SEC's Goldman Suit Sends a Chill Down Wall Street


The government lawsuit against Goldman Sachs (GS) is sending a chill across all of Wall Street because it threatens one of the most lucrative businesses in the world of finance: derivatives.

The Securities and Exchange Commission filed suit today accusing Goldman of securities fraud for creating and selling an investment based on home mortgages that was set up to fail. The lawsuit names both Goldman and Fabrice Tourre, a vice president at the firm who helped create and sell the investment.

The suit marks a culmination of allegations of wrongdoing that have been swirling around for months. In February, for instance, Philip Agelides, the chairman of the Financial Crisis Inquiry Commission told Goldman CEO Lloyd Blankfein: "It sounds to me like selling a car with faulty brakes, and then buying an insurance policy on the buyer of those cars."

For a while, it seemed that Goldman would get through unscathed. Until now. The SEC's suit says Goldman bet against the very investments it had created and sold to investors, and "did not disclose" its bets to the buyers. That way, the SEC claims, Goldman made $15 million for structuring and marketing the investment, while investors lost $1 billion.

Goldman issued a statement calling the SEC's charges unfounded and said it will "vigorously contest them and defend the firm and its reputation."

Putting a Break on Derivatives?

Advocates for derivative regulation see this as a sign that Washington is ready to take on Wall Street -- and cheered.

"We lost an entire generation to this kind of manipulation, where the best math brains went to Wall Street to pick our pockets," says Lynn Stout, Hastings professor of corporate and securities law at UCLA's School of Law. "Now it's time to reverse that trend."

Joining the growing chorus calling for reform, President Obama stated Friday that he will veto any financial reform bill that does not explicitly address derivatives.

The SEC suit is viewed as a direct challenge to the Wall Street's derivatives business, which until now has been left alone, despite being one of the major causes of the financial crisis. Derivatives are complex financial instruments that are structured as private transactions between investment banks and their clients, and trade in what's known as the shadow banking system. Wall Street has fought regulation of this business tooth and nail, saying that this kind of "financial innovation" is essential to keep the wheels of the economy greased.

Not everyone agrees. "One man's innovation is another's securities fraud, because a lot of these structures are deceptive by design," says Christopher Whalen, co-founder of Institutional Risk Analytics. Whalen says the SEC suit could be just the beginning of much more action from Washington as it moves to place curbs on Wall Street. "This would have been impossible to place during the bubble, but now the politics and the climate have changed."

Indeed, the SEC's move is just one of the many salvos that lawmakers have been fired aimed at regulating these products.

For instance, Senator Blanche Lincoln, Democrat from Arkansas, unveiled legislation Friday that would curb banks from engaging in derivatives transaction directly and make them do it via a separate entity.

And last month, Gary Gensler, the chairman of the Commodities Futures Trading Commission, said in a speech: "We need broad regulatory reform of over-the-counter derivatives to best lower risk and promote transparency in the marketplace. . . . Only with comprehensive reform can we be sure to fully protect the American public."

Further Steps

The SEC has also created a new Division of Risk, Strategy, and Financial Innovation, whose director professor Henry Hu of the University of Texas, a few months ago outlined the dangers of excluding the $450 trillion derivatives market from the current regulatory framework. "Fixing these weaknesses is vital. . . the SEC is committed to working closely with policymakers to develop appropriate regulation," he said in testimony.

All these moves seem aimed at reversing Congress's decision in 2000 to legalize over-the-counter derivatives trading with the Commodities Futures Modernization Act, which declared these over-the-counter derivatives (which are agreements between two private entities) exempt from oversight of the government regulatory agencies.

In the eight years after the Act, that market grew to almost $600 trillion and brought the financial system to its knees in 2008. Now, however, despite Wall Street's protests Congress might be less willing to give the banks a free pass to line their pockets while hurting investors and ultimately the broader American public.