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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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  1. Ted K | April 19, 2010

    The reform that comes out of this will only grow there appitite of greed arrogance and corruption and how NOT to get caught. Unless the peckers go to prison which is very un-likely. Because that would mean those crooked peckers in the SEC are just as guilty and other prominate others. We all are aware of the double standards syndrome. Much of the reason for this crisis.

  2. Tom McDonald | April 19, 2010

    I hope GS is torn limb from limb and fed back to the tax payers. Period.

  3. cortot7 | April 19, 2010

    I would like to see your wish become true. However with the various mafia's, such as Wall Street, Government and possibly other underground criminal organizations, I shall only belevie as and when Goldman Sachs will be split up or closed down.
    I am not concerned personally, since as a non American citizen, living in Europe, not holding any "asset" or "liability" in the US market, I watch this as a highly interested spectactor in as much as what happens might have widespread consequences. The SEC's record being what it is – not particularly brilliant – you may imagine my being highly reluctant to trust "official Amercia", i..e. government. My sympathy goes to all victims of the Wall Street crooks, but the average and honest American should send home almost all of the politicans in charge at present. Next November will be a splendid opportunity .

  4. Stefan Grieb | April 19, 2010

    Hi Martin,

    Your article brings up great points of, the discovery process, aggressive prosecutors, and RICO. That is the hope part of the equation.

    Here is my take and perhaps a reflection of my view, of our soul less, self interested, leaderless country. I do not believe a GD thing is going to happen because the company, regulators, and political snakes are all incredibly corrupt. Fold into the mix, too many of our fellow, we the people, just don't give a rats ass. We have a corrupt nation with a complacent populace.

    Where are the cowboys in white hats? Getting ready to take a beat down at the hands of corrupt cartel members and politicos or maybe maybe not even bothering to ride in. This whole situation is so damn demoralizing.

    I hope your version prevails.

  5. Dimos Cotsis | April 19, 2010

    Better late than never !!!

  6. PTS999 | April 19, 2010

    Unfortunately, the last 15 years has seen North America become a region run by fraudsters. Be it the Wall Street financiers (this incident of Goldman is a good example, amongst many) or the corporate juggernauts (Enron, MCI/Worldcom, Nortel, Tyco etc…). Capitalism only works well in its intended form when there are well defined bounds i.e. Government Regulations. This is not any different from well run corporations that allow employees to innovate and operate freely within certain operating guidelines – and the employees and corporations are most productive in such instances.

    It is time for the pendulum to swing the other way and bring back reforms that eliminate every one of these fraudsters. Tax the hell out of these corporate thieves and put them in jail or let them go elsewhere – they are absolutely replaceable and good riddens!

    Individual investors need to stay out of Wall Street investments until sanity returns and we start getting basic corporate value and corporate citizenry – companies paying dividends and share their profits amongst individual investors (and not these crooks on Wall Street or their colluding corporate CEOs). Individual also need to stay away from buying any goods from the likes of Wal-Mart – whose sole intentions are to fill pockets of their owners against the detriment of the society at large. It is companies and owners like these that have bought up all of North America and are the sole reason of our current economic problems. Wake up folks!

  7. Arlington E. | April 19, 2010

    I hope that starting with Goldman Sachs, wall street is made to pay through their collective noses for the havoc wrought on unsuspecting investors, with the complicity of a Republican congress and senate who had and continues to have a difficulty differentiating between capatilism and unmitigated greed!. Hopefully, this will provide the leverage that the current Investor friendly congress needs, to pass legislation that will never allow what happened in 2008, to not just only adversely affect the ecomony of the United States, but that of the entire world!

  8. Silverman | April 19, 2010

    I wish but nothing will happen to GM because our our government is controlled by people who benefit off wallstreet period.

  9. Brandon | April 19, 2010

    Burn money burn, we need to change the soul of man before any this type of thing is going to stop happening!

  10. Jim Enniss | April 19, 2010

    Did you say "a heavily anti-Wall-Street Congress in power right now"? I have not noticed. The proposed compromised legislation between Dodd and Corker offered little meaningful reform. The financial service committee has been friendly to Wall Street for quite some time. See M Hutchinson, Financial Reform 3 ways to Fix Wall Street.

  11. Richard C. Kay | April 19, 2010

    It is unfortunate that GS has been able to exist actually insulated by the SEC. The greed for and theft of investors capital is not civil but criminal. We need the full force of the law to bring severe penalty to GS and its counterparts for their actions.

  12. Owen K. | April 19, 2010

    More Wall Street victomology!!! We can save ourselves by more regulation. Ask yourselves this question. If the current regulations and regulators that are now in place couldn't (or wouldn't) deal with this, how can a new set of regulations and regulators deal with it?

  13. Grumpy and Old | April 19, 2010

    Since we have all of these safety nets and watchdogs, such as the SEC, and the Federal Reserve, and the Treasury Department, and the Congress, and they all congregate to pick on their scape goat after the cows are out of the barn. After all of the special fiduciary care provided by these 'honest' servants of the people, and they have finished setting the barn on fire, why should we believe that throwing Goldman Sachs under the bus is not just another way to wreck a bus and cheat someone else? In the US, the only thing we must be demonstrating to the rest of the planet is that if they follow us they will likely be cheated, and don't tell me that the problem is Capitalism. Capitalism is what people make of it, just like 'democracy'. It is people who make promises they NEVER intend to keep who are the problem, and they are among us in large numbers, because such behavior has proved to be very profitable. These people are in our financial institutions, in our governments and in our justice system. They are the people who have succeeded by cheating all of their lives. They are the one's who are permitted to get away with it, because if you punish one, you might have to punish them all. Goldman Sachs is not the problem. The problem lies with those who promise to serve the people and do not. Before we throw Mr's. Goldman and Sach's under the bus, we should practice with those who sat quietly by in the Fed, the Treasury, the Congress, the Justice Department and the remainder of the Executive. We should practice with them all before we find anyone else guilty of misdeeds. After all, who can point to a banker who ever expected to make money from a poorly justified mass of mortgage loans? Do we actually believe that bankers, while they may sit on lots of money, sit in the chairs of real power? The only folks who try to make a big deal about that are politicians. We must all try to see the financial disasters of the past few years in the context of the failure of power rather than the failure of financiers. Financiers may do anything to make a buck, but they can only do that if 'anything' is permitted by those charged with the responsibility to insure that the money tree remains honest.

