Good Evening: U.S. stocks spent most of Monday trying to recover from the outright shock they received on Friday when the SEC decided to bring civil fraud charges against Goldman Sachs. The news caused stocks to swoon as last week ended, while bonds and the dollar rose. Commodities, but especially the precious metals, were bludgeoned. After every financial talking head from New York to Germany weighed in on the Goldman case over the weekend, markets around the world headed down in sympathy with Friday’s decline in U.S. share prices. China’s decision to rein in mortgage lending (memo to the Maestro: this is how it’s done — before there’s a problem) also played a role in pushing global bourses back on their heels.
When follow through selling in the U.S. dried up on Monday, however, share prices recovered to finish mixed. Even GS shares rose ahead of its earnings announcement tomorrow. Bonds gave back some of Friday’s gains, the dollar was up a fraction, and commodities remained under pressure. After weeks with little to concern them, investors are definitely starting to reassess their risk appetites. With the benefit of a few days of hindsight, I find it curious that the SEC handled its case against Goldman in the way it did. The timing (with financial reforms being teed up in Congress) and methods (using the term, fraud, and giving Goldman little or no warning) will leave thoughtful citizens wondering why.
The SEC has taken its lumps in recent years — and with good reason. Whether it was giving the banks the freedom to lever up during (i.e. so as to cause) the credit bubble or refusing to properly investigate Bernie’s Ponzi scheme as he Madoff with his investors’ cash, it seemed as though the SEC was turning a blind eye to almost everything in recent years. It didn’t matter whether the White House was occupied by Republicans or Democrats, either. An anti-regulatory mood kept the SEC focused on corporate filings, junk bond registrations, and IPO listings. Wall Street’s watchdog lost both its bark and its bite as firm after firm bit the dust due to either misdeeds or excessive leverage. Finally, the SEC could only stand in mute disbelief as the financial system it was charged to help guard started to circle the drain in 2008. If its commissioners had ever once qualified for E&O (Errors & Omissions) insurance, their policies would long ago have been canceled.
Many pundits and commentators have wondered for a long time just when the SEC would again bare its fangs in the way it did during numerous insider trading scandals in the 1980’s. The Galleon case in 2009 was a hint the SEC was at least ambulatory, but Friday’s announcement was a true shocker. Displaying bark and bite, the SEC staff leveled charges against none other than Goldman Sachs. The SEC isn’t just saying our nation’s pre-eminent financial institution is guilty of mere wrongdoing in creating a certain synthetic CDO in 2007. No, they are alleging Goldman committed fraud by purposely crafting a crummy transaction to benefit Paulson & Company without disclosing the relevant facts to investors.
Please keep in mind that the SEC’s charges are just accusations and that Goldman claims to have done nothing wrong in a market where only the most sophisticated investors are supposed to tread. John Paulson’s firm has not been charged with any wrongdoing, but the creation at their behest of the synthetic CDO in question looks somewhat similar to CDOs created by other investment banks for another hedge fund, Magnetar. ProPublica’s Jesse Eisinger and Jake Bernstein have pieced together a very interesting trail of information about the type of CDOs in which Magnetar played an important role (see here). Like Paulson & Co., Magnetar has not been accused of any wrongdoing — yet.
I say “yet” because the impact of the mere claim of fraud against Goldman (and potentially other banks) may have other consequences in the days and weeks ahead. The SEC’s charges mark an escalation of the retribution phase of the 2007-2009 financial crisis. Coming as they do, just as Congress is preparing new financial regulations, the claims against GS will likely encourage our legislators to add teeth to whatever proposals they eventually enact. In fact, the timing of these charges by the SEC is more than a little curious, especially if the vote among its Commissioners was split down party lines, as suggested in the article below.
Even if the fraud charges don’t hold up in court, the drama itself has completely reinvigorated the administration’s push for financial reform legislation on the Hill. I have absolutely no evidence of any connection between the SEC vote and the administration’s reform agenda. But it wouldn’t be the first time this year a major piece of legislation benefited from some unusual political maneuvering. Healthcare reform was on life support until it was resuscitated via the budget reconciliation process. However financial reform evolves, my hope is that the dark world of Credit Default Swaps is moved onto relatively better lit exchanges.
My wish to have all CDS become exchange-traded instruments does not mean investors of the future will be spared taking the other side of a “pig-in-a-poke” transaction by enterprising investment banks of the future. No, the John Paulsons of the world will still be able to make directional bets, and traders on the other side will either make or lose money. Goldman will still stand in the middle and collect a fee for bringing both sides together, but transparency will be heightened and systemic risks will be lowered with an exchange clearing and margining these trades.
Until that happy day comes to pass, complexity will be the rule and Goldman will have to rely on for its defense the myriad risk disclosures contained in the ABACUS 2007-AC1 transaction. “Caveat Emptor” is the unwritten code among sophisticated investors, but Goldman’s attorneys went quite a bit further in the Risk Factors section of the indicative term sheet you can access below. Any one of these factors could have led a prospective investor to utter four letter words, the most appropriate of which would have been “Pass”. Go to page 8, and under Risk Factors you’ll find four items under the heading, “Certain conflicts of interest relating to Goldman Sachs and its Affiliates; No reliance”. Many pundits and opinion-givers incessantly bray about Goldman’s lack of disclosure, but item # 2 goes directly to the heart of the matter:
“Goldman Sachs may, by virtue of its status as an underwriter, advisor, or otherwise, possess or have access to non-publicly available information relating to the Reference Obligations, the Reference Entities and/or other obligations of the Reference Entities and has not undertaken, and does not intend, to disclose, such status or non-public information in connection with the Transaction. Accordingly, this presentation may not contain all information that would be material to the evaluation of the merits and risks of purchasing the Notes.” (source: ABACUS 2007-AC1 CONFIDENTIAL — INDICATIVE TERMS — italics are mine).
Case closed, right? In a court of law, perhaps, but this case will be waged more in the court of public opinion than it will before any bench. I’m sure the SEC will maintain that it is bringing this case to send a message that its lapdog days are over, that no firm — not even the venerable Goldman Sachs — is beyond its reach. I agree, and it’s high time the SEC resumed its enforcement role. But I worry about the over-reach, especially if done so for political purposes. Over-reaching themselves during the previous credit cycle, the banks can rightly be claimed to have brought actions like this upon themselves. But I think even populists would agree that if this case was brought to stir partisan passions and boost pending legislation, then the SEC’s investigation into the ABACUS transaction should have been handled in a different way. A Trojan Horse might be a clever way to achieve an objective, but the bad memories tend to linger for both giver and receiver. Troy is no more, and Greece isn’t faring much better itself these days. Let’s hope the U.S. and its banking system both fare better after this episode runs its course.
— Jack McHugh