Goldman Sachs and the SEC

Alasdair Macleod – 18 April 2010

Goldman Sachs and one of its employees have been charged with fraudulently ripping off its clients by the SEC. Specifically, the SEC alleges that Paulson & Co, a hedge fund, helped Goldman select the underlying investments in a synthetic collateralised debt obligation based on a portfolio of residential mortgage-backed securities. Paulson then shorted the issue, making $1bn, while Goldman’s clients lost a similar amount. To give the deal a veneer of respectability, Goldman appointed as independent advisor a company called ACA Management LLC (“a third party with experience analyzing credit risk in RMBS”).

The SEC has been able to make its case for fraud because of certain emails issued by the employee, Fabrice Tourre, which allegedly misled investors into believing that Paulson’s role was aligned with that of the investing clients. There is no charge made against Paulson or ACA Management, presumably because Goldman and its employee are the regulated parties.

The email evidence is central to the case, but to clients of all investment banks the existence of incriminating emails is a moot point. It is commonly believed this is how investment banks behave, evidence or no evidence. When the credit crunch first happened, we heard about the Norwegian village pension fund that somehow had invested in sub-prime mortgages and the German banks whose Irish subsidiaries turned out to have invested in worthless triple-A mortgage backed securities. Then last year there were Harvard University, which paid $500m up front, and a further $425m over the next forty years to cancel derivative transactions that went wrong, and the Italian towns and cities which bought interest rate swaps and are now faced with unexpected losses. And only this week, the French town of St Etienne was badly stung by an interest rate swap, triggered unbelievably by the fall over the last two years in the sterling-Swiss franc rate, neither of which are in common use there.

It seems that municipalities and other local authorities all round Europe are in the same boat. With combined debts of over €1.2 trillion in the EU member states, it is thought that collectively they are liable for several billion euros in derivative deals. It turns out that Italian towns and cities alone have bought investments and derivatives for an estimated cost of €35bn, all of which are now worthless. Worse, some of them have turned into debts, because that is the downside of some of the derivatives into which these unwitting treasurers invested their taxpayers’ funds. Not surprisingly, some of these deals are being taken to court. Milan for example is suing Deutsche Bank, JPMorganChase, UBS and Hypo Real Estate’s DEPFA.

It seems the investment banking community has been stuffing all sorts of clients at home and abroad with bad investments for a long time. There are two types of bad investment: those where an investment has been made in securities that turn out to be worthless, and derivatives that explode in the client’s face years after the contract was initiated. It is the latter category that is now causing trouble, and the cities, towns and local governments are reluctant or refusing to pay.

It is against this background that Goldman is now being charged with fraud by the SEC. The impression outside Wall Street and in the European plazas is that the Masters of the Universe have turned out to be little more than crooks. All those small-town treasurers were conned and swindled out of public funds. If Deutsche bank et al had a chance of Milan being forced to honour its derivative contracts by the Italian courts that chance has now probably been blown out of the water. St Etienne, which has refused to pay Deutsche Bank (yes, them again) is unlikely to hurry. These are the likely results of the SEC’s action against Goldman: to have opened the proverbial can of worms.

It is hard not to moralise. The behaviour of the investment banks is the logical result of the system. The basis of dual capacity, where the bank is both market-maker and broker is fundamentally a conflict of interest. This is meant to be addressed by regulation. Unfortunately, give a bank a book of rules, and it will devise ways to avoid them. If you make the banks very powerful and give them the reputation of being Masters of the Universe, they will even forget why the rules are there. They may even think they are beyond the rules.

The basis of regulation is also flawed in assuming that clients can be divided into expert or other investors, the former being treated on a caveat emptor basis, and the latter requiring risk warnings that exceed anything a health and safety officer would regard as reasonable. Town treasurers are paid to understand investment risk, but it turns out that they are wildly overpaid for this function. And it is not just the French and Italians: remember the list of British town councils that lost over £1bn to the Icelandic banks, and remember also that they had forgotten the lesson of BCCI less than thirty years before.

Moralising over, we are left considering the most unlikely of possibilities. Everyone saw dangers from derivatives markets emanating from within. They pointed at counter-party risk, a medium size bank failure perhaps unravelling chains of deals with unexpected consequences; the massive size of the market, with over $600 trillion in the US banking system alone; or the opacity of the over-the-counter markets. After all these expected fears, it might just turn out that the SEC has given the nod to people in distant lands, whose petty ambitions are no higher than a mayoral chain, to renege on a contract no-one understood.

Perhaps there is something in chaos theory after all.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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