Goldman Sparks Financial Reform

by John M. Curtis
(310) 204-8700

Copyright April 20, 2010
All Rights Reserved.                                

            When the Securities and Exchange Commission filed civil suit for fraud against Goldman Sachs April 16, it gave a needed shot to the White House efforts to reform the financial system.  Since parts of the Depression era 1933 Glass Steagall Act were rescinded by the Clinton era 1999 Financial Services Modernization Act, banks have added increased stock market risk to their investment portfolios.  Passing the Gramm-Leach-Bliley Act in 1999 was supposed to give financial institutions welcomed cash to capitalize on a roaring bull market of the late ‘90s.  Banks watched investment houses grow rich while they eked out a living making money the old fashioned way.  As banks increased exposure of depositors’ capital, they watched 2007 turn into a nightmare, a kind of Sept. 11 for the banking industry.  By 2008, risky stock market investing caused the collapse of the U.S. financial system.

           Glass Steagall was designed to prevent banks from toxic exposure to the stock market.  While it limited banks’ profits and earnings, it kept financial institutions from insolvency.  Among the more lucrative—and most leveraged or risky—investments were synthetic residential mortgage-backed securities [RMBS], known as derivatives or collateralized debt obligations [CDOs].  Recent revelations about the SEC civil suit against Goldman Sachs for defrauding investors raised eyebrows about such risky investment schemes.  According to the SEC complaint, Hedge Fund Paulson & Co. asked Goldman Sachs to create CDOs based on subprime mortgages doomed to fail.  Paulson & Co. made billions shorting CDOs in 2007-08   While Goldman claims that its distributor ACA Management packaged the investments, its chief CDO trader 31-year-old Fabrice Tourre boasted about the deals.

            Tourre’s derivative deals made Goldman and Paulson & Co. billions from the risky pools of derivative investments.  Whether or not Goldman knew the investments were cherry-picked for short-sellers like Paulson can’t hide the fact that derivative investments were perfectly suited for short-sellers like Paulson.  Financial regulators at the U.S. Treasury and Federal Reserve Board agree with the Senate Agriculture Committee seeking controls on risky financial products like derivatives.  Derivative investing and the exotic insurance on the investment known as “credit default swaps” brought down the U.S. and foreign banking system.  SEC’s recent action against Goldman Sachs attests to the heavy risk for abuse, when investment banks design products for short-sellers like Paulson’s hedge fund.  Members of Senate Agriculture Committee want bank restrictions.

            Lincoln seeks to ban financial institutions receiving FDIC insurance from engaging in derivative trading.  Current bank holding companies, like J.P. Morgan Chase, Bank of America, Wells Fargo, etc., would be forced to place derivative investing outside the bank holding company into separate investing firms.  Banks would not be allowed to merge bank holding companies with bank-owned brokerage houses.  While Lincoln’s legislation helps, it doesn’t deal with the currently unregulated hedge fund industry that profits routinely from short-selling.  British Prime Minster Gordon Brown, currently mired in an uphill reelection battle, blasted Goldman Sachs for “moral bankruptcy,”  selling derivatives to U.K. banks that were specifically crafted for Paulson’s short-selling hedge fund.  British regulators are now looking into legal action against Goldman’s London branch office.

             Before the SEC suit, Goldman Sachs came under heavy scrutiny for taking $12 billion in bailout funds from multinational insurance behemoth AIG Insurance.  When the derivatives’ market collapsed, AIG quickly ran out of cash to repay billions in credit default swaps, exotic insurance contracts on risky derivative investments.  Instead of allowing AIG to go bankrupt, the Federal Reserve and Treasury paid $182 billion to keep the grossly mismanaged company running.  AIG’s CEO and Goldman board member Edward Lidddy in 2008 had no problem handing over the cash.  While praised for returning the bailout funds, Goldman shouldn’t’ have received one penny, especially from AIG.  Goldman Sach’s CEO Lloyd Blankfein, scheduled to testify April 28 before the Senate Permanent Subcommittee on Investigations, handed out millions in bonuses after the derivatives’ market collapsed.

            Reforming the financial system involves much more than regulating derivative trading by bank holding companies.  Returning to some of Glass Steagall’s restrictions is a step in the right direction but doesn’t go far enough to control unregulated hedge funds from tanking the market by short-selling.  Whatever eventually happens with the SEC lawsuit against Goldman Sachs, the Congress must deal with the damaging effects of short-selling on the long-term health of U.S. and foreign stock markets.  Short selling highly-leveraged CDOs proved disastrous to global financial markets.  Past short- selling binges dropped the tech-rich Nasdaq from nearly 5,000 in March 2000 to around 1,100 in June 2002.  Short-selling, primarily by unregulated hedge funds, has taken markets on a perpetual roller coaster, leaving long-term investors, including public pension funds, holding the bag.

John M. Curtis writes politically neutral commentary analyzing spin in national and global news. He's editor of OnlineColumnist.com and author of Dodging The Bullet and Operation Charisma.