Goldman Case Shows Wall Street's True Colors

We’re still feeling the after-shocks from the bombshell complaint against Goldman Sachs Group (NYSE: GS) the Securities and Exchange Commission filed last Friday.

Though the case is a long way from being resolved—and appears to have some big legal weaknesses—several things are clear by now. The once-untouchable Goldman has suffered a severe blow to its reputation. The SEC has taken a small step to restoring its own once-good name.

This politically polarized case (which got through a divided Commission by one vote) has been a shot in the arm for the Obama administration’s efforts to get financial reform through Congress. And more big Wall Street firms may be in the SEC’s cross hairs for doing similar things to what Goldman is alleged to have done.

If so, this is going to be the biggest scandal to hit Wall Street since the dot.com meltdown, and the SEC’s actions will be seen as the sharpest attack on a major firm since then-New York Attorney General Eliot Spitzer sued Merrill Lynch back in 2002.

But even after the worst financial crisis since the 1930s, the Wall Street banks have won victory after victory in their lobbying efforts and have paid their undeserving minions rich bonuses, which has really stuck in the public’s craw.

I fervently hope that finally, finally something will be done to curb this extraordinary abuse of power by these opaque, unaccountable firms that have done so much damage.

At a time when most Americans are wary, even hostile, to big government—and rightly so—they just as decisively support reining in Wall Street’s dukes and duchesses with sensible regulation that prevents them from screwing things up again for the rest of us.

Because to me, the Goldman case—especially if we find similar patterns of behavior at other firms—reveals two things: First, conflicts of interest as most people understand them are just business as usual on Wall Street.

And second, the power of even more secretive hedge funds has grown to the point where they are often calling the tune. Traditional institutional investors, once the Street’s cash cow, now find themselves playing second fiddle.

As you all know, the SEC’s case rests on disclosure. The Commission claims that Goldman and a junior employee, Fabrice Tourre, made “material misstatements and omissions in connection with a synthetic collateralized debt obligation” the firm “structured and marketed to investors.”

A collateralized debt obligation (CDO) is a derivative of derivatives—a security based on securities that are in turn based on the cash flows of pools of mortgages.

Hedge fund Paulson & Co. had requested that Goldman structure such a CDO, so the fund could short the subprime housing market, which its head, John Paulson, presciently believed was about to crash.

So, in 2007, Goldman got ACA Management, a third party, to set up the CDO to sell to institutions, the SEC alleges. “We expect to leverage ACA’s credibility and franchise to help distribute this Transaction,” an internal Goldman e-mail said.

Paulson, the SEC claims, handpicked a bunch of the mortgage securities that ultimately went into that CDO, called Abacus 2007-AC1. They were chock full of adjustable-rate mortgages to borrowers with low FICO scores in Arizona, California, Florida, and Nevada, the complaint says.

Unfortunately, Goldman didn’t disclose Paulson’s role to IKB, the German bank to which it sold $150 million worth of the $1 billion CDO, nor did it mention it in its marketing materials to other institutions, the complaint says.

Paulson bought credit default swaps on the CDO—basically an insurance policy in case the mortgages defaulted—for which the Dutch bank ABN Amro was on the hook. It, too, didn’t learn of Paulson’s role in selecting this pile of junk, the SEC says.

When the subprime market tanked months later, the CDO and its underlying securities were practically worthless. Royal Bank of Scotland, which had acquired ABN Amro in late 2007, had to pay out the value of the CDS “insurance” policy, about $841 million.

Paulson paid Goldman a $15-million fee for its efforts. Paulson & Co. made around $1 billion from this deal and an estimated $15 billion in 2007 alone from similar short bets it made against the housing market. IKB’s investment was wiped out. RBS and IKB were bailed out by the British and German governments. In its response to the complaint, Goldman said IKB was a “sophisticated CDO market participant” and that it “never represented to ACA that Paulson was going to be a long investor” in the deal. It said it had a “long position” itself and lost nearly $100 million.

It maintains that the SEC’s “accusations are unfounded in law and fact” and has vowed to fight the charges. It just hired former White House counsel Greg Craig and has launched a PR offensive.

