with that. Short-sellers can be like canaries in the mine - harbingers of looming problems. (Think Jim Chanos and Enron.) In fact, if there had been more short-sellers, that would have been a strong signal to the markets to re-evaluate the risk associated with those exotic mortgages. Had that signal been heard, fewer would have been issued, and the accompanying fallout reduced.

No, this does not make short-sellers heroes; they were out to make a buck (or a billion of them). Nor does it make them villains. Short-selling is neither an act of virtue nor of vice; it is a tool. Blaming short-sellers for not supporting the housing market is like blaming a dog for not mooing - it's not what they do.

But Goldman was both long (betting housing securities would go up) and short (that they would go down). Isn't that a "conflict of interest," as Sen. Levin charged? No. It's a hedge, the exact kind of thing you do when putting money down on the Kentucky Derby; you bet a winner, but also make a second bet, so if your first choice falters, you still have a chance to make some money. Or it could be that Goldman simply changed its mind about the housing market. Would Congress be happier if it had kept its money in what it considered a losing position?

Again, there may well be ethical issues, in regard to what Goldman described to its clients; and there may be legal issues, if the SEC can prove its civil case of securities fraud. But Goldman should not be spanked for short-selling per se.

2. Neither is market-making. Susan Collins (R-Maine) asked Goldman executive Fabrice Tourre whether he believed Goldman had a duty to act in the best interest of its clients. The Fabulous Fab appeared not to understand the question, which is frankly, kind of sick. But again, he had the stronger argument. When Goldman acts as a market maker, it is not required, ethically or legally, to give its opinion of a transaction, any more than a bookseller is required to disclose that the ending of that novel is really disappointing or a clothing retailer needs to say that no, that dress doesn't work.

Senator Levin was dismayed that Goldman "sold a investment to someone and bet against it." But as Blankfein noted, taking a page out of Wall Street 101, the nature of "market-making is that we are the other side of what our client wants to do. And in the context of market-making, that is not a conflict." Or as Goldman's former head of the mortgage department, Daniel Sparks, said, "We could be long a deal and not like it that much, we should be short a deal and like it - our position does not always reflect our opinion."
When it acts as a market-maker, Goldman's job is to create transactions for willing buyers and sellers. It is not to advise investors. A better analogy might be real estate brokers. They are not required to tell clients that, no, they wouldn't buy that house; they just do the transaction. And like Goldman, real estate brokers can work both ends of a deal. Is a client wise to accept that? Maybe not. But is it illegal, unethical or unusual in investment banking? No.

Should it be allowed? I'll leave that to finer financial minds to settle - but the point is that grandstanding on the Hill against standard business practices is hardly useful.

3. It wasn't just the bankers. If our esteemed members of Congress would yield the microphone for a moment and look in the mirror -- in other words, if pigs flew -- they would recognize their own culpability. Senator Levin has compiled a litany of blame derived from the committee's hearings so far; Congress does not appear on the list. And I don't see anyone giving back Goldman's generous campaign contributions, either.

Specifically, Congress failed to provide oversight to Fannie and Freddie; and it created a regulatory spaghetti that made effective supervision impossible. (Note that it was the more-regulated entities that have had the most trouble; hedge funds and private equity have fared much better than the banks.) To continue: Congress failed to ask the tough questions of the Federal Reserve, such as why interest rates were held at record lows for a record period; Congress failed to curb payday and predatory lending; it failed to exert control over derivatives. Oh, and it has also signally failed to set an example of prudence and good governance, with its own house in general disorder (Entitlement reform, anyone? No, I didn't think so.)

Self-examination on Capitol Hill would be useful not only as an exercise in accountability - something we haven't seen much of in regard to the crisis -- but also in defining what direction to go in.

And if you want to bet on that happening, I'd be happy to short it.