how the goldman sachs fraud case could accelerate wall street reform

8/9/2019 How the Goldman Sachs Fraud Case Could Accelerate Wall Street Reform

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April 19, 2010

How the Goldman Sachs Fraud Case Could

Accelerate Wall Street Reform[Editor's Note: Money Morning's Martin Hutchinson, a former merchant banker, presents us

with an insider's analysis of the Goldman Sachs fraud case.]

By Martin Hutchinson, Contributing Editor, Money Morning

When the U.S. Securities and Exchange Commission announced Friday that ithad filed

a fraud action against Goldman Sachs Group Inc. (NYSE: GS), thenewshit the financial

markets like a carefully targeted bomb.

The Goldman Sachs fraudcase, which relates to the investment bank'ssubprime-

mortgage business, caused the financial giant'sshares to nosedive 12.8%. The fallout

spread to the broader markets, too, causing theDow Jones Industrial Average to drop

1.1% and theStandard & Poor's 500 Index to skid 1.6%.

That reactionwasn't overblown.

Depending onhow rough theSECwants to play it, thecasehas the potential to shut

down thecartel known asWall Street. Itcouldeven jump-start the kind ofsweeping

overhaul that legal or regulatory reformistshaveso far failed to launch.

Wall Street behemoths like Goldman Sachshave innumerableconflicts of interest. But

it's been obvioussince theglobal financial crisisstruck withgale force in 2008 that

some of the mostegregiousconflicts involved Goldman'ssubprime mortgage operations

For more than a year in 2006-07, while the marketwas falling apart, Goldmanwas

issuingsubprime-mortgagecollateralized-debt obligations (CDOs) to investorseven as it

wasshorting thehell out of thesubprime-mortgage market. Goldmanwasdoing this

bothdirectly, and throughcreditdefaultswaps (CDS), most ofwhichwerewritten byAmerican International Group Inc. (NYSE:AIG).

When the marketcollapsed, Goldman made a huge trading profit- including about $13

billion provided by U.S. taxpayers as part of the AIG bailout.

From Duty Bound to Profit Hounds


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Before the metamorphosis ofWall Street took place around 1980, the issuinghouse's

duty not to sell obvious rubbish to investorswas thought to besacrosanct. The issuing

house's reputation among investorswasviewed as its most important asset, and

blemishes on that reputation took many years to overcome.

Certainly, we in the London merchant-bankingcommunity -where I workedduring the

high-roaddays- believed all this to be true.

This all changedduring the "Go-Go '80s," leavinguswith theWall Street thatwehave

today. In the aftermath of the biggest financial crisissince the Great Depression, an

examination of precisely whathappenedhas focused on the riggednature of thegame

- andhasspawned intensecriticism of the lack of oversight from the regulatorswho

weresupposed to besafeguarding individual investors.

Given this past lack of aggressiveness by the regulatory andenforcementcrowd, it'sno

surprise that Friday'sstrident move by the SEC sparked a sell-off in Goldman'sshares-

and in the broader market indexes.

The initial reactionwas interesting: At first, goldsold off rapidly, while thegeneral stock

marketwasslower to react. I've long-suspected that trader communicationwas pretty

limited in intellectual content. And in thiscase- in an interesting manifestation of the

"Chinese-whisper effect" - a frantic "Sell Goldman" call obviously got transmuted into

"Sell Gold." After anhour or two, as thegeneral marketsold off, theslower members of

the tradingcommunity caughtup andgold reboundedsomewhat.

The "Greatest Trade Ever"

In its initial form, the SEC suit is limited, and in any case includes only civil charges of

fraud. In one particular subprime mortgage CDO ("collateralizeddebt obligation") deal

called "ABACUS," done inearly 2007, Goldman allegedly colludedwith thehedge fund

operator Paulson & Co., whichwasseeking to short thesubprime mortgage market

(which itdidvery successfully, makingcompany founder John A. Paulson a multi-

billionaire inwhathas become known as "thegreatest tradeever.")

