Maybe Goldman Sachs Sold Some Rotten Eggs? So What?

Yesterday's senatorial inquisition of Goldman Sachs revealed a fundamental misunderstanding of the federal securities laws on the part of not Goldman's execs but US Senators. 

The WSJ reports that:

The senators recently completed their own 18-month investigation and came armed with emails, performance reviews and other internal Goldman documents exposing the inner workings of the bank's mortgage-related securities business.

Their conclusion (a rare bipartisan one, at that): Goldman hawked risky mortgage-backed securities even as it was quietly betting its own money that those securities would fail.

Before each witness waited a binder, half a foot thick, filled with investigative exhibits. Sen. Carl Levin (D., Mich.), the subcommittee chairman, read scornfully from one such email sent to Mr. Sparks about two Goldman bankers who nailed a particular deal. "They structured like mad and traveled the world, and worked their tails off to make some lemonade from some big old lemons," the email said.

Maybe Goldman sold investors some rotten eggs. Maybe not. So what? Goldman argues that it is being "railroaded by Congress for performing a normal market function—pricing risk and providing investment opportunities for grown-up investors," which strikes me as precisely right. It is a central tenet of the federal securities laws that you're allowed to sell rotten eggs, so long as you disclose that they're rotten. So long as Goldman fully disclosed all material facts, the fact that Goldman thought the securities being sold were "shitty," as one scatological email reference by an unwise trader put it, is not a breach of the securities laws.

Regulation of the primary market began in this country with the passage of the first state “blue sky law” by Kansas in 1911. Unfortunately, state regulation was largely ineffective: the statutes had a limited jurisdictional reach, they contained many special interest exemptions and the states had limited enforcement resources. In the aftermath of the Great Crash of 1929 and subsequent Great Depression, there was general agreement by everyone except the securities industry that the time had come for federal regulation of the securities markets.

The New Deal Congress considered three possible models for federal regulation:

• Fraud model: simply prohibit fraud in the sale of securities;
• Disclosure model: allow issuers to sell very risky or even unsound securities, provided they gave buyers enough information to make an informed investment decision
• Merit review: federal review of the merits of a security-—unsound investments could be prohibited

Many state blue sky laws had had a merit review component. But that aspect of the laws had given enormous and largely unchecked power to state securities commissioners, who were charged with determining whether the securities to be sold were sound. Corruption, arbitrary decision making, and interference with capital formation were rife under merit review.

As a result, the New Deal Congress explicitly rejected the blue sky regulatory model in favor of a disclosure-based system. The SEC thus has no authority to pass on the merits of an offering of securities.

The system that resulted fairly has been called a rotten egg statute. You could sell all the rotten eggs you wanted as long as you fully told people just how rotten they were.

It would behoove the US Senate to learn this history before they conduct their next perp walk.