Tuesday, April 20, 2010

Do Goldman Sachs and Wall Street Require Tougher Regulation?

Time will tell if Goldman Sachs is guilty of financial misconduct as charged by the Securities and Exchange Commission. But it is timely to weigh in on the firm’s conduct as an example of what can go wrong on Wall Street, and whether new legislation is required to prevent asset-backed securities and other derivatives from putting the financial system at risk.

In the wake of the 1997 Asian currency crisis, I was asked by some investor friends to meet with three hedge fund managers in Florida and New York in December 1997 to evaluate their trading strategies. These funds only allowed redemptions at the end of each quarter. Although they beat market indices every year since 1994, the investors were concerned about financial contagion spreading from Asia. They wanted to decide whether to adjust their positions before the doors closed on redemptions for another three months.

I met with the managers of the funds and the mathematicians who designed their trading strategies. At one I was given a fifty-page paper replete with mathematics explicating its winning trading strategy. I concluded in five minutes that the mathematician was from outer space and that the manager had hit a winning streak amplified by twelve-to-one leverage. I told my friends that I wouldn’t invest a penny with that fund. They closed their positions at the end of 1997. To conclude this particular story, the fund declined 16.2% in April 1998, 8.4% in May 1998, and 19.2% in June 1998. It reduced its positions from over $5 billion to just over $400 million. The other two funds were similar in their operations, of which one was later charged by the Internal Revenue Service for failing to report income and pay taxes.

What accounted for the losses? They resulted primarily from “unusual market conditions that affected the Fund’s mortgage pass-through securities and related hedging instruments and losses in liquidating positions.” The problem was falling bond yields that dropped home mortgage rates to their lowest levels in five years, below treasury bonds, which pummeled investors in leveraged mortgage-backed securities as home owners refinanced at lower rates and prepaid loans.

Imagine that! Mortgage-backed securities were at the root of hedge fund failures in 1998. No charges or allegations of fraud were leveled by the SEC. Nor were the risks understated in the funds’ prospectus. The operations of these funds never posed any risk to the financial system until Long Term Capital Management came along with its massive, highly-leveraged bets. Still, numerous high net worth individuals were attracted to funds promising high returns based on mathematical trading and hedging strategies.

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