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Journalism of Courage
When he was a child,Warren Buffett had an awe-inspiring encounter with Sidney Weinberg,Goldman Sachs8217;s legendary leader,sparking a lifelong affection for the bank. These days the super-investor8217;s admiration for Wall Street8217;s most powerful firm,cemented by an investment during the recent crisis,puts him in a minority 8212; 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 firm8217;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 8220;collateral manager8221;,ACA. The SEC alleges that Goldman failed to disclose that Paulson amp; 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 8212; 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.
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 8220;God8217;s work8221;. An insider admits that the fraud charges will 8220;fan the flames8221;.
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 commission8217;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,America8217;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 8212; if it doesn8217;t,the case could drag on for years 8212; the monetary damage will be manageable. With 73 billion in shareholder equity,it could survive penalties of several times investors8217; 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 8220;headline risk8221;,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 firm8217;s legal troubles escalate. Britain8217;s Financial Services Authority has launched an investigation. Frank Partnoy of the University of San Diego8217;s law school expects class-action and other private suits over,among other things,Goldman8217;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 SEC8217;s timing. The decision to attack Wall Street8217;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 8220;serious questions about the commission8217;s independence and impartiality,8221; 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 Street8217;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.
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 don8217;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.
