Throughout their testimony, every single Goldman Sachs employee clung to two things like life rafts:

  1. We were market-makers, providing a service to our clients.
  2. Our clients wanted to buy risk. We sold it to them.

Senators of both parties read the GS documents, which the Wall Street Journal has posted on-line here (giant .pdf), and asked questions about the sales practices of Goldman Sachs as if it were an underwriter. The answers came back in the market-maker framework. The Senators were baffled by these answers because they read the actual documents, not the legal defense constructed by the lawyers at Sullivan and Cromwell. These conflicting frameworks allowed ignorant reporters to say that the parties were talking past each other. In fact, the Senators were using the correct framework, and the GS people were confusing things on purpose.

The staff of the Permanent Subcommittee on Investigations put together a memo explaining the basics of the transactions. After defining the terms related to securitized debt instruments, the memo explains that Wall Street firms can act as “underwriter” for the issuance of new securities.

If an investment bank agrees to act as an “underwriter” for the issuance of a new security to the public, it typically bears the risk of those securities on its books until the securities are sold. By law, securities sold to the public must be registered with the Securities and Exchange Commission (SEC). Registration statements explain the purpose of a proposed public offering, an issuer’s operations and management, key financial data, and other important facts to potential investors. Any offering document, or prospectus, given to the investing public must also be filed with the SEC. If a security is not offered to the general public, it can still be offered to investors through a “private placement.” Investment banks often act as the “placement agent,” performing intermediary services between those seeking to raise money and investors. Solicitation documents in connection with private placements are not filed with the SEC. Under the federal securities laws, investment banks that act as an underwriter or placement agent are liable for any material misrepresentations or omissions of material facts made in connection with a solicitation or sale of the securities to investors.

Firms can also act as market-makers:

Investment banks sometimes take on the role of “market makers” for securities and other assets that they sell to their clients, meaning that, in order to facilitate client orders to buy or sell, an investment bank may acquire an inventory of assets and make them available for client transactions. In addition, investment banks may buy and sell assets for their own account, which is called “proprietary trading.” The largest U.S. investment banks engage in a significant amount of proprietary trading that generates substantial revenues. Investment banks generally use the same inventory of assets to carry out both their market-making and proprietary trading activities. Investment banks also typically have an inventory or portfolio of assets that they intend to keep as long term investments.

GS wants everyone to interpret the ABACUS 07-ACI transaction and similar deals as if GS were a market-maker. The fact is GS acted as an underwriter. Underwriting is the creation and sale of new securities. That is what happened with ABACUS 07–ACI, and apparently Timberwolf and other deals. Before those transaction, there were no notes. There was nothing to buy or sell. GS created the securities and sold them. That is underwriting.

The GS strategy was to insist that it was a market-maker in these transactions. That is also its legal strategy in the SEC litigation. I don’t see a plausible basis for that strategy. The law doesn’t recognize a category of “not underwriting” that arises because parties want a Wall Street bank to create some securities.

In fact, this distinction reaches the heart of the conflict of interest that Senators of both parties, and particularly the excellent Carl Levin, tried to explore without success.

In an underwriting transaction, buyers are entitled to expect certain legal protections that don’t exist in a trade in existing securities. Blankfein is right to say that if GS gets an order to buy or sell specific securities, GS is under no obligation to tell the buyer GS’s position on those securities, whatever it may be. If GS is asked its position, and it has a position, it probably has to tell the truth. In the case of a new security, it has much greater duties.

That is the heart of the SEC litigation. There isn’t a third option, unless the business-friendly courts create one for them.