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Goldman Sachs
By Frank L. Winfrey
Frank L. Winfrey is the Clark N. and Mary Perkins Barton Professor of Management at Lyon
College in Batesville, Arkansas.
I have attempted to write this teaching note in a neutral tone. Its goal is provide the
instructor with additional resources, not pat answers. It includes my “answers” to the case
questions, definitions for the non-financially-oriented instructor (with references), a list of
internet URLs for federal laws related to the case, the URL for the New York Times (NYT)
coverage of Goldman Sachs, the URL for the NYT address that displays the original ABACUS
marketing prospectus (highly recommended), a listing of two available videos and one
forthcoming video to supplement the case, and a listing of URLs for United States House and
Senate Hearing testimony on the financial crisis. Note that the Senate hearings have very
interesting exhibits of Goldman Sachs e-mails and internal presentations to its Board of Directors
(especially the very large 44 mb file).
Questions:
1) Did Goldman Sachs deviate from any of its fourteen business principles during the
2007-2010 financial crisis?
This question most directly relates to the first of Goldman Sachs’ Fourteen Principles in
Exhibit One, to put its clients’ interests first. The obvious question is what is a client to the firm?
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2) Was it unethical for Goldman Sachs to sell the ABACUS CDO to clients?
The question revolves around the level of disclosure in the ABACUS marketing materials
and was at the crux of the SEC’s legal case against Goldman Sachs. Clearly, John Paulson &
Company was not mentioned in the marketing material. Was this, in fact, really negligence, or
an act of true deception and thus fraud? E-mail traffic from Goldman Sachs suggests that they
Goldman Sachs CEO Blankfein stated that the firm would never put clients in a deal that
the firm expected to fail, but that again begs the question of how the firm defined a “client.”
3) Why did the U.S. government refuse to intervene to save Bear Stearns and Lehman
Brothers, and then step in at the last minute when Goldman Sachs was in jeopardy?
Did Goldman have undue influence due to its alumni in government positions?
At the time, the position of the U.S. government had historically been not to create a moral
hazard for taxpayers by bailing-out private firms. Precedent had been set in the LTCM (Long
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An analysis of the AIG bailout by Dino Kos in The International Economy, Spring 2010,
suggests that the firms receiving the most of the payments from The Maiden Lane III, LLC set
There is no direct evidence that undue influence benefited Goldman Sachs during the
crisis. At least one e-mail addressed to Goldman CEO Blankfein did mention that there was the
4) Should the Glass-Steagall Act be re-instated?
This question is really as to whether there should be a return to the separation of commercial
banking from investment banking to protect the financial system from its own quest for profits.
Many international investment banks have spun-off their proprietary trading units as a result of
5) What is the role of mark-to-market accounting in creating inflations (or
devaluations) in derivative instruments?
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Mark-to-market forces firms to deal with existing market conditions, preventing outdated
historical or wishful-thinking valuations. However, the opacity of derivative instruments and
6) What legitimate purpose does a synthetic CDO serve for the capital markets or
society?
References
Kos, Dino (2010) “The AIG Backdoor Bailout: But a Bailout of Whom,” The
International Economy, 24 (2): 50-53+.
Taibbi, Matt, “The Great American Bubble Machine,” Rolling Stone, April 5, 2010.
Background Resources
Basel Agreements
The Basel Committee for Banking Supervision (BCBS) was created in 1975 to ensure the
stability of the international financial system by establishing capital adequacy standards between
equity capital in commercial banks and their risk-weighted assets. The BCBS is composed of
representatives from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the
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Netherlands, Spain, Sweden, Switzerland, the UK, and the United States, as well as observers
from the European Commission and the European Central Bank. The Basel Capital Accord
applies to banking and securities firms in 100 countries. The first regulatory framework from the
BCBS was outlined in 1988 and is known as Basel I, a revised framework known as Basel II was
adopted in 2006. The Basel II agreement required the financial institutions to meet the following
criteria: (1) compute “Value-at-Risk” (VaR) on a daily basis; (2) use a 99 percentile, one-tailed
confidence interval in calculating the VaR; (3) use a price shock equivalent to a 10 day
movement in asset prices; and (4) use a sample period of no less than one year of historical
observations.
Basel II has been criticized as an unworkable attempt at international harmonization of
capital rules and supervisory practices, for its reliance on rating agencies with their own conflicts
if interest creating an environment encouraging lax due diligence by investors, and for its use of
firm-specific internal models subject to incentive distortions an inadequate risk management to
determine capital regulatory requirements.
