Warren Buffett & Goldman Sachs: The Scandal We Might Never Know

By David Caploe PhD, Chief Political Economist, EconomyWatch.com, 11 February 2010

Advisory: The following is based purely on circumstantial evidence and analogical reasoning and NOT any inside information.

By David Caploe PhD, Chief Political Economist, EconomyWatch.com, 11 February 2010

Advisory: The following is based purely on circumstantial evidence and analogical reasoning and NOT any inside information.

By David Caploe PhD, Chief Political Economist, EconomyWatch.com, 11 February 2010

Advisory: The following is based purely on circumstantial evidence and analogical reasoning and NOT any inside information.

During the Watergate hearings of the mid-1970s – examining dirty tricks that, in today’s perspective, seem almost laughably collegiate, but were taken very seriously at the time, which only shows how degraded American political culture has since become – a dramatic moment was provided by Republican Senator Howard Baker of Tennessee, when he asked two very simple linked questions: what did President Nixon know – and when did he know it ???

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Today the biggest political economic scandal on the horizon remains the near-meltdown of the global financial system that almost took place in Black September 2008, during which the venerable Lehman Brothers did in fact go under, nearly bringing with it several of its competitive collaborators, and ushering in not just a continuing global recession, but a crisis of credibility in major financial institutions almost everywhere – except, of course, Canada, which despite its physical proximity to the US, has somehow remained immune from the contagion still running rampant just below its southern border. [Ed: EconomyWatch.com did of course cover this topic in Canada – The Best Advanced Economy in the World.]

That the Canadian situation – so close, and yet so far – is practically NEVER discussed highlights a sad truth about public discourse regarding the causes and implications of those still-frightening events: even now we know almost as little about what was going on behind the scenes as we did at the time.

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To be sure, there have been a raft of self-justifying accounts of these events, most recently by then-Treasury Secretary, and former head of Goldman Sachs, Henry Paulson, who discussed his On the Brink: Inside the Race To Stop the Collapse of the Global Financial System on February 9 with the most successful proponent of “value investing”, the Oracle of Omaha himself, St. Warren of Buffett, in an interview streamed live on CNBC.com.

Now I generally like Buffett, basically because he takes a long-term approach to investing, and never hesitates to criticize Wall Street practices he considers shady, deceptive, or dishonest, even when they are the SOP of the day.

But as I watched his disappointingly unrevealing chat with Paulson, skipping here and there over various “highlights” of the run-up to, and dark days of, that Black September, I suddenly got a very bad feeling.

Because despite the great deal we still don’t know about what was going on then, one thing we DO know, all-too-clearly, is that Goldman Sachs, at least so far, has come out of the still-unfolding crisis in visibly better shape than any other Western financial institution.

And as indicated by two disturbing, yet brilliantly reported, articles by Gretchen Morgenson and Louise Story of the New York Times – both of which, we have argued, were seemingly “hidden in plain sight”, one on Christmas Eve, the other on the Friday night / Saturday morning of Super Bowl weekend – it also seems Goldman Sachs took a major role in “heightening the contradictions” that led to the outbreak of this global disaster.

There are several explosive tidbits in the Christmas Eve story about how Goldman – and, to be sure, other investment banks and hedge funds – sold their clients derivative packages, allegedly solidly backed by mortgages – the infamous mortgage-backed securities, or MBSs – while, at the same time, making OTHER bets against the very same items they were selling their clients.

Now, to be sure, Buffett has railed against derivatives, famously calling them “weapons of economic mass destruction”.

But the crucial point in this context is WHEN did Goldman start playing this double game of betting against the very same debt packages they were selling their clients as if they had no doubts about their solidity ???

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Worried about a housing bubble, top Goldman executives decided in December 2006 to change the firm’s overall stance on the mortgage market, from positive to negative, though it did not disclose that publicly.

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Indeed, the article points out that several key players within Goldman had started taking this stance even before the firm’s general policy on the housing market shifted into bear-ish precincts.

So a good 18 months at least before Black September 2008, Goldman as an institution had moved against what it perceived from that point forward as a bubble in the housing market they were pretty certain was going to collapse – even as they continued to sell derivatives based on that market to their clients.

