The Sophisticates: What Goldman Sachs, Bill Clinton and Alan Greenspan Have in Common

Last Updated Apr 21, 2010 3:05 PM EDT

"The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world." -- Goldman Sachs in an April 16 press release
"On derivatives, yeah I think they were wrong and I think I was wrong to take [their advice] because the argument on derivatives was that these things are expensive and sophisticated and only a handful of investors will buy them and they don't need any extra protection, and any extra transparency." -- Bill Clinton in an April 17 interview
"For almost a half century, we have depended on our highly sophisticated system of financial risk management to contain such market breakdowns." -- Alan Greenspan in his April 7 testimony before the Financial Crisis Inquiry Commission
Sophisticates will have picked up on a common theme threading through the remarks above. And if the "efficient market hypothesis" is correct (which anyone with the slightest sophistication knows it isn't), we can count on Wall Street's top-hatted swells to act responsibly on what they've just learned.

More crudely put, the notion of a "sophisticated" financial market is largely a crock. It's rooted in a fanciful, Utopian idea -- that companies, investors and other economic actors behave rationally if they're allowed to pursue their own interests without restraint. If recent events haven't put this fiction to the sword, here's calling for a public execution.

One of the main planks of Goldman's (GS) defense against the SEC, which says the banking firm defrauded investors, is that any parties to the deal that lost money should've been aware of the risks. As others have noted, and if the SEC's allegations are true, that's nonsense. Although there may be legitimate questions about whether the information Goldman allegedly withheld from its Abacus CDO was material, securities law doesn't give firms carte blanche to scam professional investors.

But what's truly subversive about Goldman's argument is the suggestion that the mere presence of "sophisticated" investors in the deal somehow proves it was kosher. That presumes such players are always in the know, always possess the necessary information to make sound decisions, always act in the interest of their customers. The financial crisis -- not to mention every bout of speculative madness ever recorded -- provides strong evidence to the contrary.

Clinton unwittingly echoed Goldman's line by conceding last week that he'd assumed, under the influence of his economic advisers, that derivatives didn't need to be regulated. Oops. Writes Jennifer Taub, a lecturer at the U. of Massachusetts and a former senior exec with Fidelity Investments:

Much of our recent deregulation rested on the premise that sophisticated investors can fend for themselves and have the ability to select and monitor "private," unregulated investment options, and that such investment choices only affect the direct owners, not underlying investors nor market integrity. Based upon the sophisticated investor myth, deregulators argued, successfully, that a wide swath of complex investment options did not need government-mandated disclosure or substantive protections, such as restrictions on conflicts of interest.
Greenspan, who still seems baffled at the failure of our "highly sophisticated" financial system to control risk, peddled the same myth for years. All of these suppositions are, in effect, dogma. Among the articles of faith: Markets police themselves; investors, and consumers, are rational; pursuing private interests necessarily benefits the common intererest. Not that these nostrums are always wrong. It's that they're not always, or even usually, right.

Even a rube can understand that.

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    Alain Sherter covers business and economic affairs for