In the U.S., the Dodd-Frank Act has specified even more stringent capital standards for
“systematically vital institution” and a “generally applicable” standard for most other banks.
Strategically banking decisions are typically based on two capital driven factors: risk-adjusted
return on capital (RAROC) driven by line-of business capital allocation and return on equity
(ROE) based on investor expectations. Banks balance their capital and risk based on their
analysis of such profit opportunities.
Sources:
Benston, George J. (2007) “Basel II and Bankers’ Propensity to Take or Avoid Excessive
Risk,” Atlantic Economic Journal, 35 (4): 373-382.
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Buehler, Kevin S., D’Silva, Vijay, and Pritsch, Gunnar (2004) “The business case for
Basel II,” McKinsey Quarterly, 1: 82-91.
Moosa, Imad (2010) “Basel II as a casualty of the global financial crisis,” Journal of
Banking Regulation, 11 (2): 95-114.
Panagopoulos, Yannis (2009) “Bank Lending, Real Estate Bubbles, and Basel II,”
Journal of Real Estate Literature, 17 (2): 295-310.
Sjolander, Par (2009) “Are the Basel II requirements justified in the presence of
structural breaks?” Applied Financial Economics, 19 (12): 985-998.
Collateralized Debt Obligations (CDOs), Synthetic CDOs, and Credit Default Swaps
(CDSs)
A collateralized debt obligation is a security composed of a pool (portfolio) of defined
collateral financial assets (such as residential Mortgage Backed Securities, RMBS) in a special
purpose vehicle (SPV) that will perform in a predictable manner. The underlying debt
obligations are classified (tranched) and graded for quality by a rating agency (Nationally
Recognized Statistical Organization, NRSRO) as senior bond classes, mezzanine bond classes,
and a subordinate/equity class based on their level of credit enhancement. The use of tranches
creates a waterfall of legal subordination that makes it possible to create security that can receive
an investment grade rating from an NRSRO. The price of a CDO is determined by a variety of
criteria: default rates, loss severity/recovery amounts, recovery rate, the maturity of the contract,
the joint default function, and the risk-free interest rate. CDOs are not traded on any organized
exchange, they are “over the counter” private party contracts.
6
In a synthetic CDO, the CDO does not actually have legal ownership the diversified pool
of underlying assets, the synthetic CDO holds the economic credit risk of a referenced credit
derivative instrument, a basket of credit default swaps.
A credit default swap (CDS) is a form of privately negotiated insurance contract sold by
an insurance firm to a financial institution that would compensate the financial institution if a
specific “credit event” was triggered on the underlying security.
The complexity and relative illiquidity of CDOs combine to provide potentially attractive
returns to investors. It is thought that CDOs may help insurance and reinsurance companies to
attain better capital efficiency.
Sources:
Dwyer, Gerald P., and Tkac, Paula (2009) “The Financial Crisis of 2008 in Fixed
Income Markets,” Federal Reserve Bank of Atlanta Working Papers Series, 2009-20.
Forrester, J. Paul (2008) “Insurance Risk Collateralized Debt Obligations: What? Why?
Now?” The Journal of Structured Finance, (Spring): 28-32.
Goodman, Laurie S. and Fabossi, Frank J. (2003) “Managing a Portfolio of
Collateralized Debt Obligations,” The Journal of Investing, (Winter), 22-30.
Horton, Brent, and Vrablik, Jack (2010) “The Troubled Asset Relief Program (TARP):
Uses and Abuses,” Banking and Financial Services Policy Report, 29 (9): 24-23.
Hu, Jain (2007) “Assessing the Credit Risk of CDOs Backed by Structured Finance
Securities: Rating Analysts’ Challenges and Solutions,” The Journal of Structured Finance,
(Fall): 43-59.
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Li, Ping, Chen, Housheng, Deng, Xiaotie, and Zhang, Shunming (2006) “On Default
Correlation and Pricing of Collateralized Debt Obligation by Copula Functions,” International
Journal of Information Technology and Decision Making, 5 (3): 483-493.
Longstaff, Francis A., and Rajan, Arvind (2008) “An Empirical Analysis of the Pricing
of Collateralized Debt Obligations,” The Journal of Finance, 63 (2), 529-563.
Walker, Michael J. “The static hedging of CDO tranche correlation risk,” International
Journal of Computer Mathematics, 86 (4): 940-954.
Fair-Value, Mark-to-Market, and Mark-to-Model
Steve Forbes of Forbes magazine stated that he thought that mark-to-market accounting
was “the principal reason” that the U.S. financial system was in crisis in 2008. Peter Wallison of
the American Enterprise Institute blamed fair-value-accounting for “transforming a major
economic downturn into a full-blown crisis.”
