Goldman’s Washington showdown could be the first of many

In the days after the SEC charged Goldman Sachs with fraud, the rest of Wall Street was left reeling. Anyone expecting hands to be rubbed in glee at the sight of mighty Goldman confronted with allegations that it misled investors would have been sorely disappointed.

“The SEC’s case just looks so weak,” one banker exclaims to Euromoney. “It does look weak, doesn’t it?”

It’s easy to label the SEC’s surprise attack as political theatre designed to bounce the industry into acceptance of more intrusive regulation by picking on its smartest and most successful firm, and distract attention from the inspector general’s stinging criticisms of the SEC’s own manifold failures.

It’s not hard, either, to see why so many are nervous. Rather than being a one-off set piece this case could be the first of many. Citigroup’s chief financial officer John Gerspach, speaking to analysts and investors on the bank’s first-quarter earnings call, broke off his discussion of the bank’s excellent results to say: “Citigroup is not involved in the matter the SEC announced on Friday. It has been reported that the SEC among other regulators is conducting industry-wide investigations into a wide range of sub-prime related issues. We are fully cooperating with those investigations.”

Pressed about individual Wells notices that might have been delivered to the bank, Gerspach refused to say more.

Mike Cavanagh, his counterpart at JPMorgan, similarly declined to go into details on the bank’s addition of $2.3 billion to its litigation reserves, other than to acknowledge that these largely reflected “mortgage-related matters”.

And the concern spreads far beyond Wall Street. In Europe, bank analysts at Credit Suisse offer far-from-comforting thoughts on the potential for litigation risk arising from the sub-prime fiasco to drag on and to grow in size as it does so.

“The nearest comparison we can think of is to the dotcom litigation; for banks which broke out the two categories separately in disclosures, private litigation was nearly twice as big a cost as the regulatory settlement, and the total cost of resolution was nearly eight times as big as the initial provision,” the analysts say. “Although the dotcom and sub-prime crises are different both quantitatively and qualitatively, in our opinion this illustrates the tendency of litigation risk to get worse.

“Problems of this sort are rarely confined to one institution; once more, the dotcom era shows us that in the wake of a crisis, business practices which were considered normal at the time can look very much worse with the benefit of hindsight and in a legal setting.”

 To gauge potential exposure to litigation risk, Credit Suisse constructed a Dealogic league table of lead underwriters of synthetic CDOs sharing the salient characteristics of Abacus 2007-AC1, looking just at deals in 2007 and also for the whole period 2005-08. Goldman ranked seventh for 2007 and ninth for the longer period, behind leaders Bank of America Merrill Lynch, UBS, JPMorgan and Citi (see tables).

Of course, each deal is unique and these firms might have nothing to worry about. But in some ways the inherent weakness of the SEC’s case looks potentially more troublesome. Is it attacking a single deal or does it have its sights on the entire market? In the first paragraph of its complaint to the US District Court for the Southern District of New York, the SEC asserts: “Synthetic CDOs like ABACUS 2007-ACI contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.”

The Goldman case seems to hinge on how ACA, which was taking long-side, super-senior exposure to the sub-prime MBS referenced in the CDO, somehow came to believe that Paulson & Co, with which it was discussing collateral selection, was also taking a long position in the equity tranche of the structure. Paulson & Co was, of course, taking the short side and betting the deal would crap out, which it did spectacularly.

The relevant paragraphs of the SEC’s complaint contain no suggestion that it has any email or written note in which any Goldman employee tells ACA that Paulson intends to go long the structure as well. Does it have a smoking gun that it will whip out in court?

ACA initially seems confused as to Paulson’s precise role as the two pass back and forth ideas on the collateral to be placed inside the CDO. A capital structure for the CDO is mapped out. Thereafter ACA starts referring to Paulson as the equity tranche investor. Why? “We have no idea where ACA got the impression that Paulson was a long equity tranche investor,” says Greg Palm, co-general counsel at Goldman Sachs.

It will be here that the case is fought and over the question of whether Goldman, even if it didn’t mislead, also had a duty to take note of and correct such a mistaken impression.

 It’s a safe bet that Goldman must have examined in minute detail the data the SEC asked for on the deal and would have fired the trader responsible on the spot if he had clearly done wrong, then settled with the client and the SEC.

As presented, the case does look weak. There had to be a short investor for the trade to happen at all, and ACA and IKB Deutsche Industriebank must have known that. Having worked on previous deals where hedge funds came in as first-loss investors for high yield on equity tranches, ACA might have been amazed eventually to discover that Paulson & Co was the short side.

But the SEC acknowledges that, in constructing the portfolio, ACA rejected more than half the securities Paulson put forward for inclusion. And of course, its losses came not from putting the worst underlying MBS into the CDO but for betting on 2006 mortgages at all. The entire vintage was crushed. Blaming Goldman looks like the gambler that has backed a horse that finished last criticizing the bookmaker for taking his bet. He might be better off questioning his own ability to pick a stayer or whether he should be spending so much time hanging round the bookies in the first place.

Of course that doesn’t put Goldman entirely in the clear. Even if its position is legally defensible – and that remains to be seen – that won’t help it much if it is seen to be morally reprehensible. Its pieties about always serving the client’s interest may ring a little hollower in future. There’s a lot at stake here, perhaps more than the figure of $1 billion soon being bandied around the market as an estimate of the potential all-in cost of settling the case.

On the same day that Palm laid out the firm’s defence against the fraud charge, Goldman also produced strong first-quarter results, once again boosted by trading operations, especially FICC, where its franchise is very strong. But other businesses aren’t in quite such good shape. M&A advisory and underwriting revenues both fell from the prior quarter and David Viniar, Goldman’s CFO, could offer little comfort about the underwriting backlog. Revenues also fell in asset management where the firm seems to be losing money flowing out of its money-market funds as investors increase risk. “All of these businesses require Goldman to make a major effort to hold customers and build on relationships,” says Richard Bove, analyst at Rochdale Securities. He judges: “In many respects this was a lacklustre quarter.”

Goldman is keeping its options open on settling the Abacus case or fighting it all the way. “We would never intentionally mislead anyone,” says Palm, manfully resisting any temptation to put undue emphasis on the word “intentionally”. And only one relatively junior employee is named. “Goldman Sachs would never condone...” No, of course it wouldn’t.

How the outcome of the case affects its reputation is vital to Goldman. The outcome is no less important to the SEC itself. The regulators cannot be made to look like fools again. It is unthinkable that they should have misunderstood the mechanics of the synthetic CDO market and the need for there to be a counterparty to take the short side for every long.

The SEC own credibility is clearly at stake. The regulator utterly failed to intervene in the creation of huge volumes of real tradable securities comprising liar-loans and similarly badly underwritten mortgages. It failed to prevent the Madoff Ponzi scheme despite many warnings. Its own inspector general has criticized it, most recently over the conduct of its investigation into Allen Stanford’s alleged Ponzi scheme. It hasn’t fared so well on recent enforcements either. It took it into its head to take Bank of America Merrill Lynch to task for misleading shareholders over the Merrill acquisition, which the Federal government and the nation’s central bank had brokered. It extracted derisory damages.

It needs to prove itself.

For now, the SEC and Goldman are squaring up to each other and preparing to go to court. A settlement still looks the likeliest outcome though. Goldman needs the bad press like a hole in the head and the SEC can’t afford another failure.

 It’s what other cases might follow that most worry Goldman and the rest of the industry now.

More on Goldman

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