Friday, April 16, 2010

The SEC's Case: Goldman, Too, Danced to the Music

Today's enforcement case by the SEC against Goldman Sachs for allegedly making misrepresentations in the marketing of a synthetic CDO called ABACUS 2007-AC1 signifies many things. Goldman hasn't formally responded in court, but has denied certain assertions by the SEC. We won't attempt to predict the legal outcome at this early stage. But a few observations seem fair.

First, the case signals a return by the SEC and its Division of Enforcement to the big leagues, after a painful stint in Triple A. The agency will be on the front pages of newspapers tomorrow--this time in a positive light. Of course, the SEC needs to get a good result--victory at trial or a favorable settlement. But its willingness to take on the most imperious doyenne on Wall Street--which couldn't even get its CEO on the train from New York to Washington for a meeting with the President late last year (are they now rethinking that one?)--reflects pugnaciousness badly needed in the regulatory structure.

Second, the case will strengthen the movement toward reforming financial regulation, with a special nod in favor of the Volcker rule--there's really no good reason for insured deposits to subsidize this sort of behavior. Additionally, the two principal victims were European banks. The SEC charges will only fuel the already robust movement in Europe to rein in the Wild West antics of the derivatives markets--in part because the case broadly echoes Goldman's reported role in helping Greece pretty up its balance sheet, thus effectively increasing Greece's risk of overextending itself, and then creating a trading vehicle in London to short sell Greece.

Third, regardless of whether or not Goldman is legally liable, one has to wonder what on earth Goldman's management was thinking when they signed off on this deal? By early 2007, when the deal was done, Goldman was aware of the growing weakness in the mortgage markets. Certain e-mails were quoted in the SEC's complaint which make that clear and Goldman hasn't denied the contents of the e-mails. When a bank knows a market is poised for problems, why structure a deal that involves selling long positions in that market? Surely there are less problematic ways to make money. Goldman made $15 million in fees for structuring this deal (although it claims to have lost $90 million in the end). It could pay out a lot more than $15 million to injured investors if it loses at trial. And even if it turns out that Goldman didn't break any rules, why would it have benefited from putting clients in a position of significant potential for loss? These weren't dot com IPOs. These were interests in mortgages, supposedly a pretty safe investment. Clients would reasonably have expected that they wouldn't be put at major risk by a silk stocking firm like Goldman when they were looking for comparative safety.

The old Goldman Sachs (primarily, the firm before it went public), had a strong sense of self-awareness and propriety, turning away from many deals and their potential fees simply because they would have been too risky for clients and therefore too risky to Goldman's reputation and standing. Today's Goldman seems to have lost that sense of judgment and moderation.

What may have really been going on, we speculate, could be that Goldman wanted the fees. Although $15 million isn't much for an investment bank that makes billions a year, it is a lot to individual Goldman executives, like the man who was named as a defendant by the SEC, Fabrice Tourre. Tourre, alleged to be 31 today, was in 2007 exactly at the young age where ambitious investment bankers push extremely hard to climb the career ladder toward anticipated stardom--old enough to have significant responsibility and latitude, but frequently not enough experience to know that cents and sense--especially common sense--are very different things. Young, high powered execs will push, push, and push their deals because they're focused on bonus time. But a mature financial institution can't just knuckle under to its young guns. In a highly visible and highly regulated industry like financial services, how you generate revenues matters as much as how much you generate. Chuck Prince, former CEO of Citigroup, famously said (and we paraphrase) that as long as the music in the mortgage markets was playing, Citigroup had to get up and dance. It did, and it got clobbered. Now we have Goldman, by early 2007 seemingly aware of the growing difficulties in the mortgage markets, yet also wanting to dance while the music was playing.

The nightly cleaning crews at Goldman's offices surely earn modest wages. But those are honest wages earned in exchange for a fair night's work. With today's allegations about ABACUS 2007-AC1, we have Goldman, which has tried for decades to present itself as a cut above all those scumbags on Wall Street, not comparing well to its cleaning staff. Goldman was supposed to be smarter, a protector of clients' interests, a firm that took the long view and would forgo current income for the sake of propriety. Its elite, blue blood aura provided special entree in Washington, as well as on Main Street. People thought of Goldman as clever, very quick on its feet, highly profitable, yet thoughtful before it was greedy. That bubble has now burst, and GS is revealed to have feet of clay. On one level, that's reassuring, but on many others, it's not. Expect financial regulatory reform legislation to be enacted by the mid-term elections.

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