Vampire squished?
Apr 22nd 2010 NEW YORK
From The Economist print edition
What is bad for Goldman is bad for Wall Street, but good for regulatory reformers
WHEN he was a child, Warren Buffett had an awe-inspiring encounter with Sidney Weinberg, Goldman Sachs’s legendary leader, sparking a lifelong affection for the bank. These days the super-investor’s admiration for Wall Street’s most powerful firm, cemented by an investment during the recent crisis, puts him in a minority—and one that shrank further when, on April 16th, the Securities and Exchange Commission (SEC) accused Goldman and one of its employees of fraudulently misrepresenting structured instruments tied to subprime mortgages. The civil charges have dented the firm’s aura of invincibility, sent shivers across Wall Street and possibly (and perhaps not coincidentally) changed the calculus of regulatory reform.
The case centres on a synthetic collateralised debt obligation that Goldman structured and marketed. It told investors that the securities bundled together to form the CDO, known as ABACUS, had been selected by an independent “collateral manager”, ACA. The SEC alleges that Goldman failed to disclose that Paulson & Co, a hedge fund that also had a hand in choosing what went in, had bet that the CDO would perform poorly. This gave it an incentive to select securities that would bomb—and bomb they did, costing investors, including IKB, a German bank, and ACA itself, $1 billion. The employee, Fabrice Tourre, is alleged to have misled ACA into believing the hedge fund was a long investor.
Such charges are usually announced along with a settlement. But Goldman’s determination to fight—with help from a former White House counsel—is not surprising, given what is at stake. The charges are sharply at odds with the firm’s jealously guarded self-image as a paragon of integrity. Goldman sees itself as “long-term greedy”, preferring to forgo profit today rather than to alienate a client.
Many outsiders think the crisis exposed this characterisation as bogus. The popular narrative is that Goldman uses its privileged trading position in capital markets to double-deal, favouring some clients more than others, but above all favouring itself; that it sneakily sought to profit from the crash; that its alumni in high places helped it manipulate the bail-out; that it contributed to the global fiscal crisis by helping Greece and other countries mask their debt; and so on. The media have heaped on the pressure, comparing Goldman to a vampire squid and mocking its boss, Lloyd Blankfein, for suggesting, albeit tongue-in-cheek, that it was doing “God’s work”. An insider admits that the fraud charges will “fan the flames”.
Still, the SEC must prove its case. The regulator has helped itself by boiling it down to a fairly straightforward failure of disclosure. But lawyers say it is a gamble, reflected in the commission’s three-to-two split on whether to proceed. The investors were sophisticated (on paper, at least) and the securities unregistered, reducing underwriter liability. Much of structured finance is uncharted territory for litigation. Only months ago, America’s Department of Justice lost a high-profile legal battle against two hedge-fund managers from Bear Stearns (although criminal cases have to clear a higher bar than civil cases).
Whether or not Goldman settles—if it doesn’t, the case could drag on for years—the monetary damage will be manageable. With $73 billion in shareholder equity, it could survive penalties of several times investors’ losses. More worrying is the possibility that its deep base of clients will begin to lose faith. So far they have remained loyal. Goldman posted stellar first-quarter net profits of $3.5 billion this week, driven by strong trading income. It even announced a share buy-back.
At a minimum, though, Goldman faces “headline risk”, likely further probes and distractions from running the business, says Mike Mayo, an analyst with CLSA. The board is firmly behind Mr Blankfein, but a top-level sacrifice may eventually be needed, especially if the firm’s legal troubles escalate. Britain’s Financial Services Authority has launched an investigation. Frank Partnoy of the University of San Diego’s law school expects class-action and other private suits over, among other things, Goldman’s failure to inform markets last year that it had received notification of a probe. IKB is considering its options, as is AIG, which lost a fortune selling Goldman credit protection on duff CDOs.
Goldman is not alone. It was far from the biggest CDO underwriter in the go-go years (see chart). A number of banks worked with hedge funds that wanted to short housing. The newly muscular SEC is scrutinising other deals. The rating agencies that gave CDOs such absurdly high ratings, though not named in the ABACUS case, should also worry.
Some question the SEC’s timing. The decision to attack Wall Street’s bogeyman-in-chief just as the White House makes a big push to get its financial-reform bill through the Senate is certainly striking. It raises “serious questions about the commission’s independence and impartiality,” said Darrell Issa, the top Republican on the House Oversight Committee.
Whatever the motive, the charges will increase pressure on Republican senators, already wary of being cast as Wall Street’s buddies, to compromise, reckons Douglas Elliott of the Brookings Institution, a think-tank. For many Americans, clamping down on banks is almost as big a concern as jobs, says Ted Kaufman, a Democratic senator. As The Economist went to press, Democratic leaders were hoping to bring the bill to the Senate floor within days.
The Goldman case could make it harder to see off draconian legislative proposals, such as a plan to force banks to divest their swaps-trading units. Combined with higher capital charges for trading and with the Volcker rule, which would ban banks from proprietary trading and investing in hedge funds and private equity, these would hit capital-markets businesses hard. Goldman is arguably the most exposed: 80% of its first-quarter net revenue came from trading and principal investments.
Writing the firm off would be foolhardy. It has recovered from adversity many times. Its risk management is top-notch, its people super-smart (and don’t they know it). For all its ham-fisted PR, it has, so far, been able to ride out its image problems. But now it must defend itself, both in the court of public opinion and also, quite possibly, in courts of law. And where Goldman goes, much of Wall Street could be dragged.
Copyright © 2010 The Economist Newspaper and The Economist Group. All rights reserved.
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