Blogs & Comment

Social impact bonds and Goldman Sachs

The ethically challenged Goldman Sachs is investing in social impact bonds. What could go wrong?

The Goldman Sachs building in Manhattan (Photo: Youngking11/Wikimedia)

There was a remarkable report out yesterday (August 2) concerning Goldman Sachs getting into the business of social impact bonds. Apparently, New York City, desperate to lower recidivism among youth felons, but increasingly lacking the money to pay for it, will sell these bonds to the bank. The bank will get back its investment only if recidivism rates decline at least 10%; if rates decline further the bank will book a profit. The idea of involving the private sector in social services provisioning in this particular way is a contentious one, but to me it’s less so than the choice of investor. It’s Goldman Sachs. Really?

The irony is as thick as you please, but the bank’s pedigree bears reviewing because in that light New York’s choice possibly verges on the offensive for some people. Here are the highlights:

• In the run-up to the financial crisis, Goldman Sachs engaged in the practice of selling securities backed by sub-prime mortgages, but also shorted those same securities to make money once those mortgages blew up. Not technically illegal, but, as Paul Krugman once pointed out, “Goldman made profits by playing the rest of us for suckers.” The resulting crisis has led to untold misery across the U.S. and abroad.

• The Securities and Exchange Commission in 2010 accused Goldman of fraud in a civil lawsuit alleging that the bank “created and sold a mortgage investment that was secretly intended to fail.” The charge references an investment vehicle called Abacus 2007-AC1. (The bank ultimately settled for US$550 million but, in a contender for understatement of the decade, admitted only to having provided “incomplete information” in marketing  the product.)

In fact, a 2010 Senate investigation revealed there were several such vehicles, the details of which were presented in a series of incriminating e-mail messages and other documents numbering in the tens of millions. According to the Senate’s Levin report, released last year, “In addition, the case study shows how conflicts of interest related to proprietary investments led Goldman to conceal its adverse financial interests from potential investors, sell investors poor quality investments, and place its financial interests before those of its clients.” As one former Goldman salesman was quoted in the New York Times, “Here we are selling this, but we think the market is going to go the other way.”

• Goldman was also investigated in 2010 by the New York Attorney General for allegedly providing misleading information to ratings agencies in order to inflate the grades of mortgage backed securities. From one report: “At Goldman, there was even a phrase for the way bankers put together mortgage securities. The practice was known as ‘ratings arbitrage,’ according to former workers. The idea was to find ways to put the very worst bonds into a deal for a given rating. The cheaper the bonds, the greater the profit to the bank.” (The AG’s office, which is now under a different administration, informs me there was no resolution to the investigation.)

• In another case, Goldman lawyers in May accidentally released documents incriminating the bank in a naked short selling scheme directed at, which had been involved in an unsuccessful lawsuit against the bank and others.

• Previous to that Goldman settled another short-selling investigation by the SEC and paid US$450,000 while—as is the unfortunately standard practice in the financial world—neither admitting nor denying wrongdoing.

• Goldman hasn’t been content to break the hearts and banks of only local investors. In Greece, it took on a sovereign. It doesn’t get nearly the attention it should—many observers seem content instead to use Greece’s fall as an occasion to cheer on the dismantling of the welfare state—but global banks have played a very particular role in that country’s troubles. On one hand, Goldman is part of a group backing a market maker called the Markit Group of London, which deals in credit default swaps, the sale of which some argue has worsened Greece’s problems:

“A result, some traders say, is a vicious circle. As banks and others rush into these swaps, the cost of insuring Greece’s debt rises. Alarmed by that bearish signal, bond investors then shun Greek bonds, making it harder for the country to borrow. That, in turn, adds to the anxiety — and the whole thing starts over again. … Trading in Markit’s sovereign credit derivative index soared this year, helping to drive up the cost of insuring Greek debt, and, in turn, what Athens must pay to borrow money. The cost of insuring $10 million of Greek bonds, for instance, rose to more than $400,000 in February, up from $282,000 in early January.”

• That ’s the back end. But on the other hand, on the front end, Goldman is the same bank that in 2001 helped Greece’s government hide the true state of its finances—just in time for the country to gain EU membership. Result: Goldman wins going in and coming out, while the customer loses. In both cases, what was done may not have been strictly illegal (it’s contentious, but I’ll leave it to lawyers), but it was at the very least of a highly questionable ethical character.

• Goldman was involved in a municipal bond rigging scheme dating to 2002 in which it accepted money from JPMorgan Chase to not participate in bidding for business from now bankrupt Jefferson County, Alabama. (JPMorgan Chase settled in 2009 for US$75 million without admitting or denying wrongdoing.)

• And no one should forget what Mike Smith, a former executive director at Goldman, had to say about the company from which he recently resigned. Note the precise degree with which it is corroborated by all the other evidence above.

Based on this record (which is not even a complete accounting of the bank’s misdeeds), how does Goldman Sachs find itself invited in for so much as a coffee, never mind working with New York City to fund social programs? It could be that the bank is trying to burnish its relatively frayed image while making a profit, but its recent behavior is so sketchy and often deeply anti-social that at best it looks like the kind of overture the city should reject. At worst there may be some yet to be discovered fraud or gerrymandering, er, financial innovation, that ultimately leaves this “client” worse off than when it started.

It’s perhaps too early to tell, but as one of the observers in the Times article says, everyone will be watching very closely. Keep one eye on your wallet, too.