Friday, April 16, 2010

Jewish Law and the SEC’s Suit Against Goldman Sachs


The SEC sued Goldman Sachs and Fabrice Tourre on April 16, 2010 and charged them with fraud in connection with the structuring and marketing of a synthetic collateralized debt obligation (CDO). Goldman Sachs ended up settling the charges by agreeing to pay $550 million. See here.

Unless you have been living in a cave and have been completely cut off from outside society, you know that in the space of a few months, at least $11,000,000,000,000 ($11 trillion) was lost from the U.S. economy in 2008, and that the world was turned upside down and plunged into a deep recession, if not depression.1

What happened?

Fraud and greed had a lot to do with it.

Savvy investor George Soros said in mid-February 2009 that the world financial system has effectively disintegrated, and that there is as yet no prospect of a near-term resolution to the crisis. Soros said the turbulence is actually more severe than during the Great Depression, comparing the current situation to the demise of the Soviet Union. He said the bankruptcy of Lehman Brothers in September marked a turning point in the functioning of the market system.

"We witnessed the collapse of the financial system," Soros said at a Columbia University dinner. "It was placed on life support, and it's still on life support. There's no sign that we are anywhere near a bottom."

Could the current fiscal crisis confronting the United States have been avoided if Wall Street firms abided by Halacha (Jewish law)?.

Prof. Aaron Levine, formerly an Associate Professor of Economics at New York University and currently the Samson and Halina Bitensky Professor of Economics and Chairman of the department at Yeshiva University thinks so. He deals with this issue in an article "The Recession of 2008: The Moral Factor — A Jewish Analysis" in a forthcoming book to be published by the Oxford University Press. The same article, summarized here, appeared in the prestigious journal, The American Economist in April 2009.

Prof. Levine asserts that "The current downturn is the first post World War II recession that has its roots in widespread moral failure." Prof. Levine marshals in his article numerous Halachic authorities from the Talmud, the work of medieval jurists like Maimonides and a host of Responsa to support his argument.

He begins by locating the failures of the various players in the current crisis in terms of Jewish law.

(1) Some borrowers were guilty of taking on mortgage debt that they knew would eventuate in default. Taking on debt payment that one knows or even is not sure he can meet violates Jewish law's good faith imperative (Bava Metzia 42a and Ein Mishpat onTosafot Betzah 15b).

(2) Some mortgage brokers mislead their clients regarding the risks they were undertaking. Proffering ill-suited advice and/or misleading someone violates Jewish business ethics. Moreover, the duty devolves on the lender to disclose the hidden flaws of his mortgage product. Unless the borrower agrees upfront to discover these hidden debits on his own, the seller may not shift the burden of discovery of the hidden flaws to the borrower.

(3) Lenders gave out mortgage loans based on the borrower's stated income without requiring verification. Insofar as empirical studies overwhelmingly show that not asking the borrower to verify his stated income encourages him to lie about his income, loans without documentation effectively tempt the borrower to do so. (See Bava Metzia 75b).

(4) In the securitization process that ensued, the originator of the loan typically sold the loan to loan aggregators, who also bought loans from many other originators. The loan aggregator, in turn, sold the loans to a securitizer, who sold tranches of the income from the mortgage-backed securities he issued to investors. The securitizers failed to disclose to investors the hidden flaws in his mortgaged backed security products. Doing so would have made it clear to them that buying the securities involved great risk because the securitizer was relying on the originator for the quality of the loan.

(5) The credit rating agencies gave a triple A rating to the vast majority of tranches of the mortgaged backed securities. Since the mortgage pool consists of borrowers of impaired credit, the triple A rating makes the defect of impaired credit inherent in any one of the mortgages of the pool disappear when an investor buys a bond that entitles him to a slice of income from the entire pool. In accordance with the moral obligation to disclose hidden flaws, the credit rating agencies should have explained why the mortgage-backed securities make this flaw disappear.

Levine points out those Jewish medieval jurists like Maimonides directly linked the obligation for fiscal disclosure to these hidden flaws. Almost the entire chain of transactors in the mortgage crisis were guilty: predatory brokers for not alerting working-class borrowers to the fine print; middle-men selling mortgage debt to investment banks sliced and diced them into "tranches" that obscured their riskiness; and bankers who used hard-to-fathom financial instruments that left ultimate responsibility for the loan a mystery, even to experts.

He also notes that no amount of wrongdoing by the primary players in the subprime market could have expanded into a global recession without a mechanism that continuously replenishes the capital of the mortgage originators. That mechanism was the securitization process described above.

Additional information about Professor Levine is available here.

As noted in an earlier post, prosperity is good, as emphasized by Rabbi Daniel Lapin in Thou Shall Prosper: Ten Commandments for Making Money. As Rabbi Lapin notes, making money honestly is not a morally reprehensible activity. Indeed, it is viewed as a Divine gift, and therefore carries with it a responsibility – an obligation - to help others less fortunate through giving.

But cheating and deceiving to achieve prosperity is simply not allowed.
(A version of this post was published as "What If Goldman Sachs and Morgan Stanley Had Followed Jewish Law?"  that just appeared in the Jewish Voice and Opinion, It is available on the Internet at http://bit.ly/bZ7nbi )