Goldman sent me the following statement:
“In this private transaction, Goldman Sachs essentially acted as an intermediary, helping to facilitate the investing objectives of two clients. Extensive disclosures as to each of the securities in the reference portfolio, similar to those required by the SEC in public transactions, were contained in the offering documents which provided all the information needed to understand and evaluate the portfolio.”
To me, this case is a microcosm of everything that went wrong on Wall Street in the last decade. And it’s not the first time Goldman, still the Street’s premier firm, has been on the hot seat about the same issue.

In January, its chief executive officer, Lloyd Blankfein, had a confrontation with Phil Angelides, chairman of the Financial Crisis Inquiry Commission, which was set up by Congress to examine the roots of the crisis.

In the hearing, excerpts of which you can watch here (about three minutes in), Angelides, the Democratic former treasurer of California, pressed Blankfein on what he described as the firm’s practice of “simultaneously [betting] against securities you sold to clients,” many of which “went bad within months of issuance.”

Blankfein responded that Goldman was a “market maker” simply trying to meet the demands of different clients. Angelides shot back: “It sounds to me a little bit like selling a car with faulty brakes, and then buying an insurance policy on the buyer of those cars.”

And the practice appears to have been extensive. Last November, McClatchy reported that “in 2006 and 2007, Goldman peddled more than $40 billion in securities backed by at least 200,000 risky home mortgages, but never told the buyers it was secretly betting that a sharp drop in US housing prices would send the value of those securities plummeting.”

And Goldman wasn’t even the leader in this market. According to Credit Suisse, Merrill Lynch, now part of Bank of America (NYSE: BAC), and UBS (NYSE: UBS) were the biggest issuers of CDOs.

Who knows how many other clients of these firms got the short end of the stick? The New York Times reported that the SEC has a 40-person unit investigating the CDO market on Wall Street, and undoubtedly more shoes will drop.

It all comes down to conflict of interests, which some clients even seem to expect in dealing with Goldman.

“As a firm, I am cautious about telling them anything and assume they will use whatever will make them money,” a private equity chief told The Financial Times.

“Goldman is only interested in Goldman,” another big client said.

Because Goldman, whose partners once prided themselves as being investment bankers/statesmen, is now basically a money machine. 

In its blowout first-quarter 2010 earnings report, it said 80% of its revenues—80%!—came from trading and principal investments (for its own account). Asset management and the once-mighty investment banking accounted for a mere 10% of revenues each.

A lot of Goldman’s trading and principal investing, of course, involves clients as well, but the overall trend is clear: Wall Street is less and less a relationship business and increasingly a transactional one.

“A hit to ‘reputational capital’ is not the disciplinary force it once was. They have no compunction about being short one customer and long the other,” says Professor Franklin Edwards, an expert in securities markets at Columbia Business School.
 
“It is that I don’t care anymore about any relationship; I [only] care where the money comes from,” says Tamar Frankel, professor at Boston University School of Law. “The only client they [serve] is themselves.”

And the big hedge funds, of course.

“There’s so much money in these hedge funds,” says John Steele Gordon, a financial historian and author of The Great Game, a comprehensive history of Wall Street.

Before World War II, he says, individual investors were Wall Street’s bread and butter. Then mutual funds became the focus, followed by pension funds, and now hedge funds appear to be in the driver’s seat.

“Both hedge funds and traditional institutional investors represent important client bases for Goldman Sachs,” a Goldman spokesman said.

“Hedge funds have become powerful institutions. They are now giant money managers and traders and they probably generate more fees than pension funds,” says Professor Edwards.

During the dot.com boom and bust, Wall Street dumped rotten technology stocks on individual investors while the firms pocketed fat investment banking fees from those same tech turkeys.

Now they’ve stuck giant pension funds and banks—some of whom should clearly have known better—with CDOs the firms shorted or helped hedge fund clients short. Size is no longer a barrier to being road kill on Wall Street.

Those institutions need to defend their interests more vigorously. Some of them, who are big stockholders in investment banking firms, need to push managements harder on bonuses and executive pay. They also need to insist on a much broader application of the fiduciary duty standard in the markets in which Wall Street operates, says Professor Frankel.

“It’s past the point of no return,” she says. Clients have to demand whether these firms are betting against them, and if they are, “head for the door.”

Otherwise, the big institutions will be taught the lesson we individual investors have learned the hard way.

When you’re dealing with Wall Street, it’s like being in a high-powered poker game. If you sit down at the table and don’t know right away who the patsy is, well, then—it’s you.

Howard R. Gold is executive editor of MoneyShow.com. The views expressed here are his own.