Page last updated at 16:08 GMT, Tuesday, 27 April 2010 17:08 UK

Have Goldman Sachs charges opened floodgates?

By Laurence Knight
Business reporter, BBC News

Goldman Sachs
Goldman is under political pressure in the US and beyond

When news broke that Goldman Sachs had been charged with fraud by the US financial watchdog, its shares plunged, wiping about $11bn (£7.1bn) off the value of Wall Street's most famous shop.

And that was before the UK's regulator announced it was planning an investigation of its own or that its German equivalent was said to be mulling its options.

On the face of it, the Securities and Exchange Commission (SEC) charge relates to a deal worth $1bn.

That is the amount UK and German taxpayers have had to cough up to cover losses that their banks made on "Abacus 2007-AC1" - the sub-prime mortgage instrument that the watchdog alleges Goldman sold fraudulently.

In the grand scheme of things, that $1bn liability is not a huge amount.

After all, the sub-prime mortgage market grew to some $1.3 trillion at the peak of the credit bubble in March 2007, while the £500m loss on Abacus that landed in the UK's lap is less than half a per cent of the government's total deficit of £167bn ($255bn) this year.

Goldman itself made profits of almost $3.5bn in the first three months of 2010 alone.

I expect everybody will jump on the bandwagon now
Richard Bove
Equity analyst, Rochdale Securities

But the issues raised by the SEC's charges are a lot bigger than just this one collateralised debt obligation (CDO) - and throw open the sort of questions that worried investors when they rushed to sell shares in Goldman and other Wall Street giants.

The questions being asked are many:

After Abacus, how can clients trust Goldman or indeed any other Wall Street firm? Is Abacus just the tip of the iceberg?

How many other deals could be challenged by the SEC if it succeeds in prosecuting this case?

And what does it mean for investment banker practices which, up until now were assumed to be perfectly legitimate?

Litigation worries

One risk is that the SEC's move has opened the floodgates for a plethora of investors to sue the firm over money they lost on sub-prime debt they bought from it.

Failed insurance company AIG was quick to announce that it was considering doing just that.

"I expect everybody will jump on the bandwagon now," says Richard Bove, equity analyst at Rochdale Securities, who thinks that the cost to Goldman of defending lawsuits could be enormously expensive over the next few years.

And it is not just Goldman. JP Morgan, for example, took the unusual step of setting aside $2.3bn of cash in the first quarter to cover possible mortgage-related lawsuits. That is compared with total profits of $3.3bn.

JP Morgan's chief financial officer is particularly worried about litigation by the government-sponsored federal home loan banks.

Lloyd Blankfein
Goldman's boss, Lloyd Blankfein has defended the reputation of his bank

Should Goldman be worried about the damage this case will cause to its reputation?

The SEC says that the Wall Street firm told Abacus investors what amounted to a lie about the interest in the deal of a hedge fund, Paulson & Co.

Goldman flatly denies this, although the firm does concede that the main purpose of the CDO was to help Paulson speculate on the collapse of the sub-prime mortgage market - something the investors in Abacus were apparently unaware of.

Valuable services

What matters is that Paulson was allowed to have a say over what mortgages went into the CDO.

ACA Capital - the insurance company that was the main investor in Abacus - says it thought Paulson was batting on the same side, and naively accepted some of the hedge fund's recommendations.

But instead, Paulson was actually picking the very worst mortgages it could find, knowing that it stood to profit when the deal went bad.

So does this mean that investors should no longer trust Goldman and other investment banks to take care of their interests?

According to Mr Bove, this is not the right question when it comes to Goldman, because in his view the Wall Street firm is simply too dominant.

"The services it provides in the trading sector are not easy to replicate," he says. "There is no other company that could jump up and take its place."

So whatever Goldman's clients may think of its behaviour, it seems they are not about to desert the firm in droves.

Broader attack?

All the same, Goldman undoubtedly still wants to be trusted - and liked.

But for investment banks, "trust" is a narrowly defined term when it comes to their dealings with big sophisticated investors such as banks or insurance companies.

Certainly, it precludes outright lying, or using inside information, or manipulating prices, and other obvious no-no's.

But at the same time the investment banks would insist that they do not have any so-called "fiduciary" obligation to do only what is in the best interests of their big sophisticated clients.

This is something that the law only requires when they are dealing with ordinary members of the public.

A repossessed home in the US
Chaos in the US housing market lies at the heart of the Abacus deal

Another concern for the investment banks is that Abacus may just be the first step in a broader attack by the SEC on Wall Street.

There were plenty of other CDOs which, like Abacus, were designed to help hedge funds speculate against the market.

In fact, it was common practice for the investment banks to use CDOs to offload risk they did not want, or to speculate.

It is unclear exactly how many other cases could follow if the SEC is successful with Abacus.

But considering the size of the market, and the amount of investor anger, there could be quite a few.

Next in the SEC's firing line may be a series of deals arranged for hedge fund Magnetar Capital.

Unlike Abacus, Magnetar's trades were structured so that - legally speaking - the hedge fund really was the equity buyer.

But the substance of the trades was exactly the same - like Paulson, Magnetar would gain if the mortgages became worthless.

So the question for the SEC will be whether Magnetar was allowed to choose the mortgages in its deals, without this being disclosed to investors.

Magnetar, for its part, says it had no view on which way the market would move.

Reputational risk

The defence that Goldman and others will rely on is that companies such as ACA and IKB were capable of assessing the risks involved, and they should not be relying on anyone else to do this for them.

Indeed, the presentation sent by Goldman to IKB about Abacus - which has been leaked to the press - contained no less than eight pages of small-print detailing the risks and disclaiming the investment bank's responsibility.

And many questions can be asked about the investors' own culpability.

As the CDO manager, ACA was legally responsible for giving its blessing to every mortgage that went into Abacus. So why did it rely on Paulson's judgement?

Moreover, if both of these investors were confident in their investment nouse, and had looked carefully at the mortgages in Abacus, why should they even have cared if a relatively unknown hedge fund such as Paulson held the opposite view to them?

Both were heavy investors in US sub-prime mortgages, quite apart from the Abacus transaction. And the big losses they took on all these investments sunk both of them later that year.

So perhaps the biggest question for them is why, despite their supposed sophistication, why did they not see what Paulson apparently saw coming?

Fraud commonplace

The answer is that there was a giant flaw at the heart of the entire CDO business. It had forgotten one of the basic ingredients of traditional lending - the relationship with the borrower.

Because ACA and IKB never met a single one of the US home-buyers who ultimately borrowed their money, they were blind to what was really happening.

They did not see that by 2006, fraudulent mortgage applications had become commonplace in California and elsewhere.

Nor did they see how rising food and fuel bills during 2007 stretched their borrowers' finances to the breaking point.

Yet both Paulson and Goldman were smart enough to see all this early on.

Fabrice Tourre, the Goldman employee at the centre of the SEC's case, said in one private email that "the whole business is about to collapse anytime now".

But he was under no legal obligation to disclose his view to the Abacus investors.

Goldman and Paulson are certainly not guilty of acting on inside information. All the information about the wretched state of sub-prime borrowers was publicly available in the Spring of 2007, if only the investors were willing to go and look for it.

All of which begs a simple question: did investment banks have the right to exploit the naivety of their big and supposedly sophisticated clients in this way?

Legally speaking, the answer may well be yes. Unlike ordinary members of the public, big investors are expected to do their own homework and understand the risks they are taking.

And they are also supposed to accept that the investment banks they are dealing with may not be acting in their best interests.

But perhaps that is something that regulators such as the SEC, not to mention legislators, want to change now?

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