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Case against Goldman is 'very weak'

  • SEC charges Goldman Sachs with defrauding investors in complex financial product
  • Fareed Zakaria says Goldman was booking a bet between sophisticated investors
  • He says the bet seems like a bad one for one side, but only in hindsight
  • Zakaria: Anger over bailouts shouldn't lead to retroactively criminalizing behavior

Editor's note: Fareed Zakaria is an author and foreign affairs analyst who hosts "Fareed Zakaria GPS" on CNN U.S. on Sundays at 10 a.m. and 1 p.m. ET and CNN International at 2 and 10 p.m. Central European Time / 5 p.m. Abu Dhabi / 9 p.m. Hong Kong.

New York (CNN) -- Federal regulators have filed a "very weak" case against the Wall Street investment bank Goldman Sachs, relying on hindsight to bolster the charges at a politically sensitive time, says analyst Fareed Zakaria.

The complaint, filed last week, accuses Goldman of defrauding investors in a complex financial instrument that was designed to allow one of the firm's clients to bet against securities tied to mortgages for U.S. homes.

SEC officials, who denied any political motivation in bringing the case, filed the charges as Congress was debating new regulations to rein in Wall Street excesses. President Obama is speaking on the subject in New York on Thursday.

"I'm largely in favor of financial reform," Zakaria told CNN. "But I also believe in the rule of law, and I believe people should be innocent until proven guilty. And the government should not use the police power of the state to retroactively criminalize things that were considered fine when the market was going up.

"I just think that we have a tendency in this country -- every time there's a boom and bust -- we get embarrassed and ashamed and we feel guilty about the boom years and the people and institutions who we glorified and lionized, we then want to throw to the wolves, and we do that using courts and criminality. And I just think that that's not fair. And it also does have the effect of chilling business activity in a way that's not ultimately helpful for the economy."

Zakaria, author and host of CNN's "Fareed Zakaria GPS," spoke to CNN on Wednesday. Here is an edited transcript:

CNN: What's did we learn about Wall Street from the SEC's complaint against Goldman Sachs?

Fareed Zakaria: I think what we really learned is that very large institutions were as involved in the very esoteric world of derivatives trading as were the hedge funds. ... I think there was a tendency to believe that these products distributed risk all over the place and therefore you actually made the system more stable. ... while that may have been one effect, another effect was actually to concentrate risk in some places, to have some institutions like Lehman Brothers with enormous amounts of risk on their balance sheet, which of course meant if they failed they would drag the whole system down with them.

CNN: What about Goldman's own behavior?

Zakaria: I think when you read the SEC's case carefully, frankly the civil case against Goldman is very weak, because what Goldman Sachs did was act as a bookie between two people who wanted to make bets.

[John] Paulson's hedge fund wanted to bet that the American housing market was going to go down. He said if you can find me someone who's willing to take the other side of that bet, I'll make the bet with you guys.

So Goldman goes out to try to find someone on the other side of that bet. ... That's why they're often called an intermediary in these things. The SEC alleges that John Paulson was deliberately putting stuff in that basket of securities that he wanted to bet against that he thought was crap. Goldman says he didn't have the final say in it but he was consulted.

What I'm not clear about is that even if Paulson did select the securities he wanted to bet against, why is that illegal? That happens in markets every day. Somebody comes to a bank like Goldman Sachs and says, "Hey, I want to bet against oil futures. I want to bet that oil is going to go down in value. Here's the instrument I want to bet against. Find me someone who wants to take the other side of this bet" -- and they go out and find that person.

The argument that Paulson was deliberately putting in securities that he thought were valueless makes no sense because, of course, that's why he was betting against them.

Now the key here is that on the other side of that bet were highly sophisticated investors with much larger funds than John Paulson's. They had seen every single security that they were betting on. So the idea that they were somehow fooled doesn't make any sense.

CNN: What about the argument that Goldman wasn't correctly describing Paulson's role?

Zakaria: There's a specific allegation that Goldman mischaracterized Paulson's involvement by saying that he was actually betting that the market would go up rather than down. Goldman denies that and Paulson's fund has also denied it. That is a case of "he said, she said."

That we'll find out in the course of a trial, if that's true, obviously it changes matters. But that does not seem to me to be the crux of the argument. ...

John Paulson in 2007 was a nobody, a midlevel hedge fund manager who had been wrong about the housing industry for the last year. So the idea that some big bank would quiver and immediately abandon all their own analysis because they realized that John Paulson was on the other side of the bet seems highly implausible. It only makes sense today because we now know that Paulson turned out to be right.

Had the bet been made six months earlier, had the same contract been drawn up, Paulson would have lost a billion dollars and the other guys would have made it because the market had been going up for years and years and all the people like Paulson who thought it was overvalued had been wrong. So the idea that this was a kind of a foolish bet that Goldman must have known would unravel was only true in hindsight.

CNN: Is there a political context to the SEC filing charges at this time?

...The idea that this was a kind of a foolish bet that Goldman must have known would unravel was only true in hindsight.
--Fareed Zakaria
Video: Goldman Sachs on the defensive
Video: Bailed out and in trouble?

Zakaria: Well it certainly seems pretty strange. One has to take at face value what administration officials are saying about the independence of the SEC, but to have the financial reform legislation proposed, to have the Senate committee hearings, to have the SEC called before the Senate and in the context of that to have them all happening within days of each other, the SEC slaps these charges on Goldman after a 3-2 vote, a very rare situation for the SEC to pursue charges despite a very divided commission, the whole thing certainly seems as though it is politically motivated.

CNN: What do you think the impact is going to be on the financial regulation debate in Washington?

Zakaria: It may be a spur that allows it to move forward, which is fine. By and large I think that many of these products should be more tightly regulated, these derivatives should be traded in a much more open and transparent way, there should be greater capital requirements, which means if you're going to take bets you should have the money to cover the bets. ...

The irony here is Goldman Sachs managed its risk better than probably every other bank on Wall Street. That's why they're still around. The ones that really managed their risk badly and imposed huge systemic costs on the taxpayer were Lehman Brothers. and Bear Stearns and AIG. Goldman is one of the places that managed its risk pretty well, precisely because it succeeded and it came out of this crisis fastest, there is a certain degree of envy and resentment that these firms all benefited from government action. And I get all that. ...

CNN: What about the issue that probably concerns the American taxpayer most -- how can people be sure they won't have to bail out Wall Street again?

Zakaria: Honestly it's a very difficult question because the financial system has become so complex. But my own view is that we were all asleep at the switch, and that government most particularly was asleep at the switch.

Look, Canada did not have a single bank failure or bailout. Canada did not have any of these elaborate new regulations that we're trying to put into place. They just had a more conservative banking culture and a more aggressive regulatory culture where the regulators using the powers that they had, which is about what the American regulators have, went into the banks and said you can't engage in so much risky behavior.

We just didn't do that in the United States. The only way to really ensure that it doesn't happen again is to have a certain kind of vigilance, for regulators to take their job seriously ... and try to make sure that these institutions are not taking on excessive risk.

We didn't do that. Everyone was asleep at the switch.