Goldmans fall

OUR clients interests always come first.... Our assets are our people, capital and reputation. If any of these is ever diminished, the last is the most difficult to restore. This is what the preamble to the prospectus of Goldman Sachs, the giant United States investment bank, trumpeted when the institution chose to go public in 1999. We now know how prescient these pompous words have proved to be.

The mighty organisation, whose Chief Executive Officer Lloyd Blankfein proclaimed not long ago that he was doing Gods work, is in deep trouble because of the fraud charges slapped on it by a feisty Securities Exchange Commission (SEC). Its much-vaunted reputation has been punctured, although the bank has stoutly denied it did anything bordering on deceit. Not many are, however, willing to buy this.

Unfortunately, Goldman is no great friends with the media. The latter had always considered the bank too arrogant and proud. As a consequence, a trial by the media is in full swing. For instance, The Economist writing on the sordid episode chose to caption its leader: Greedy until proven guilty. This is testimony to how the bank is regarded by even a sedate weekly like The Economist, and how Goldman had over the years acquired the reputation of being avaricious.

This is, to an extent, the fallout of the widely circulated fact that when all others were failing and piling up losses during the recent economic crisis, Goldman alone had shown a huge profit and was generously dishing out handsome bonuses to its employees. The conventional wisdom is that even if you are rich or have stumbled upon gold (no pun intended here), never parade your wealth and be ostentatious. Goldman chose to ignore this time- honoured prudence and is now paying a heavy price.

There are those who say that the banks detractors are more jealous than moralistic. Whatever be the case, there are lessons in modesty to be learnt. A difficult task lies ahead for the bank to prove its innocence. But my bet is, as in any corporate crime, the investigators will find it equally daunting to establish guilt conclusively. This is especially so when they face a sophisticated entity like Goldman Sachs, whose skills are enormous. Traditionally, of all forms of crime, the white collar variety is the most laborious for investigators because they have to wade through mountains of documents where chicanery could be hiding rather unobtrusively and innocuously. With the advent of the Internet more than a decade ago, the whole exercise became even more complex. Somehow cyberspace lulls the criminal into great complacence, and an ace investigator with a strong foundation in computers is better off in probing the allegations against Goldman than a conventional sleuth who is not computer savvy.

The SECs complaint against Goldman and one of its senior executives, Fabrice Tourre, refers to violations of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Exchange Act Rule 10b-5. Shorn of their legalese, the charges are relatively easy to comprehend. Basically, they relate to the non-disclosure of vital information to at least two clients regarding a structured financial product, a CDO (collaterised debt obligation), that was tied to failing subprime mortgages, the villain of the recession that we witnessed a couple of years ago.

The transaction (called Abacus) goes back to 2007. The investors were allegedly not told that the mortgages in question were handpicked by a hedge fund, Paulson & Co, which itself had betted against their longevity. Interestingly, Paulson, who manages the latter firm, made millions of dollars betting on the subprime collapse. To prove its bona fides, Goldman now claims that like some of the unwary investors it also incurred severe losses, a statement that has been disputed by some on Wall Street. The transaction had been under SEC scrutiny for quite some time.

Actually, the SEC issued a Wells Notice in September 2009, indicating that there was a proposed enforcement action. Goldman mentioned this in a roundabout manner in its periodical financial statements, stating that certain information had been sought from it by regulators. It never made a frank and categorical disclosure to investors and others that it was under the SEC scanner. According to some observers, Goldman had trivialised this, whereas in the past companies such as General Electric and Bank of America had announced that they had received a Wells Notice. Goldmans failure in this regard has been assailed by some as in tune with its general lack of transparency.

However simple to understand in retrospect, this is no routine or straightforward crime that an average policeman can solve and present a credible file before a judge. It calls for good knowledge of the markets and the way they function. Apart from the SEC, the U.S. Senate Sub-committee on Investigation is probing Goldmans alleged misdemeanour. Early reports confirm that the evidence is primarily documentary, as in many other scandals of this hue. It is in the form of emails, both internal and to the rest of the world.

Recently, the Senate sub-committee grilled Goldman executives, particularly Blankfein and Tourre, the French-born and London-based vice-president, and confronted them with some clinching emails. Committee Chairman Senator Carl Levin was convinced that the electronic trail showed that from being a mere facilitator, Goldman went on to become a party by itself betting on the failure of the bonds in question. The Senators point was that Goldman had every incentive to stand by and watch the failure at a time when it was promoting the same nearly junk bonds to its clients. The shift from neutrality to a short position began to show from as early as 2007. According to Levin, the bank made $3.7 billion in the process.

From whatever has appeared in the press, there is an increasing feeling that Goldman will make the 31-year-old Tourre the fall guy. Perhaps, not without justification. It was he who designed the CDO in question. His mens rea (criminal intention) is evident from the email (now released by the bank) he sent to his girlfriends, which read: The whole building is about to collapse any time now. Only potential survivor, the fabulous Fab... standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities [sic]. (The fabulous Fab was none other than Tourre himself.)

Yet another mail showed how erratic and insensitive he was. He said he had sold a few abacus bonds to widows and orphans that I ran into at the airport. Senator Levins summation leaves no one in doubt: It (Goldman) often saw its clients not as valuable customers, but as objects for its own profit... instead of doing well when its clients did well, Goldman Sachs did well when its clients lost money.

The outcome of the investigation against Goldman Sachs is difficult to predict. Interestingly, some political motives have been attributed to the SEC in pressing the charges. The reported split (3-2) within the SEC over whether to proceed against Goldman or not is also projected as a reason to believe that the case against the bank is not watertight and could fail.

Another argument is that the Goldman investigation had become necessary to bolster President Barack Obamas stand that a sweeping reform of regulatory law was necessary if the ordinary citizen was to be protected from the intrigues of dealers on Wall Street. Those who endorse Obama will be dismayed by the early setback Democrats suffered in the Senate when their Bill was blocked by a defiant Republican Opposition. But this is described to be only a temporary reverse.

One thing is, however, very clear. The action against Goldman should be a sufficient deterrent, at least for a while, against market manipulation. If Goldman can be touched, almost no one else will be spared.

The Goldman episode has a number of lessons to offer to us in India. I am sure the Securities and Exchange Board of India (SEBI) is monitoring closely the events in New York and Washington. The Indian investor needs to be assured that SEBI is as watchful and aggressive as its U.S. counterpart and that it has enough tools to pursue electronic trails. One positive development is the induction of a former Central Bureau of Investigation and Mumbai Police officer into SEBI as an Executive Director.