Goldman told investors that theresidential mortgage-backedsecurities (RMBS) for

ABACUS had beenchosen by a neutral "portfolio selection agent," ACA Capital. In

reality, Goldman allowed Paulson to sort among the RMBS selected by ACA Capital for

ABACUS -choosing, ofcourse, those most likely to go wrong. In return, Paulson paid

Goldman a fee of $15 million (he reaped $15 billion onhis "greatest trade").


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Paulson's role in thedeal wasnowheredisclosed to investors. By January 2008, less

than a year after the issue, 99% of the RMBS in the ABACUS portfolio had been

downgraded by the rating agencies.

Goldman thensold CDOs in ABACUS to investors, who lost more than $1 billion,

according to the SEC. Among those investorswere the Dutch bank,ABN AMRO Bank

NV, which lost $850 million, and Germany'sIKB Deutsche Industriebank AG, which lost

$150 million. Both bankswere later bailed out by their respectivegovernments- at the

expense of their country's taxpayers, ofcourse.

If this SEC suit remained isolated, itwould be a serious matter to Goldman, butnot life-

threatening. However, in the process of fighting thecase, SEC lawyerswill have the

right to carry out a "discovery process," whichwill enablegovernment lawyers to fish

around in Goldman's records to find anything that mightsolidify thecase- quite

possibly boosting Goldman's potential culpability and liability.

By definition, thediscovery processcan't becontrolled: An aggressive prosecutor often

finds moredamningevidence- possibly evenenough to transform thecase from a civil

proceeding into a criminal one. At that point, thestakesescalateexponentially. Indeed,

the terms levied against thosewho aredirectly involved- andeven against the top

managers onwhose "watch" the transgressions took place-can rival the 25-year

sentence imposed on former Enron Corp. PresidentJeffrey K. Skilling (this is, after all, a

billion-dollar case.)

What's more, if prosecutorswant to get really aggressive andenoughevidence is there,

they can invoke theRacketeer Influenced and Corrupt Organizations Act of 1970

(RICO), alleging that thecrimes formed a "pattern of racketeering activity" committed

by an "ongoingcriminal organization." At that point, if Goldman lost, itcould

conceivably beshutdown.

You may think that'sextreme- and I agree- but RICO prosecutionshave beenused

againstWall Street in the past. Thewell-respected investmentcompany, Princeton-Newport, wasshutdownunder a RICO prosecution in 1988. Junk-bond king Michael

Milkenwas also prosecutedunder RICO. Andhisemployer Drexel Burnham Lambert,

almost as prominent as Goldman Sachs in itsday, avoided a RICO prosecution only by

paying a $600 million fine-whichsubsequently forced the firm into bankruptcy.

In other words, thissuit against Goldman is a really major deal. Youcanexpect that


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Wall Street's massive lobbying musclewill be brought to bear - by Goldman and

probably by other Wall Street investmenthouses- in aneffort to make prosecutors

tread lightly. Butwith public opinion on the other side and a heavily anti-Wall-Street

Congress in power rightnow, such a lobbyingeffortcouldgo either way.

In the aftermath of theworst financial crisis that most investorshaveever lived

through, theultimate irony could be that this lawsuit- andnot reformist legislation-

could be the lever that breaksup Goldman Sachs andsome of its powerful brethren.

Indeed, the SEC actioncouldeven be thevehicle that transportsWall Street back to the

dayswhen its institutions feltduty bound to its investor/customers.

And thatwould beno bad thing.

[Editor's Note: Martin Hutchinson has terrific foresight. He warned investors

about the dangers of credit-default swaps - half a year before those deadly

derivatives ignited the worldwide financial firestorm. Hutchinson even

predicted where and when the U.S. stock market would bottom (a feat that

won him substantial public recognition).

During the stock market rebound that started in the middle portion of March

2009, Hutchinson's calls on gold, commodities and high-yielding dividend

stocks made winners of investors who took his advice.

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how the goldman sachs fraud case could accelerate wall street reform

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