All that glisters

If banks really want to buy and sell insurance, they ought to be regulated like insurers. The US SEC's charges against Goldman Sachs bring this a little closer.
Peter Johnson
19 April 2010

No one should be surprised that – finally – a regulator is taking on an investment bank in relation to the sale of financial derivatives. That the US Stock Exchange Commission has charged Goldman Sachs with fraud, attacking the biggest of the pack, is interesting, to say the least. The BBC has details of the case here and with links beyond on the transactions involved, particularly here.

To put it as briefly as possible, Goldman were asked by the US hedge fund Paulson & Co to structure and market a collateralised debt obligation (CDO). A CDO is a derivative instrument created from mortgage-backed bonds. Paulson told Goldman which bonds to package into the CDO, which was then named Abacus 2007-ACI. It was then sold to banks who might have been attracted by the returns.

But here’s the twist. Paulson believed that the US mortgage market was going to bomb and wanted to speculate on that event. So Paulson didn’t want to buy Abacus 2007-ACI: it wanted to sell it short, hoping to be able to buy it up for a song later. Goldman had not created – at least as far as Paulson was concerned – just another CDO, but a CDO purposely structured to be particularly likely to crash. And sure enough, nine months after Abacus 2007-ACI was issued, 99% of its constituent securities had been downgraded. Paulson cashed in big-time.

The allegation against Goldman is that they misrepresented the nature of the transaction to the buyers of this instrument. Had the buyers known who was behind the CDO and why it was being issued, they would not have invested.

The German government is reported to be looking at the case too, since one of the biggest investors in Abacus 2007-ACI was the German bank IKB, which was bailed out for some €10 billion. In the UK, bailed-out RBS lost $841 million on the transaction – money collected by Goldman and passed on to Paulson – on an insurance contract written against the value of Abacus 2007-ACI by ABN before RBS acquired it.

Naturally, Goldman rejects the SEC charges, at least in its public pronouncements, on the basis that in a sophisticated market people need to understand the risks. Yes, but...

This case has tremendous implications, not only for Goldman Sachs.

The principle may be established that investment banks have responsibilities to their counterparties in the market and are not, as Goldman seems to be saying, merely there to get the deal away. In the insurance industry, for example, it is axiomatic that all relevant facts be disclosed between insured and insurer. If they are not, the policy is void. The intermediary is expected to manage this and is at risk if information is not passed on. Why should the financial markets be any different? This is a huge opportunity for regulatory or ethical arbitrage.

As a result of this case further assaults may be made on the citadel of investment banking and even bring down one or two of its towers. In the long run this would be highly salutary. Whilst one bank may be able to fend off the SEC, a sustained international approach would be far harder to resist.

It adds a different category of support to the arguments for separation of the utility and casino banks. Not only do the casino banks gamble with publicly guaranteed funds, but they inhabit a different moral universe: one in which they themselves generate incentives to create bubbles. They simply cannot be trusted, even if (or perhaps especially if) they know what they are doing.

It shows the pointlessness of all the fiddle-faddling regulation that so far has been the only public response to the financial crisis – trenchantly criticised recently by John Mauldin.

UK readers may remember the pensions and financial products mis-selling scandal of the 1980s. The victims were largely members of the public. The result was the Financial Services Act 1986, which for all its faults, changed the landscape for personal financial transactions in the UK. It was big for the UK, though peanuts in global terms.

But if it turns out that there has been global mis-selling of financial products to the ‘professional’ markets (where again, of course, the public picks up the bill), the pressure for that system – one in which institutions tell lies in order to make a profit – to be dismantled and rebuilt will surely become irresistible. I shall be fascinated to see which merchant bank first lobbies for significant change.

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