What about the Super Bowl weekend story ???

Well, it was about how Goldman basically pushed AIG to the wall in a quiet but intense dispute over valuations of these very same “derivatized” mortgage-based securities against which Goldman had been institutionally betting, for at least a year, by taking out insurance on them with AIG.

The dramatic climax of this conflict, with which the Times’ story begins, took place in a conference call at the end of January 2008 – a year after Goldman had privately turned bearish on the housing market, and nine months before the explosion of Black September – a major feature of which, you may recall, was the hysteria engendered by the possible collapse of the largest insurer in the world, that very same AIG.

The obvious inference, of course, is that Goldman’s desire to make good on its bets AGAINST the housing market led it to put pressure on AIG they knew the insurance company could not withstand.

Not surprisingly, Goldman potentates vehemently took umbrage at the very idea:

[quote] [David] Viniar [Goldman’s Chief Financial Officer] said that Goldman had done nothing wrong and that the firm was merely seeking to enforce its insurance policy with A.I.G. “I don’t think there is any guilt whatsoever,” he concluded.

Lucas van Praag, a Goldman spokesman, reiterated that position. “We requested the collateral we were entitled to under the terms of our agreements,” he said in a written statement, “and the idea that A.I.G. collapsed because of our marks is ridiculous.”

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But read on and you might feel these distinguished gentlemen were being a bit disingenuous, to say the least:

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Perhaps the most intriguing aspect of the relationship between Goldman and A.I.G. was that without the insurer to provide credit insurance, the investment bank could not have generated some of its enormous profits betting against the mortgage market.

And when that market went south, A.I.G. became its biggest casualty — and Goldman became one of the biggest beneficiaries.

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So why is the timing here so important ???

Because when St Warren of Buffet finally did come in on his white horse to rescue Wall Street from its own voracious greed, and the rest of the world from its callousness and stupidity, he had his choice of places where he could put his money as a way of showing faith in the system that seemed to be falling apart at the seams.

He obviously hadn’t gotten involved during the whole Bear Stearns debacle earlier in 2008. And he could have chosen to rescue Lehman Brothers, the venerable investment house established in 1855 – but he didn’t. Or he could even have taken his billions and help stabilize the world’s biggest insurance company, AIG – but he didn’t do that either.

Instead, on the 23^rd of September, 2008, Goldman announced a private deal to sell Berkshire Hathaway $5 billion of perpetual preferred stock – basically a loan with a guaranteed 10% annual dividend of $500 million dollars – AND a “bonus” of the right to buy $5 billion of GS common at $115 / share at any time during the next five years.

Now, given Buffett’s penchant for long-term investments, one could bet he wasn’t too concerned when, at one point in the first year of the “bonus” period, GS was, like so many American homes were and would become, “underwater”, at around $47 / share.

Only these 43,478,260 warrants weren’t places Buffett was planning to live in, but, rather cash in at some point later in the 5-year period. So when the price a year later was at $186, Buffett – had he sold the entire lot – would have made a nice profit of some $3 billion.

In this context, we are duty-bound to raise the question of due diligence.

Certainly Buffett is not a man to throw his money away. And, almost equally certainly, the Oracle of Omaha had enough connections in and around Wall Street to know both

a)    that GS had turned bear-ish on the housing market by the end of 2006 AND

b)   that they had taken out downside positions backing that up with AIG – positions that, if he had known about them, he certainly knew would put AIG in the toilet to the benefit of GS if the housing market collapsed, as he almost certainly knew it would.

The questions therefore that Howard Baker asked of President Nixon re Watergate suddenly resound loudly in the wake of Black September 2008:

What did Warren Buffett know about the negative position of Goldman Sachs towards the housing market – and when – such that he had great confidence giving a $5 billion loan to GS at a time when the whole financial world seemed heading towards Doomsday ???

Maybe someday we’ll know if there’s yet another Goldman Sachs scandal to be uncovered – this time involving the last man anyone would ever suspect: Warren Buffett.

Or maybe we won’t.

 

David Caploe PhD

 

 

 

 

EconomyWatch.com