Goldman Sachs

The news hit the financial market like a carefully targeted bomb when the US Securities and Exchange Commission announced it had filed a fraud action against Goldman Sachs, which relates to the investment bank’s sub-prime mortgage business. Depending on how rough the SEC wants to play it, the case has the potential to shut down the cartel known as Wall Street.

For more than a year in 2006-07, while the market was falling apart, Goldman was issuing sub-prime mortgage collaterized-debt obligations (CDOs) to investors even as it was shorting the hell out of the sub-prime mortgage market. Goldman was doing this both directly and through credit-default swaps (CDS), most of which were written by American International Group. When the market collapsed, Goldman made a huge trading profit, including about $13 billion provided by US taxpayers as part of the AIG bailout.

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 deal called ‘ABACUS’ done in early 2007, Goldman allegedly colluded with the hedge fund operator Paulson & Co, which was seeking to short the sub-prime mortgage market, hence making the company founder John A. Paulson, a multi-billionaire in what has become known as the greatest trade ever. Goldman told investors that the residential MBS for ABACUS had been chosen by a neutral ‘portfolio selection agent’, but in reality Goldman allowed Paulson to sort among the RMBS – choosing, of course, the most likely to go wrong. In return, Paulson paid Goldman a fee of $15 million, while he reaped $15 billion on his greatest trade. Paulson’s role in the deal was nowhere disclosed 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 then sold CDOs in ABACUS to investors, including ABN AMRO Bank, IKB Deutsche Industriebank AG, who lost more than $1 billion.

Given this situation, it seems the financial-reform bill introduced by US Senator Christopher Dodd will likely to pass both houses without all that much alteration. And if that is the case, it should immediately raise our suspicions. After all, the US financial services business has a very effective lobby. Now, the real risk to the economic recovery is that regulators could over-regulate.