BY THE time Goldman Sachs yesterday reported its first quarter earnings – a doubling to $3.29 billion on a year – the sheen had already gone off the company. On Friday the US Securities and Exchange Commission, in a decision that has sent shivers down Wall Street, said it is charging the street’s most influential bank with fraud. To add to its woes, Britain’s Financial Services Authority (FSA) said yesterday it had started its own investigation.
At issue is the creation in 2007 by Goldman Sachs of a complex financial product, known as a “collateralised debt obligation” (CDO), that was in effect a piece of insurance against default for multiple tranches of highly dubious subprime mortgages – Abacus 2007-AC1. Goldman omitted to tell purchasers that Abacus had been put together largely at the direction of a hedge fund which was “shorting” it, or betting it would fail. When the mortgages covered by Abacus went belly up the hedge fund, Paulson Co, made $1 billion, and Abacus’s investors lost the same.
Goldman vigorously denies fraud – “completely unfounded in law and fact” – and claims it was not obliged to tell purchasers of Paulson’s role because it had used an “independent” intermediary, ACA, to create Abacus. How independent will be the issue before the court, but company internal memos referred to Abacus as the “Paulson portfolio”.
Legal arguments notwithstanding, there are huge questions raised both about Goldman’s ethics and the transparency of the derivatives market. To its credit and Goldman’s embarrassment it has emerged that Bear Sterns, now part of JP Morgan Chase, declined to participate in a similar Paulson venture because, as one of its traders put it, the proposal “didn’t pass the ethics test”.
To the grief of Wall Street, the Goldman disclosure has given impetus to administration attempts to introduce new measures to regulate the financial sector in the wake of the crash. These are being seen by the White House as a political challenge akin to a second healthcare Bill, though significantly more popular with the public. A Bill backed by Senate banking committee chairman, Chris Dodd, is due to go to the Senate this week and will contain new measures, as yet unspecified, curbing derivatives trading. That will be welcomed in Brussels which is also exploring requiring derivatives to be traded in specialised, regulated exchanges, seen as key to bringing transparency to this huge but opaque market.