classical economics
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and policy design

Financial Tower of Babel

Goldman Sachs, SEC, Federal Reserve,
Treasury, Congress, White House
By Wayne Jett © April 20, 2010
    Last Friday, the Securities & Exchange Commission filed a civil complaint in Manhattan federal court alleging Goldman Sachs and one of its junior executives engaged in fraud in 2007 enabling one party, J. P. Paulson & Co., Inc., to gain about $1 billion from other Goldman clients. On Tuesday, Goldman announced first quarter 2010 earnings up 91% at $3.46 billion after compensating insiders $5.49 billion, 43% of revenues.
    Some may insist the two events are unrelated, but they are not. Goldman took $9 billion from financial markets for its operators and investors during the past three months. This is $3 billion per month, or about $140 million per trading day. They do this, the public is told, by being smarter and quicker than everyone else, but their practices are secret.
The SEC Civil Complaint
    The SEC allegations of fraud give a rare glimpse at Goldman practices by telling of a single deal done three years ago. Goldman insists it did nothing wrong and the deal was business as usual. The SEC says Goldman allowed Paulson to assist in designing a collateralized debt obligation and in selecting the asset portfolio for the CDO. Having done this, Goldman then failed to disclose to buyers of the CDO Paulson’s involvement or Paulson’s purchase from Goldman of credit default swaps betting the debt instruments in the CDO would default.
    The SEC alleges Goldman deceived buyers of the CDO by failing to tell them of Paulson’s involvement and interests, and that this was fraud because Goldman had a duty of fairness to its buyers. Paulson is not sued because, the SEC says, it had no duty of disclosure to the CDO buyers. Goldman’s “so what’s the problem” attitude portrays ethical standards presumably applied in all its financial dealings.
    If pigs could fly and ordinary people had subpoena powers, the public might learn that the CDO targeted by the SEC complaint (ABACUS 2007 AC1) – far from being the worst of Goldman Sachs practices – was much closer to its most innocent conduct of the past ten years. Consider Goldman enabling its clients to evade the SEC up-tick rule and drive down equity prices throughout the 2000-2002 market collapse. Consider Goldman’s pressure on the SEC to repeal the up-tick rule in 2007 at the same time this CDO was going down. Consider Goldman’s own shorting of mortgage backed securities as it sold those MBS to its clients. Consider Goldman’s continued dominance of equities markets using high frequency trading software despite inadvertent disclosure on July 4, 2009, that its software codes could be used to manipulate markets worldwide.
    Goldman Sachs revenues for 2009 more than doubled 2008 revenues. Even with that stunning revenue growth, 2009 earnings were $24.73 per share, including $7.01 in the Sept-Oct-Nov 4th quarter, versus $22.13 in 2007 and $8.04 in that 4th quarter. If Goldman lost money on the CDO targeted by the SEC, as the firm alleges, then that CDO must have been the rarest of birds.
Guidance for the SEC Litigator
    The SEC action against Goldman Sachs must be termed litigation, not prosecution, because the SEC filed no indictments for criminal fraud. Likewise, the SEC did not name Paulson a defendant although he gained $1 billion from his actions. Why the SEC came in with guns blazing against Martha Stewart’s $45,000 stock sale a few years ago, but meekly approaches an alleged billion dollar fraud, is best understood in the historical context of the agency’s symbiotic-subservient relationship with Wall Street.
    The SEC litigation team would do well to examine carefully the mechanism by which the CDO was made “toxic.” The malicious act may not have been selecting bad assets to put into the CDO portfolio. The assets selected may have been sound when identified and acquired by the CDO. However, Goldman telling Paulson the specific assets acquired by the CDO may have been enough to arm him for taking down the assets and the CDO. Buying credit default swaps and other options on the underlying assets and on a CDO were capable of driving down their market prices.
    Some suggest the SEC action against Goldman Sachs is preliminary to bigger things. Discovery of additional facts may lead to criminal indictments. British and European financial regulators may investigate, although Goldman is influential there, too. Paulson may be brought into the case. If Goldman did this with one CDO, other buyers ask whether the same or worse was done to CDOs and MBS they bought from Goldman or from other Wall Street firms. If Goldman did this, perhaps so did J. P. Morgan Chase, Morgan Stanley, Citigroup, UBS, Merrill Lynch and others. The bankrupt Lehman Bros. seeks records of two major hedge funds to determine whether illicit practices damaged that firm.
Financial Reform Legislation
    This is hardly news, particularly here, where financial fraud has long been described as the central macro-force in the financial markets, including the collapse of 2008. In 2004, the SEC was aware of questionable practices in Wall Street’s securitization of debt, but warned about “reputational risk” rather than possible prison time.
    Recently Senator Edward Kaufman of Delaware and Simon Johnson, economics professor at Massachusetts Institute of Technology, have identified financial fraud as being at the heart of Wall Street and the financial collapse. Even the New York Times was moved by the SEC case against Goldman Sachs to ask mildly by editorial whether “malfeasance” might be responsible for the 2008 financial debacle.
    How the SEC chose Goldman Sachs’ CDO as a target and discarded others is a mystery and likely to remain so. Some suggest the SEC motive is to assist passage of financial legislation pending in the Senate dubbed as “reform” but actually another raft of actions highly beneficial to the largest Wall Street banks. One Democratic congressman says the Dodd bill provides unlimited authority to bail out big banks.  The bill also entitles Wall Street banks to expand into every state without regard to state banking laws. The bill’s contents are very difficult to determine because the primary bill has been amended by a separate bill of 100 pages of technical changes, and no amended bill has been compiled.
    Senator Kaufman and Senator Sherrod Brown (D-OH) reportedly will introduce on April 21 a new bill in the Senate requiring the “too big to fail” banks to be broken up. Ohio lost its biggest bank in October, 2008, to the tender mercies of Pennsylvania’s largest bank, and other banks have met similar or worse fates since. This may lead to a real chance for substantive reform of financial sector practices, but Senators of both parties must tune in to voices back home instead of courting the money barons of Wall Street.     Legislation which fails to stop Wall Street fraud in financial markets, fails to stop manipulation of the price of crude oil, fails to ban “cash settlement” CDS side-bets on debt instruments, or fails to break up the “too big to fail” cabal of Wall Street is unworthy of the name “reform.” By all indications, the Obama administration and congressional leadership have in mind, not reform, but consolidation of power by Wall Street’s big banks.
    Those who reign on Wall Street and in Washington, D.C., speak a common language with other Americans, but their words inspire little trust. Empires have fallen in less dangerous circumstances than these. ~