Stated simply, fair-value is the price that would be received for an asset in an orderly
transaction between market participants at a particular point in time. However, during the
financial crisis in 2008 write-downs of derivative instruments of mortgage backed securities led
8
underlying assets in a turbulent and illiquid market environment. The problem was exacerbated
by elaborate models that were used by firms to forecast the values of the underlying assets in the
derivative instruments, an under appreciation of compounded risk, disagreements as to methods
of valuation, and the complexity of the market position of firms legally constrained by
Sources:
Cortese-Danile, Teresa M., Mautz Jr., R. David, and McCarthy, Irene M. (2010) “Ethics
is Imperative to Effective Fair Value Reporting: Weaving Ethics into Fair Value Reporting,”
Review of Business, 30 (2): 50-58.
Editorial (2009) “The Role of Mark-to-Market Accounting in the Financial Crisis,”
CPA Journal, 79 (1): 20-24.
Laux, Christian and Leuz, Christian (1020) “Did Fair-Value Accounting Contribute to
the Financial Crisis? Journal of Economic Perspectives, 24 (1): 93-118.
Pozen, Robert C. (2009) “Is It Fair to Blame Fair Value Accounting for the Financial
Crisis?” Harvard Business Review, 87 (11): 84-92.
Sanders, Thomas B. (2009) “SFAS No. 157 and the Current Banking Crisis,” Strategic
Finance, 91 (6): 50-53.
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TARP
TARP, the Troubled Asset Relief Program, was one element of the Emergency Economic
Stabilization Act which was enacted on October 3, 2008. The purpose of TARP was to get
distressed assets such as residential mortgage backed securities (RMBS) moving through the
market through government injections of equity capital. The first TARP program was the Capital
Purchase Program (CCP) aimed at U.S. financial institutions engaged exclusively in financial
Sources:
Collins, Daniel (2010) “Was TARP Necessary?” Futures: News, Analysis & Strategies
for Futures, Options & Derivative Traders, 39 (7): 18-21.
Henry, Theresa F. (2009) “TARP Funding: Who and Why?” Bank Accounting and
Finance, 22 (6): 3-47.
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Horton, Brent and Vrablik, Jack (2010) “The Troubled Asset Relief Program (TARP):
Uses and Abuses,” Banking & Financial Services Policy Report, 29 (August): 24-33.
Stein, Gabrielle (2008) “TARP Dead On Arrival,” Asset Securitization Report, 8 (44):
10-13.
Yang, Jia Lynn (2009) “The World According To TARP,” Fortune, 159 (3): 78-79,
February 16, 2009.
Value-at-Risk
Value-at-Risk (VaR) was created at J.P. Morgan Bank in 1989 to detail the market risk of
the bank’s trading portfolio. It is now used by international banking institutions under the Basel
II Agreement to specify the amount of capital required for a given trading portfolio.
VaR has been defined as a “loss that will not be exceeded at some specified confidence
level.” Using a Markowitz portfolio model, an analyst can identify an optimal portfolio for any
set of n securities and obtain its mean-variance boundary. A portfolio manager can then select a
portfolio on the efficient frontier of the boundary with the highest certainty expected return
identified by applying indifference curves to the frontier. To control the tail risk of a trading
portfolio, a firm executive sets a maximum level of VaR believed to be acceptable.
Because VaR is a parametric approach its principal weakness is that it is rooted in the assumption
its distribution exhibits normality. A risk management system based on VaR could also lead to
the perverse result of a riskier portfolio being selected because it focuses on the upper end of the
tail distribution.
The successful use of VaR is further impeded in the presence of unstable distributions,
illiquidity during turbulent times, acute estimation risk in accurately modeling the potential for
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extreme losses in tail of a portfolio, and the presence of “unknown unknowns” (also termed
“Black Swans”). Most users of VaR tend to ignore these problems and thus vastly underestimate
their firm’s value at risk.
VaR is appropriate for situations where asset price movements are stable, but in
mark-to-market environment of derivative instruments it is vital to know the risk exposure
during the holding period of an asset and not at just the end of the period. There is also the
problem that VaR “is not sub-additive” and thus “the risk of a portfolio could be larger than the
sum of the individual risks” held. VaR should therefore be considered a conservative estimate of
needs.
Sources:
Alexander, Gordon J. (2009) “From Markowitz to modern risk management,” The
European Journal of Finance, 15 (5-6): 451-461.
