Million Dollar Ideas: Debunking the myth of the sophisticated investor

As part of their defense in a messy SEC investigation, Goldman Sachs and investor John Paulson have trotted out a classic Wall Street defense: Their customers were "sophisticated investors."

So buyers, beware -- this is just how the big boys roll. It's a high-stakes game for experienced players; they all know the real rules; the public shouldn't care. Don't fret over the higher workings of the princes of finance, because it's not as though Mom and Pop lost money in their deals. Goldman's Fabrice Tourre told the Senate on Monday: "I was an intermediary between highly sophisticated professional investors -- all of which were institutions. None of my clients were individual, retail investors."

Wall Street loves the "sophisticated investors" argument, and little wonder: It could generate infinite financial fees if only the populace could be convinced that it's okay to fool some of the people all of the time. The problem is that even when only some of the people get fooled, all of us are paying all of the time.

Let's examine what happened with Goldman and Paulson. Goldman Sachs stands accused, in part, of giving favored financial treatment to Paulson's firm, allowing him to advise on the creation of a security, Abacus, that he wanted to fail; Goldman later sold it to investors who wanted the security to succeed, but it didn't tell them Paulson had played a role in creating the thing and shorted it to bet it would fail. To sell the deal, Goldman apparently withheld information about Paulson's involvement from the buyers, including Royal Bank of Scotland and Germany's IKB Deutsche Industriebank. The buyers lost about $1 billion on the deal, according to the Securities and Exchange Commission.

Economists call this "informational asymmetry." Everyone else calls it "not telling the whole story." The hitch is that America's securities laws require disclosing all warts to potential buyers, and banks pay lawyers millions of dollars every year to comply.

Informational asymmetry is also contagious: Once it's started, it becomes easier and easier to withhold information that buyers need in order to make decisions. And if it's done to one client, it can be done to any. Most of those clients can put 2 and 2 together and recognize that what happened in the Abacus deal is probably not an isolated incident; in Wall Street parlance, there's never just one roach. That's why Goldman and Paulson started assiduously groveling to their other clients after the SEC announced its case, hoping to ease those clients' predictable fears that the bank and the hedge fund could have treated them the same way they treated RBS and IKB.

It's not just the big clients, however, that get hurt. What Wall Street would like to ignore when it is taking bets in its casino is that a big pile of chips on the table come from regular consumers -- from their bank deposits, retirement accounts, credit-card balances, car loans and mortgages. That's why the distinction between these sophisticated investors and everyone else is nonexistent. When Wall Street banks omit information and draw profits from "institutional investors," that means they are taking money from your pension funds, your school endowments, and your city and state governments. Other sophisticated investors include hedge funds, which take money from those pension funds, or private-equity funds, which own companies that employ 10 percent of all Americans.

Pension funds, for instance, are considered "sophisticated investors" on Wall Street. But those are just pools of retirement money owed to workers. The pension funds, looking to expand their stash, invest in stocks and bonds sold by Wall Street. These pension funds also give their money to other funds, such as hedge funds and private equity funds, that invest that money in riskier investments, perhaps troubled companies or distressed mortgages. Pension funds play the Wall Street game to score a healthy return -- but when they lose, the money lost belongs to regular people.

Consider synthetic collateralized debt obligations -- which describes bets made on a bundle of securities tied to home loans -- like Abacus. Banks would need to lend $50 billion of mortgages to regular people in order to create a $1 billion CDO like Abacus, according to Michael Lewis in "The Big Short." These deals didn't cause the greatest financial crisis since the Great Depression; what they did was far worse.

They took the basic subprime losses and magnified them to a point at which no one -- not banks, not investors, not entire governments -- could bear the cost of the massacre that followed. It cost only $35 million a year to buy protection against the failure of billions of dollars of assets. When these assets failed, the insurance holders didn't get $35 million a year; they received many multiples of that. Banks nearly collapsed trying to scrounge together the money to pay back these insurance policies. The two banks that bought the Abacus deal both received multiple bailouts from the taxpayers of Germany and Britain. Yet Goldman and Paulson insist their deals concerned only sophisticated investors. Tell that to the foreign governments.

The truth is, there are no real lines dividing Wall Street and Main Street and Washington. They are all interconnected. Promiscuous federal subsidies to homeowners and low interest rates made mortgages and refinancing very popular. Unethical mortgage lenders wrote these terrible, no-money-down, no-documentation deals because they wanted the fees. Wall Street seized on the popularity of those products and churned out more bundles of mortgages to be packaged and sold to big investors. Goldman and other banks sold some of these securities and took some of them onto their own books, and many banks turned around and insured themselves against the failure of the deals by buying policies from American International Group. AIG loaded up on contracts to protect the investments, and when the housing market collapsed, AIG came up short without enough money to pay the contracts.

The banks were caught empty-handed. To save them, the Federal Reserve cut interest rates to zero and ate the banks' poison: It bought with its own money $1.4 trillion of the remaining mortgage dreck; as a result, the Fed is now the least-capitalized bank in the United States and would not pass one of its own stress tests, although there isn't enough money in the world to bail it out if necessary. Besides that, the banks got the law changed so that they could keep optimistically boosting the value of these toxic mortgage securities still on their books, making their financial positions today look far stronger than they are.

So while Wall Street is swearing up and down it was dealing only with sophisticated investors, in reality every single part of the financial system, from high to low, was involved. Taxpayers and investors lost money in the bailouts while the banks made a killing: They were paid by clients to do sloppy deals, then paid again by the government to clean them up.

It's a top-to-bottom mess. So here's a radical million dollar idea: Instead of buying the notion that there's a difference line between sophisticated investors and the mom-and-pop variety, banks should tell the truth. To everyone. Wall Street is the factory for all the financial products in the United States, and you can't allow a factory to put out some poisonous products and claim the rest are healthy.