How the Goldman Sachs Fraud Case Could Accelerate Wall Street Reform

[Editor's Note: Money Morning's Martin Hutchinson, a former merchant banker, presents us with an insider's analysis of the Goldman Sachs fraud case.]

When the U.S. Securities and Exchange Commission announced Friday that it had filed a fraud action against Goldman Sachs Group Inc. (NYSE: GS), the news hit the financial markets like a carefully targeted bomb.

The Goldman Sachs fraud case, which relates to the investment bank's subprime-mortgage business, caused the financial giant's shares to nosedive 12.8%. The fallout spread to the broader markets, too, causing the Dow Jones Industrial Average to drop 1.1% and the Standard & Poor's 500 Index to skid 1.6%.

That reaction wasn't overblown.

Depending on how rough the SEC wants to play it, the case has the potential to shut down the cartel known as Wall Street. It could even jump-start the kind of sweeping overhaul that legal or regulatory reformists have so far failed to launch.

Wall Street behemoths like Goldman Sachs have innumerable conflicts of interest. But it's been obvious since the global financial crisis struck with gale force in 2008 that some of the most egregious conflicts involved Goldman's subprime mortgage operations

For more than a year in 2006-07, while the market was falling apart, Goldman was issuing subprime-mortgage collateralized-debt obligations (CDOs) to investors even as it was shorting the hell out of the subprime-mortgage market. Goldman was doing this both directly, and through credit default swaps (CDS), most of which were written by American International Group Inc. (NYSE: AIG).

When the market collapsed, Goldman made a huge trading profit - including about $13 billion provided by U.S. taxpayers as part of the AIG bailout.

From Duty Bound to Profit Hounds

Before the metamorphosis of Wall Street took place around 1980, the issuing house's duty not to sell obvious rubbish to investors was thought to be sacrosanct. The issuing house's reputation among investors was viewed as its most important asset, and blemishes on that reputation took many years to overcome.

Certainly, we in the London merchant-banking community - where I worked during the high-road days - believed all this to be true.

This all changed during the "Go-Go '80s," leaving us with the Wall Street that we have today. In the aftermath of the biggest financial crisis since the Great Depression, an examination of precisely what happened has focused on the rigged nature of the game - and has spawned intense criticism of the lack of oversight from the regulators who were supposed to be safeguarding individual investors.

Given this past lack of aggressiveness by the regulatory and enforcement crowd, it's no surprise that Friday's strident move by the SEC sparked a sell-off in Goldman's shares - and in the broader market indexes.

The initial reaction was interesting: At first, gold sold off rapidly, while the general stock market was slower to react. I've long-suspected that trader communication was pretty limited in intellectual content. And in this case - in an interesting manifestation of the "Chinese-whisper effect" - a frantic "Sell Goldman" call obviously got transmuted into "Sell Gold." After an hour or two, as the general market sold off, the slower members of the trading community caught up and gold rebounded somewhat.

The "Greatest Trade Ever"

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 ("collateralized debt obligation") deal called "ABACUS," done in early 2007, Goldman allegedly colluded with the hedge fund operator Paulson & Co., which was seeking to short the subprime mortgage market (which it did very successfully, making company founder John A. Paulson a multi-billionaire in what has become known as "the greatest trade ever.")

Goldman told investors that the residential mortgage-backed securities (RMBS) for ABACUS had been chosen by a neutral "portfolio selection agent," ACA Capital. In reality, Goldman allowed Paulson to sort among the RMBS selected by ACA Capital for ABACUS - choosing, of course, those most likely to go wrong. In return, Paulson paid Goldman a fee of $15 million (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, who lost more than $1 billion, according to the SEC. Among those investors were the Dutch bank, ABN AMRO Bank NV, which lost $850 million, and Germany's IKB Deutsche Industriebank AG, which lost $150 million. Both banks were later bailed out by their respective governments - at the expense of their country's taxpayers, of course.

If this SEC suit remained isolated, it would be a serious matter to Goldman, but not life-threatening. However, in the process of fighting the case, SEC lawyers will have the right to carry out a "discovery process," which will enable government lawyers to fish around in Goldman's records to find anything that might solidify the case - quite possibly boosting Goldman's potential culpability and liability.

By definition, the discovery process can't be controlled: An aggressive prosecutor often finds more damning evidence - possibly even enough to transform the case from a civil proceeding into a criminal one. At that point, the stakes escalate exponentially. Indeed, the terms levied against those who are directly involved - and even against the top managers on whose "watch" the transgressions took place - can rival the 25-year sentence imposed on former Enron Corp. President Jeffrey K. Skilling (this is, after all, a billion-dollar case.)

What's more, if prosecutors want to get really aggressive and enough evidence is there, they can invoke the Racketeer Influenced and Corrupt Organizations Act of 1970 (RICO), alleging that the crimes formed a "pattern of racketeering activity" committed by an "ongoing criminal organization." At that point, if Goldman lost, it could conceivably be shut down.

You may think that's extreme - and I agree - but RICO prosecutions have been used against Wall Street in the past. The well-respected investment company, Princeton-Newport, was shut down under a RICO prosecution in 1988. Junk-bond king Michael Milken was also prosecuted under RICO. And his employer Drexel Burnham Lambert, almost as prominent as Goldman Sachs in its day, avoided a RICO prosecution only by paying a $600 million fine - which subsequently forced the firm into bankruptcy.

In other words, this suit against Goldman is a really major deal. You can expect that Wall Street's massive lobbying muscle will be brought to bear - by Goldman and probably by other Wall Street investment houses - in an effort to make prosecutors tread lightly. But with public opinion on the other side and a heavily anti-Wall-Street Congress in power right now, such a lobbying effort could go either way.

In the aftermath of the worst financial crisis that most investors have ever lived through, the ultimate irony could be that this lawsuit - and not reformist legislation - could be the lever that breaks up Goldman Sachs and some of its powerful brethren. Indeed, the SEC action could even be the vehicle that transports Wall Street back to the days when its institutions felt duty bound to its investor/customers.

And that would be no bad thing.

[Editor's Note: Martin Hutchinson has terrific foresight. He warned investors about the dangers of credit-default swaps - half a year before those deadly derivatives ignited the worldwide financial firestorm. Hutchinson even predicted where and when the U.S. stock market would bottom (a feat that won him substantial public recognition).

During the stock market rebound that started in the middle portion of March 2009, Hutchinson's calls on gold, commodities and high-yielding dividend stocks made winners of investors who took his advice.

Experts are taking notice. And so should you.

Hutchinson is now making those insights available to individual investors. His trading service, The Permanent Wealth Investor, combines high-yielding dividend stocks, gold and specially designated "Alpha-Bulldog" stocks into winning portfolios.

To find out more about The Permanent Wealth Investor, please just click here.]
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