Andreu, Jordi, and Torra, Salvador (2009) “Optimal market indices using value-at-risk:
a first empirical approach for three stock markets,” Applied Financial Economics, 19:
1163-1170.
Bhattacharyya, Malay (2008) “Contemporary Financial Risk Management: The Role of
Value at Risk (VAR) Models, An Academic Perspective,” IIMB Management Review, 20 (3):
292-296.
Janabi, Mazin A. M. (2009) “Commodity price risk management: Valuation of large
trading portfolios under adverse and illiquid market settings,” Journal of Derivatives & Hedge
Funds, 15 (1): 15-60.
URLs for Federal Laws:
12
Brief Summary of the Dodd-Frank Wall Street Reform and Consumer Protection Act
http://banking.senate.gov/public/_files/070110_Dodd_Frank_Wall_Street_Reform_compre
hensive_summary_final.pdf
Text of the Gramm-Leach-Bliley Act, The Financial Services Modernization Act of 1999
http://thomas.loc.gov/cgi-bin/query/z?c106:S.900.ENR:
Text of the Glass-Steagall Act, The Banking Act of 1933
http://www.archive.org/details/FullTextTheGlass-steagallActA.k.a.TheBankingAcoOf1933
URLs for The New York Times coverage of the Goldman Sachs Case:
The New York Times at
http://dealbook.blogs.nytimes.com/category/main-topics/the-goldman-fraud-case/
The New York Times, Goldman Sachs “Abacus” Marketing Materials at
http://documents.nytimes.com/goldman-mortgage-document
Videos related for the Case Study:
Goldman Sachs CEO Lloyd Blankfein speaks with Charlie Rose, April 30, 2010, 51.11
minutes. View streaming at www.charlierose.com/view/interview/10989; Purchase:
http://www.amazon.com/gp/product/B003ES5GLS/?tag=charlierose-20, $24.95
Goldman Sachs CEO Lloyd Blankfein speaks with CNN’s Fareed Zakaria, May 2, 2010,
33.07 minutes. View streaming:
http://money.cnn.com/video/news/2010/04/40/n_goldman_intv.cnnmoney/index.html
CNBC’s David Faber, “Goldman Sachs: Power and Peril,” premiered on Wednesday,
October 6, 2010, 9 pm EDT, at http://www.cnbc.com/id/37274104
13
Financial Crisis Inquiry Commission: Subprime Lending & Securitization &
Government, April 7, 2010 at http://www.c-spanvideo.org/videoLibrary/event.php?
id=183204
2008 Financial Crisis and the Federal Reserve, Day 1, Part 1, Program 292886-1, 1 hour
44 minutes, $29.95
2008 Financial Crisis and the Federal Reserve, Day 1, Part 1, Program 292886-101, 53
minutes, $29.95
2008 Financial Crisis and the Federal Reserve, Day 1, Part 1, Program 292886-2, 2 hours
30 minutes, $29.95
2008 Financial Crisis and the Federal Reserve, Day 1, Part 1, Program 292886-3, 2 hours
24 minutes, $29.95
Senate Homeland Security and Governmental Affairs Subcommittee, April 27, 2010 sy
http://www.c-spanvideo.org/videoLibrary/event.php?id=183605
Investment Banks and the Financial Crisis, Directors, Program 293196-1, 5 hours 21
minutes, $59.90
Investment Banks and the Financial Crisis, Executives, Program 293196-2, 1 hours 42
minutes, $29.95
Investment Banks and the Financial Crisis, Goldman Sachs Chairman and CEO, Program
293196-3, 3 hours 28 minutes, $29.95
Original Documents for the Case Study:
14
United States Senate Committee on Homeland Security and Government Affairs,
Permanent Subcommittee on Investigations, Wall Street and the Financial Crisis: The Role of
Investment Banks at http://hsgac.senate.gov/public/index.cfm?
FuseAction=Hearings.Hearing&Hearing_ID=f07ef2bf-914c-aagg-27129f8e6282
Member Statements
Senator Carl Levin (D, Michigan)
Senator Tom Coburn (R, Oklahoma)
Senator Mark L. Pryor (D, Arkansas)
Witness Testimony (Statements) from:
Daniel L. Sparks, Former Partner, Head of Mortgages Department
Joshua S. Birnbaum, Former Managing Director, Structured Products Group Trading
Michael J. Swenson, Managing Director, Structured Products Group Trading
Fabrice Tourre, Executive Director, Structured Products Group Trading
David A. Viniar, Executive Vice President and Chief Financial Officer
Craig W. Broderick, Chief Risk Officer
Lloyd C. Blankfein, Chairman and Chief Executive Officer
United States Senate Committee on Homeland Security and Government Affairs, Permanent
Subcommittee on Investigations, Wall Street and the Financial Crisis: The Role of Bank
Regulators at http://hsgac.senate.gov/public/index.cfm?