  14. Kylin | April 19, 2010

    Too many Govnt. regulators and members of Congress are too corrupt to "regulate" right now. Chris Dodd's indignation is laughable, considering how he personally profited with Countrywide, Fannie and Freddie. His committee position is like the fox guarding the hen house. Read Joshua Cooper Ramo's "The Age of the Unthinkable", why the New World disorder constantly surprises us & what we can do about it. Get control again, Americans.

  15. Paul Coote | April 19, 2010

    Do we really need Wall Street? Someone should do an empirical study to determine what value Wall Street adds to the Mainstream Economy vs How much money Wall Street extract from Mainstream. The players on Wall Street never loose.
    As long as there is a Wall Street, It will always be business as usual.

  16. honestann | April 20, 2010

    This is nothing but quid pro quo. GoldmanShafts and the feds control a mutually beneficial, infinitely unethical and criminal enterprise known as the totalitarian USSA… on its way to becoming a totalitarian world government – with them in control of everyone and everything. Anyone who believes this is more than window dressing to improve the chances of re-election of Obama and his cronies (including all mainstream republicans (which is 99%+ of them)).

    We will all see a carefully selected set of "actions" like this designed to defuse the anger of every honest, productive, liberty-advocating individual for the 2010 and 2012 elections. GoldmanShafts has benefited more than any other commercial entity from their criminal collaboration with the powers-that-be. You can be assured both parties have agreed in advance how this will be played. GoldmanShafts knows they gain at least 1000 times more from the protection and collaborations the powers-that-be provide, and they know those same powers-that-be will get more benefit from putting on a show and seeming to "come down on" GoldmanShafts than doing so on anyone else. By selecting GoldmanShafts, they tend to support the infinitely absurd and insane notion they wish everyone to believe – that GoldmanShafts employees and ex-employees and future-employees have no more influence on the criminal cartel of "government" than any other individuals. Yes, we all know that is utterly insane, but they know that typically they only need to fudge elections a few percent to change the result (on top of the massive election fraud they are now able to control via electronic voting with no paper-trail).

    Yup, this whole show is nothing but a show. Even if one individual in the SEC is not corrupt, and not totally bought-and-paid-for, that individual will find himself stripped of significant power to move this show forward in an honest way. That's always how it works, and how it shall always work in the future unless the new-world-order world-government totalitarians are somehow removed from power (which means, virtually every high position in every government worldwide at this point). Oh, and since those who were ripped-off are mostly [pseudo]-government or [pseudo]-central bank entities, this also provides a way for the powers-that-be to refund the losses their co-conspirators suffered on the backs of american taxpayers (which they will surely attempt to make non-obvious to all but the most insightful).

    Make no mistake about it. At this point in history, the most viscious predators on earth have total control of government, and everything "official" is part of a game to stay in power and rape every honest, productive individual to the greatest possible degree. They could, if they wanted, destroy every honest, productive individual on earth. Why don't they? For the exact same reason slave-owners do not kill their slaves – the predators are not productive, but need and want drink, food, clothing, shelter and other goodies that only productive individuals create. So they established this system of fiat-debt-money and total-control to enslave and control productive individuals, and (only for the short~medium term) bribe the mostly unproductive masses of human waste to provide cover for them (vote for their chosen democrat and republican politician-operatives) to create confusion (for a little while longer) about whether the world is a gigantic slave-pen, or not. In a matter of a decade or less they will no longer need to continue this illusion, at which time you are either a productive-slave, or discarded.

    How can anyone today imagine this GoldmanShafts "show" will play out in any ethical way?

  17. anne glynn | April 20, 2010

    Why on earth is everyone so surprised about Goldman Sachs and Wall Street? Look who is in charge of the finances in your country -mostly ex employees of Goldman Sachs and The Federal Reserve

  18. William J McKibbin | April 20, 2010

    The executive leadership teams at our nation's largest banks and financial insitutions are responsible for everything that happens or fails to happen within their domains. If firms such as Goldman Sachs cannot ethically manage their affairs in detail (including the actions of their non-principal employees), then we should dissolve Goldman as "too big to manage." The nation is exhausted from the excesses on Wall Street, and if the leadership at Goldman Sachs cannot fulfill their duties and responsibilities, then let's proceed now with breaking them up for the good of the banking industry, as well as the nation. Again, the senior mangement teams at our nation's banks and insurance companies are responsible for everything that happens or fails to happen within their domains, and quibbling about that responsibility is outrageous.

  19. Doug Stevens | April 21, 2010

    TERM LIMITS NOW !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

  20. zorro | April 26, 2010

    blah! blah! blah! the blame game never ends… sick & tired of all this!
    So I'm goin' to tell all ya folks: Let's salute with my trusted RUM and eat, drink & be merry while there's still time left to enjoy… 'cos the good times ain't gonna last much longer.
    The aftermath? WellCome to the New World (Financial) Order… and the good old mighty U.S. of A. relegated to a NEW BANANA REPUBLIC! ComPrande?

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