A volcanic cloud over Wall Street

Apr 16th 2010 | NEW YORK
From Economist.com

The charges against Goldman could have far wider consequences


IS THE most powerful and controversial firm on Wall Street about to get the comeuppance that so many think it deserves? On Friday April 16th America’s Securities and Exchange Commission (SEC) filed civil charges against Goldman Sachs and one of its vice-presidents, Fabrice Tourre, for allegedly defrauding investors by failing to disclose vital information about a financial product linked to subprime mortgages, as America’s housing market was starting to wobble. Goldman’s shares tumbled, dragging down stockmarkets.

The instrument in question, structured and marketed by Goldman, was a synthetic collateralised debt obligation (CDO), whose performance was tied to that of residential mortgage-backed securities. Goldman told its investors, who included some European banks, that the securities bundled together to form the CDO had been selected by an independent third party, ACA Management. The SEC alleges that the investment bank failed to disclose that another firm, Paulson & Co, a big hedge-fund manager, had in fact had a hand in choosing what went into the CDO.

This was a crucial omission, since Paulson & Co—run by John Paulson, who made billions in 2007-08 betting against the housing market—had taken a short position against the CDO; in other words, his firm would profit if the instrument performed poorly. “The product was new and complex but the deception and conflicts are old and simple,” said Robert Khuzami, head of the SEC’s enforcement division.

Goldman called the charges “completely unfounded” and said it would contest them vigorously. Paulson & Co has not been charged; the firm issued a statement saying that ACA, as the third-party collateral manager, had sole authority over the selection of securities in the CDO. In a more detailed response issued later, Goldman said it had itself lost money on the transaction and insisted that extensive information about the portfolio had been provided to the buyers, who were sophisticated investors aware of the risks.

The SEC says Paulson had an incentive to select mortgage securities that would bomb

According to the complaint, Paulson shorted the portfolio it helped to select by purchasing protection against the default of certain layers through credit-default swaps (CDSs) it entered into with Goldman. The SEC argues that these derivatives gave the hedge fund an incentive to select mortgage securities that would bomb. And bomb they did. The deal closed in April 2007; by the end of January 2008, 99% of the portfolio had been downgraded by credit-rating agencies.

Mr Tourre was responsible for the CDO, known as ABACUS. He is alleged not only to have known about Paulson’s undisclosed short position, but also to have misled ACA into believing that Paulson & Co had ploughed around $200m into the equity of the CDO.

The charges could hardly come at a worse time for Goldman. The firm has been under fire on a number of fronts, including over the handsome payout it secured from the New York Fed as a derivatives counterparty of American International Group, an insurer that almost failed in 2008. In a string of negative articles over the past year, Goldman has been accused of everything from double-dealing for its own advantage to planting its own people in the Treasury and other agencies to ensure that its interests were looked after. One profile memorably likened the firm to a “great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”
Goldman has continued to insist that it fared better than most of its rivals because of smart risk management, not because of any conflicts or duplicity. Its boss, Lloyd Blankfein, launched a vigorous defence of the firm’s practices in his recently published letter to shareholders.

The charge against Goldman will unleash waves of Schadenfreude

But this week’s hammer-blow will unleash waves of Schadenfreude. Sceptics will say it confirms their suspicions that, for all the talk of helping its customers (Mr Blankfein used the words “client” or “clients” 56 times in his letter), Goldman puts its own interests, and those of favoured trading partners, first. The SEC’s move “marks an escalation in the battle to expose conflicts of interest on Wall Street” and exposes a “cynical, savage culture” that allows dealers to deceive one customer to benefit another, said Christopher Whalen of Institutional Risk Analytics.

The charges also have implications for financial regulation. American senators are caught up in a heated debate over a wide-ranging reform bill, a key part of which covers over-the-counter derivatives, especially CDSs, which many see as having exacerbated the crisis. The head of the Senate’s powerful agriculture committee has proposed that large banks be forced to spin off their derivatives-trading units. Goldman’s problems could make it more difficult to see off such draconian measures.

The cost of any penalties to Goldman, if found guilty, is likely to be in the tens, possibly hundreds, of millions. The SEC is seeking the return of any ill-gotten gains plus a penalty. Investors in the CDOs are said to have lost more than $1 billion. But the damage could be much greater, if the affair shatters Goldman’s fragile reputation, weakened as it has been by all the negative publicity of recent months. In a sign of how seriously the market views the civil charges, Goldman’s shares were down by more than 15% at one point on Friday.

Its rivals should not feel too smug. The SEC has been working hard to beef up enforcement. The case is the first to be brought by its new structured-products group. It will not be the last. On a call with reporters, Mr Khuzami said the team was looking at other instruments, some of them no doubt structured by other firms. Goldman’s rivals have long been envious of its prowess. Some of them may soon be empathising with its plight.

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