FuseAction=Hearings.Hearing&Hearing_ID=455470c7-f48b-422c-a416-e210f3619633
Member Statements
Senator Carl Levin (D, MI)
15
Witness Testimony (Statements) from:
The Honorable Eric Thorson, Inspector General, U.S. Department of the Treasury
The Honorable Jon T. Rymer, Inspector General, Federal Deposit Insurance Corporation
Mr. John Reich, Former Director, Office of Thrift Supervision
Mr. Darrel Dochow, Former West Regional Director, Office of Thrift Supervision
Mr. Lawrence Carter, Former Examiner-in-Charge (2004-2006), Current National Examiner,
Office of Thrift Supervision
Mr. John Corston, Acting Deputy Director, Large Institutions and Analysis Branch, Federal
Deposit Insurance Corporation
Mr. J. George Doerr, Deputy Regional Director, Division of Supervision and Consumer
Protection, Federal Deposit Insurance Corporation
The Honorable Shelia C. Bair, Chairman, Federal Deposit Insurance Corporation
Mr. John E. Bowman, Acting Director, Office of Thrift Supervision
United States Senate Committee on Homeland Security and Government Affairs, Permanent
Subcommittee on Investigations, Wall Street and the Financial Crisis: The Role of High Risk
Home Loans at
http://hsgac.senate.gov/public/index.cfm?
FuseAction=Hearings.Hearing&Hearing_ID=d16e2709-2e60-4b1e-9255-37a40aefdc13
Member Statements
Senator Carl Levin (D, Michigan)
Senator Susan M. Collins (R, Maine)
Witness Testimony (Statements) from:
16
James Vanasek, Former Chief Risk Officer (2004-2005), Washington Mutual Bank
Ronald Cathcart, Former Chief Risk Officer (2006-2008), Washington Mutual Bank
Randy Melby, Former General Auditor, Washington Mutual Bank
David Schneider, Former President of Home Loans, Washington Mutual Bank
David Beck, Former Division Head of Capital Markets, Washington Mutual Bank
Stephen Rotella, Former President & Chief Operating Officer, Washington Mutual Bank
Kerry Killinger, Former President & CEO, and Chairman of the Board, Washington Mutual
Bank
United States Senate Committee on Homeland Security and Government Affairs, Permanent
Subcommittee on Investigations, Wall Street and the Financial Crisis: The Role of Credit Rating
Agencies at
http://hsgac.senate.gov/public/index.cfm?
FuseAction=Hearings.Hearing&Hearing_ID=5f127126-608-a-4802-ba77-d1bdffdfbe9b
Member Statements
Senator Carl Levin (D, Michigan)
Senator Tom Coburn (R, Oklahoma)
Witness Testimony (Statements) from:
Frank Raiter, Former Managing Director, Mortgage-Backed Securities, Standard & Poor’s
Richard Michalek, Former Vice President Senior Credit Officer, Structured Derivative Products
Group, Moody’s Investors Service
Eric Kolchinsky, Former Team Managing Director, Structured Derivative Products Group,
Moody’s Investors Service
17
David Schneider, Former President of Home Loans, Washington Mutual Bank
Arthur C. Cifuentes, Ph.D., Former Moody’s Senior Vice-President, Current Director, Finance
Center, University of Chile
Susan Barnes, Current Managing Director, Mortgage-Backed Securities, (Former North
American Practice Leader, Residential Mortgage-Backed Securities), Standard & Poor’s
Yuri Yoshizawa, Group Managing Director, Structured Finance, Moody’s Investors Service
Peter D’Erchia, Current Managing Director, U.S. Public Finance, (Former Global Practice
Leader, Surveillance), Standard & Poor’s
Raymond W. McDaniel, Jr., Chairman and Chief Executive Officer, Moody’s Corporation
Kathleen A. Corbet, Former President (2004-2007), Standard & Poor’s
Ethical Training provided to Registered Traders:
FINRA Institute at Wharton CRCP Program
Session: Enhancing Professional Conduct in the Financial Services Industry, Professor
Eric Orts, Legal Studies and Business Ethics and Management, University of Pennsylvania
Session: Current Issues in Financial Reporting, Professor Brian J. Bushee, Associate
Professor of Accounting, University of Pennsylvania
18
