goldmanThe Washington Post got its hands on an 11 page memo that Goldman Sachs (GS) CEO Lloyd Blankfein will use in his Senate testimony in Washington on Apr. 27. I'm not sure that this testimony represents Goldman's best foot forward in its attempt to deflect the idea that it's not acting in its clients' best interests.

But it could represent an interesting line of reasoning in Goldman's effort to defend itself against Securities and Exchange Commission charges that it committed fraud in marketing a collateralized debt obligation (CDO) called Abacus on which investors lost $1 billion.

I was more interested in what this defense left out -- proof that it didn't deceive its clients -- than what it included, a long diatribe on Goldman's intent. But if what it includes is the strongest part of its argument, then Goldman might be in a bit of trouble.

Was Goldman Really Unsure?

According to the Washington Post, Blankfein will use this memo as the basis for his testimony on Tuesday before the Senate Permanent Subcommittee on Investigations. The memo uses meeting notes and emails to prove that in 2006 and 2007 Goldman's top executives were confused about whether the mortgage market would keep climbing or was poised to collapse.

This confusion led to debate that resulted in Goldman's decision to reduce its mortgage-market exposure by making bets on a collapse via shorting a subprime index called ABX. But the memo also notes that Goldman retained "$13.5 billion in exposure to safer, prime mortgages." And this ongoing bullish bet cost Goldman a 2008 loss on its residential mortgage investments of $1.7 billion.

Since Goldman probably believes that this argument is the best it can muster, I'm not overwhelmed by the strength of its public relations position. That's because the public will probably be surprised that Wall Street's most powerful investment bank didn't know whether the mortgage market was going up or down.

Not Warning Clients About Uncertainty

Indeed, a report in The New York Times feeds skepticism: Goldman made more money in shorting mortgages than buying them. For example, according to the Times, Goldman CFO David Viniar bragged on July 25, 2007 that Goldman made $51 million more in one day shorting mortgages -- Viniar dubbed this "the big short" -- than it lost going long on them. Viniar patted Goldman on the back in his email to now-President Gary Cohn: "Tells you what might be happening to people who don't have the big short," according to the Times.

Goldman's confusion about the mortgage market doesn't really strike me as completely genuine because of Viniar's enthusiasm for Goldman's short position. To be fair, if Goldman had been 100% convinced that mortgages would fall, self-interest would have dictated getting rid of all its long positions. So I'm willing to accept the idea that Goldman was confused to some extent.

But rather than let its clients in on its confusion and warning them to get out before the collapse, Goldman decided it would be more profitable to let its customers keep betting on whatever outcome they believed would happen and to place a big bet against subprime mortgages for its own account.

Viewing Clients as Counterparties

This tells me that at some point, Goldman's values shifted away from always serving their clients' best interests. The client-service focus was epitomized in the 1980s when, under its leader, John Weinberg, Goldman refused to help companies do hostile takeovers because he thought it was against current and potenital clients' best interests. But Weinberg also acquired J. Aron, the trading firm that hosted Blankfein and other traders who now run Goldman and view customers as counterparties.

That subtle shift makes a huge difference because a counterparty is more like a person sitting next to you at a poker table than a company that hires you to help it achieve a business goal. Blankfein's testimony reveals that Goldman is participating in the same game as its client. Furthermore, Goldman seems to believe that clients would know this and realize that Goldman's pursuit of its own interests won't always align with those of its customers.

Blankfein's testimony also could be part of its defense against fraud charges on Abacus. Goldman isn't talking about whether it disclosed to IKB, the German bank that lost money going long on Abacus, hedge fund manager John Paulson's role in picking its designed-to-fail mortgage securities. But by testifying before the Senate that Goldman was confused about which way mortgages were headed, it might try to argue that it had no intent to deceive IKB because it didn't know whether Paulson was betting the right way or not.

If Goldman could prove that it had disclosed Paulson's role in Abacus to investors, then it probably would have done so already. And if Blankfein's testimony is the best defense that money can buy, the SEC may be on a stronger footing than I thought.

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