In Defense of Goldman Sachs: Why the Economy Needs Short Sellers

photo: americans4financialrefo rm

Let’s say you agree with the SEC (and perhaps the Justice Department) that Goldman Sachs did something fishy. Not just regular guys-in-suits fishy, but fishy enough to be illegal. What was it, exactly?  

To judge from some of the coverage, what Goldman did wrong was to profit from the housing bust. “Goldman executives cheered housing market’s decline,” went the headline in the Washington Post:

Goldman executive Donald Mullen predicted a windfall because credit-rating companies had downgraded mortgage-related investments, which caused losses for investors.

“Sounds like we will make some serious money.” Mullen wrote.

Aha, smoking electrons!

Or forget dry financial reporting. How about musical theater? A recent episode of This American Life reported on the shenanigans of a hedge fund called Magnetar (it really makes a reporter’s life easier when the bad guys in the story give themselves comic book villain names), commissioned a Broadway showtune called “Bet Against the American Dream”:

Bet Against The American Dream from Planet Money on Vimeo.

Catchy tune, and the lyrics tell a more nuanced story than the title would suggest. But is betting against the housing market necessarily a comic-book villain thing to do? Is that Goldman’s alleged crime?

A short history of short selling

There are a variety of ways to bet against something on Wall Street, but they’re collectively called “short selling.” If the asset you’re shorting goes down in value, you make money. The more it goes down, the more you make.

The practice of short selling is centuries old, and short sellers have been vilified as Cassandras for just as long. As Investopedia puts it, “It’s safe to say that short sellers aren’t the most popular people on Wall Street. Many investors see short selling as ‘un-American’ and ‘betting against the home team’ because these sellers are perceived to seek out troubled companies.”

Indeed they do. Take Enron, for example. Remember them? One of the reasons Enron unraveled when it did is because a short seller, hedge fund manager James Chanos, shorted Enron stock. He took at look at Enron’s financials, saw that the company was built on hot air, and bet against it.

When the market delivers a bubble–whether it’s a housing bubble or an overvalued company–short sellers are the guys with pins, waiting to pop it.

This makes them hard to like. We had this great thing going! Why’d you have to go and pop it?

The tack-wielder in the Goldman case is hedge fund manager John Paulson, who saw trouble in the subprime market and wanted to do something about it (and get richer in the process). For this, David Brooks of the New York Times calls Paulson a “prescient outsider.”

In this drama, in other words, the establishment was pleasant, respectable and stupid, while the contrarians were smart but hard to love, and sometimes sleazy.

We need prescient, unlovable contrarians who put their money where their mouth is, because the bigger a bubble gets before someone comes along and pops it, the bigger and more painful the explosion.

As the Economist puts it, “Goldman helped the client on the other side of the trade profit from falling house prices. That is no crime, however, and even judged by the yardsticks of morality and economic stability, those who puffed up the housing market have more to answer for than those who bet against it.”

The Economist is a conservative commentator. Paul Krugman is not. But he agrees. “When Goldman Sachs employees bragged about the money they had made by shorting the housing market, it was ugly, but that didn’t amount to wrongdoing.”

What Goldman did

The SEC hasn’t charged Paulson with anything. They’ve charged Goldman, who helped Paulson press a bunch of bad mortgages into a security so he could bet against it.

In order to bet against something, you need someone on the other side to take the bet. The SEC alleges that Goldman, after helping Paulson stuff a sack full of junk, turned around and sold the sack to its customers, telling them it was full of sunshine.

“This was a security that was floated in the market that was expected to fail, and that’s what makes it evil,” says Robert Brusca, Chief Economist at Fact & Opinion Economics. “It’s a time bomb. Just like a terrorist leaving a bomb in Grand Central Station and walking away. And you say, well, wouldn’t it be okay if he told people he did it? Well, maybe, but it’s still a destructive act, isn’t it?”

I’m not so sure. Perhaps Goldman wouldn’t have found a German bank to invest in the bond, but it might have found more risk-tolerant investors. It’s hard to remember at this point that there was a time just three years ago when most people thought housing prices would continue to go up.

When the next bubble arrives, whatever it is (I’m hoping it’s something involving air guitar and craft beer), I want an unlikable hedge fund guy to try and pop it. One of the proposed financial reforms working its way through Congress would require derivatives to trade on exchanges. Part of what makes this a good idea is that it would make it easier to bet against the derivatives.

Sure, if Goldman defrauded its customers, hang ’em high. As for the guys who bet against the American Dream, or at least the version where people buy $500,000 houses for no money down? Two cheers for them.

Matthew Amster-Burton, author of the book Hungry Monkey, writes on food and finance from his home in Seattle.