Senators vs. Goldman, Course 1.01: Difference between a market-maker and an investment adviser.

Here is an article of the WSJ from the opinion section, that explain clearly why the senators should go back to school. At one point, they will have to go after the real architects of the subprime mortgage collapse that have yet to be called to account. Lets talk about Fannie Mae and Freddie Mac, lets talk about the 1977 Community Reinvestment Act (CRA), which compels banks to make loans to low-income borrowers that caused thousands of mortgage defaults and foreclosures in the “subprime” housing market. Thirty years of government policy that has forced banks to make bad loans to un-creditworthy borrowers…

“If an investor buys shares in General Electric, and then GE’s stock declines in the future, is the New York Stock Exchange to blame? What if the investor chooses to purchase the shares through TD Ameritrade or Charles Schwab? Is the broker also responsible for the losses?

Senators interrogating Goldman Sachs executives yesterday appear to believe the firm has a duty to protect all of its institutional trading partners from making bad decisions. Such protection has never been extended even to mom-and-pop investors of course, and for good reason. Yet much of the Beltway class, looking back at the financial crisis, now believes that gamblers who bet their money on an always-inflating housing bubble are the real victims.

Yesterday’s hearing of the Senate’s Permanent Subcommittee on Investigations came in the wake of a Securities and Exchange Commission lawsuit accusing Goldman of fraud. The SEC case concerns a 2007 transaction arranged by Goldman in which John Paulson’s hedge fund bet that subprime mortgage-backed securities would decline, while institutional investors IKB and ACA bet they would rise.

The SEC claims that Goldman’s Fabrice Tourre misled ACA into thinking Mr. Paulson’s firm would be going long on subprime, just like ACA. It’s not clear that this would have mattered, but Mr. Tourre flatly denied the allegation under oath yesterday.

The SEC also claims Goldman should have disclosed that Mr. Paulson’s firm suggested some of the particular mortgage-backed securities on which the two sides in the transaction would bet. Yet Mr. Tourre testified that the pool referenced in the transaction performed no worse than similar pools of subprime loans not included in the transaction.

In sum, it appeared to be another bad day for the SEC’s specific case against Goldman. But lawmakers seemed intent on finding the firm generally guilty of meeting institutional demand for subprime housing risk.

We’re not sure which of the politicians at yesterday’s Senate hearing did the most to confuse spectators. Investigations subcommittee chairman Carl Levin of Michigan seemed unaware of the difference between a market-maker, whose role is to offer prices at which a client may buy or sell a given asset, and an investment adviser, whose role is to act in the interests of the client as a fiduciary.

Ranking member Susan Collins of Maine showed that she understood the difference, yet still decided to badger the market makers at Goldman Sachs to admit they weren’t acting as fiduciaries. Of course they weren’t, as their sophisticated institutional customers would have known. Noticeably absent were any of these alleged victims who in 2007 were happily chasing yield and hoping to enrich themselves off subprime housing.

Senator Claire McCaskill of Missouri veered closer to the truth when she described Goldman’s facilitation of trading in mortgage-related instruments as “pure gambling” and told the executives: “and you are the house.”

This was a valuable contribution. It reminded spectators that the transactions getting all of the attention—synthetic collateralized debt obligations (CDOs)—did not contain any mortgages. These were side bets. One could argue, as an astute reader did in a recent letter to the Editor, that investors like Mr. Paulson may even have helped reduce the impact of the housing crisis because they allowed stupid housing bulls to make their bets without actually creating any more bad loans.

If yesterday’s hearing had any value, it was the recognition, even by the Senate inquisitors, of the real root causes of the crisis: too many bad mortgage loans with poor underwriting, and too many pools of these bad loans carrying a triple-A rating. Exploring the creation of junk loans should lead Senate investigators to the same place where most of the taxpayer losses are occurring—Fannie Mae and Freddie Mac.

Former Fannie Mae Chief Credit Officer Edward Pinto calculates that as of June 2008, the toxic twins and other government entities were responsible for more than $2.7 trillion in subprime and Alt-A mortgage exposure. Goldman’s mortgage business was small potatoes in comparison; in fact this figure is three times Goldman’s entire balance sheet.

The Senate’s pending financial-regulation bill has no reform of Fannie and Freddie. Fresh off their meeting yesterday with the marketplace, the committee members might start on the road to useful reform by insisting on a rewrite.”

Freddie Mac and Fannie Mae?

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