Last week's fraud indictment of Goldman Sachs was validation for that firm's critics but left some wondering what exactly Goldman did wrong. After all, defenders of Goldman and its ilk point out, brokerage firms need to be able to be on both sides of transactions in order to serve their customers. Or they offer the "we were just hedging our positions" argument.

Let's step back and look. Say, for example, that client A owns a NY State Dormitory Authority bond and wants to sell to raise some cash. Unlike with common stock, there is no organized single-market trading facility for bonds. So Mr. A calls up his brokerage firm, and the firm surveys the market to set a price. Quite often they will have another client who is eager to buy the bond, so the sale and purchase (a "cross" in brokerage parlance) can take place in-house. Mr. A sells his bond for 99 cents on the dollar, and Ms. B buys it for 100. The firm earns the difference for putting buyer and seller together.

Hedging commonly takes place when a firm carries an inventory of securities for sale to clients. To guard against losses on that inventory, a firm might seek to hedge its position by going short. In this case the firm could be said to be "betting against" its own securities. But that contrary position is merely a balancing function so that the firm is not too heavily weighted by its holdings for offer to its clients, it is not a trade designed for profit.

What Goldman did was serve one client, John Paulson, to the apparent detriment of other clients. Paulson sensed the housing market was a bubble and sought to profit from its decline, asking Goldman to assemble a portfolio of bonds with a high likelihood of default so he could bet against them. This was not the problem. But when Goldman touted these toxic bond pools to investors (dare we say "suckers"?) around the world, the transaction may have crossed the line into fraud. If you build a house with bad wiring and flammable materials at the request of someone who wants to buy insurance when it burns down, then you sell that house as a cozy family dwelling, you have defrauded the family that moved in.

Now the courts can decide if what Goldman Sachs did constitutes fraud, and let the consequences fall.


(This article contains the current opinions of the author but not necessarily those of Brighton Securities Corp. The author's opinions are subject to change without notice. This blog post is for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities).