S.E.C. Puts Wall St. on Notice/Looters in Loafers/Top Goldman Leaders Said to Have Overseen Mortgage Unit/Gambling With the Economy

S.E.C. Puts Wall St. on Notice
By EDWARD WYATT
Copyright by The New York Times
Published: April 18, 2010
http://www.nytimes.com/2010/04/19/business/19sec.html?th&emc=th


WASHINGTON — In the last few years, the Securities and Exchange Commission seemed like the cop in the doughnut shop, sitting idly by while the likes of Lehman Brothers and Bernard L. Madoff ran amok.

But with its latest lawsuit against Goldman Sachs, the most powerful, most feared and most envied firm on Wall Street, the S.E.C. is sending a signal that it is back on the beat and that it is going after very big targets.

In interviews this weekend, Mary L. Schapiro, the commission’s chairwoman, and Robert Khuzami, its new director of enforcement, said the agency was stepping up both its rule-making and its investigations in the wake of the financial crisis.

Neither would elaborate on the case being pursued against Goldman, but Ms. Schapiro said the commission had recently proposed new rules for credit rating agencies and for the reporting of the specific investments behind asset-backed securities, two issues that were integral to the recent financial crisis.

The Goldman case is not the only example of the agency raising its sights. Last week, General Electric said the S.E.C. had asked for information about reassurances that its chief executive, Jeffrey R. Immelt, made in 2008 about the company’s ability to refinance its debt.

In his recent memoir, Henry M. Paulson Jr., the former Treasury secretary, said Mr. Immelt told him at the time that G.E. was having problems selling short-term debt. G.E. said on Friday that it was cooperating with the agency and that its disclosures were accurate.

The S.E.C. also has joined an international investigation into whether Hewlett-Packard paid bribes to win business in Russia. The company said it was cooperating with investigators while conducting its own inquiry.

“We’re seeing a resolve in the enforcement division that was lacking a year and a half or two years ago, and even 10 years ago,” said James D. Cox, a Duke University law professor. “Americans should take heart” in the Goldman case, he said.

Ms. Schapiro, who took over as S.E.C. chairwoman last year, has vowed to reinvigorate the agency.

“I think everybody a few years ago got caught up in the idea that the markets are self-correcting and self-disciplined, and that the people in Wall Street will do a better job protecting the financial system than the regulators would,” she said. “I do think the S.E.C. got diverted by that philosophy.”

The S.E.C. has adopted an unusually aggressive posture with Goldman Sachs. Though it informed the company in the middle of last year that it might face charges, Goldman did not know until the news was already out on Friday that the S.E.C. had filed a civil fraud lawsuit, according to people on both sides of the issue who spoke on the condition of anonymity because they were not authorized to discuss the case. Goldman was not given the chance to discuss a settlement or prepare for the announcement, a departure from common practice.

In the long run, the agency’s reputation will rest more on whether it can win its case against Goldman than on its aggressive tone.

The S.E.C. charged last week that Goldman had created and sold a mortgage investment that was secretly intended to fail. Goldman said the charges were “completely unfounded in law and fact,” and that it would “vigorously contest them and defend the firm and its reputation.” Goldman said that it lost money on the transactions at issue.

Goldman has already provided answers to some of the S.E.C.’s questions. In the fall Goldman responded to a Wells notice from the S.E.C., producing two hefty filings — a 40-page response on Sept. 10 and a 16-page response on Sept. 25. In those filings, Goldman said it was common practice for banks to devise synthetic C.D.O.’s — collateralized debt obligations, which are a bundle of mortgage bonds — to suit an investor. Goldman cited other mortgage bundles that other banks created in partnership with hedge funds, where the hedge fund’s role was not disclosed.

Regarding the S.E.C.’S allegation of fraud in a specific Abacus deal by Goldman that was created at the request of the hedge fund Paulson & Company, in which Paulson helped select the toxic securities that went into that deal, Goldman said, “the non-disclosure of Paulson’s role (and its separate hedge in transaction with Goldman Sachs) simply reflected industry practice not to disclose client names.” Indeed, it added later that firms had an ethical “obligation not to divulge client information.”

Not all of the S.E.C.’s recent actions have been winners. Last August, a federal judge in New York slapped down a proposed $33 million settlement with Bank of America over accusations that it had failed to adequately disclose to shareholders details of the financial condition of Merrill Lynch as the two were merging. More than six months later, the judge reluctantly approved a $150 million settlement, but he complained that it was an insufficient penalty.

And the commission has been the subject of three scathing investigative reports over its failure to catch irregularities in some of the biggest investment debacles in history, including those involving Lehman Brothers and Bernard L. Madoff Investment Securities. It had even received tips years ago that Mr. Madoff was running a Ponzi scheme but failed to develop a case against him.

On Friday, the S.E.C. inspector general faulted the commission for failing to uncover a possible $7 billion Ponzi scheme at the Stanford Financial Group. Although its examiners had discovered evidence of wrongdoing in 2002, the district enforcement division did not take action, the inspector general said.

Ms. Schapiro said in an interview over the weekend that the S.E.C. shortcomings noted in the recent reports had been addressed in part by the makeover of the enforcement division.

Mr. Khuzami, the new enforcement director, said one of the most important changes was eliminating a rule that required investigators to get majority approval of the five-person commission in order to issue subpoenas, which has allowed the division to move more quickly.

Marcel Kahan, a law professor at New York University, said the risk to Goldman’s reputation was greater than its legal exposure. For instance, he said that Goldman’s stock dropped nearly 13 percent on Friday, causing a greater loss in market capitalization than the worst imaginable S.E.C. fine.

“I think the negative P.R. for Goldman is a multiple of the legal one,” he said. “It’s very bad for business. You don’t want to get the impression with your client that you are doing shady things.”

As a consequence, Professor Kahan said, Goldman had no incentive to settle the case and would hire the nation’s best lawyers to try to clear its name. Similarly, he said the S.E.C. had as much or more to lose, given its record in the last decade.

But just taking on Goldman Sachs is a sign the agency is more certain of its role as a tough watchdog for the markets, said Donald C. Langevoort, a law professor at Georgetown University who formerly worked in the office of the agency’s general counsel.

“The S.E.C. has long lacked the kind of resources that would give them the confidence that they could take on a Goldman Sachs,” he said, “because if Goldman Sachs decides to litigate, you know it’s going to be a war.”

Andrew Martin contributed reporting from New York.


Looters in Loafers
By PAUL KRUGMAN
Copyright by The New York Times
Published: April 18, 2010
http://www.nytimes.com/2010/04/19/opinion/19krugman.html?th&emc=th


Last October, I saw a cartoon by Mike Peters in which a teacher asks a student to create a sentence that uses the verb “sacks,” as in looting and pillaging. The student replies, “Goldman Sachs.”

Sure enough, last week the Securities and Exchange Commission accused the Gucci-loafer guys at Goldman of engaging in what amounts to white-collar looting.

I’m using the term looting in the sense defined by the economists George Akerlof and Paul Romer in a 1993 paper titled “Looting: The Economic Underworld of Bankruptcy for Profit.” That paper, written in the aftermath of the savings-and-loan crisis of the Reagan years, argued that many of the losses in that crisis were the result of deliberate fraud.

Was the same true of the current financial crisis?

Most discussion of the role of fraud in the crisis has focused on two forms of deception: predatory lending and misrepresentation of risks. Clearly, some borrowers were lured into taking out complex, expensive loans they didn’t understand — a process facilitated by Bush-era federal regulators, who both failed to curb abusive lending and prevented states from taking action on their own. And for the most part, subprime lenders didn’t hold on to the loans they made. Instead, they sold off the loans to investors, in some cases surely knowing that the potential for future losses was greater than the people buying those loans (or securities backed by the loans) realized.

What we’re now seeing are accusations of a third form of fraud.

We’ve known for some time that Goldman Sachs and other firms marketed mortgage-backed securities even as they sought to make profits by betting that such securities would plunge in value. This practice, however, while arguably reprehensible, wasn’t illegal. But now the S.E.C. is charging that Goldman created and marketed securities that were deliberately designed to fail, so that an important client could make money off that failure. That’s what I would call looting.

And Goldman isn’t the only financial firm accused of doing this. According to the Pulitzer-winning investigative journalism Web site ProPublica, several banks helped market designed-to-fail investments on behalf of the hedge fund Magnetar, which was betting on that failure.

So what role did fraud play in the financial crisis? Neither predatory lending nor the selling of mortgages on false pretenses caused the crisis. But they surely made it worse, both by helping to inflate the housing bubble and by creating a pool of assets guaranteed to turn into toxic waste once the bubble burst.

As for the alleged creation of investments designed to fail, these may have magnified losses at the banks that were on the losing side of these deals, deepening the banking crisis that turned the burst housing bubble into an economy-wide catastrophe.

The obvious question is whether financial reform of the kind now being contemplated would have prevented some or all of the fraud that now seems to have flourished over the past decade. And the answer is yes.

For one thing, an independent consumer protection bureau could have helped limit predatory lending. Another provision in the proposed Senate bill, requiring that lenders retain 5 percent of the value of loans they make, would have limited the practice of making bad loans and quickly selling them off to unwary investors.

It’s less clear whether proposals for derivatives reform — which mainly involve requiring that financial instruments like credit default swaps be traded openly and transparently, like ordinary stocks and bonds — would have prevented the alleged abuses by Goldman (although they probably would have prevented the insurer A.I.G. from running wild and requiring a federal bailout). What we can say is that the final draft of financial reform had better include language that would prevent this kind of looting — in particular, it should block the creation of “synthetic C.D.O.’s,” cocktails of credit default swaps that let investors take big bets on assets without actually owning them.

The main moral you should draw from the charges against Goldman, though, doesn’t involve the fine print of reform; it involves the urgent need to change Wall Street. Listening to financial-industry lobbyists and the Republican politicians who have been huddling with them, you’d think that everything will be fine as long as the federal government promises not to do any more bailouts. But that’s totally wrong — and not just because no such promise would be credible.

For the fact is that much of the financial industry has become a racket — a game in which a handful of people are lavishly paid to mislead and exploit consumers and investors. And if we don’t lower the boom on these practices, the racket will just go on.



Top Goldman Leaders Said to Have Overseen Mortgage Unit
By LOUISE STORY
Copyright by Bloomberg News
Published: April 18, 2010
http://www.nytimes.com/2010/04/19/business/19goldman.html?th&emc=th


It was late 2006, and an argument had broken out inside the Wall Street bank’s prized mortgage unit — a dispute that would reach all the way up to the executive suite.

One camp of traders was insisting that the American housing market was safe. Another thought it was poised for collapse.

Among those who saw disaster looming were an effusive young Frenchman, Fabrice P. Tourre, and his quiet colleague, Jonathan M. Egol, the mastermind behind a series of mortgage deals known as the Abacus investments.

Their elite mortgage unit is now at the center of allegations that Goldman and Mr. Tourre, 31, defrauded investors with one of those complex deals.

The Securities and Exchange Commission filed a civil fraud suit on Friday that essentially says that Goldman built the financial equivalent of a time bomb and then sold it to unwitting investors. Mr. Egol, 40, was not named in the S.E.C.’s suit.

Goldman has vowed to fight the S.E.C. But the allegations have left many on Wall Street wondering how far the investigation might spread inside Goldman and perhaps beyond.

Pressure on Goldman mounted on Sunday as two members of Congress and Gordon Brown, Britain’s prime minister, called for investigations into the bank’s role in the mortgage market. Germany also said it was considering legal action against the bank.

Mr. Tourre was the only person named in the S.E.C. suit. But according to interviews with eight former Goldman employees, senior bank executives played a pivotal role in overseeing the mortgage unit just as the housing market began to go south. These people spoke on the condition that they not be named so as not to jeopardize business relationships or to anger executives at Goldman, viewed as the most powerful bank on Wall Street.

According to these people, executives up to and including Lloyd C. Blankfein, the chairman and chief executive, took an active role in overseeing the mortgage unit as the tremors in the housing market began to reverberate through the nation’s economy. It was Goldman’s top leadership, these people say, that finally ended the dispute on the mortgage desk by siding with those who, like Mr. Tourre and Mr. Egol, believed home prices would decline.

Lucas van Praag, a Goldman spokesman, said that senior executives were not involved in approving the Abacus deals. He said that the executives had sought to balance Goldman’s positive bets on the mortgage market, rather than take an overall negative view.

Mr. Tourre, who now works for Goldman in London, declined to comment, as did Mr. Egol, Mr. van Praag said.

Mortgage specialists like those at Goldman were, in a sense, the mad scientists of the subprime era. They devised investments by bundling together bonds backed by home loans, a process that enabled mortgage lenders to make even more loans.

While this sort of financing helped make loans available, the most exotic creations also spread the growing risks inside the American housing market throughout the financial world. When the boom went bust, the results were disastrous.

By early 2007, Goldman’s mortgage unit had become a hive of intense activity. By then, the business had captured the attention of senior management. In addition to Mr. Blankfein, Gary D. Cohn, Goldman’s president, and David A. Viniar, the chief financial officer, visited the mortgage unit frequently, often for hours at a time.

Such high-level involvement was unusual elsewhere on Wall Street, where many executives spent little time learning the workings of their mortgage businesses or how those businesses might endanger their companies.

The decision to get rid of positive bets on mortgages turned out to be prescient. Unlike most other Wall Street banks, Goldman profited from its mortgage business as the housing bubble was inflating and then again when the bubble burst.

At the heart of all of this is the mortgage trading unit that, at its peak, employed several hundred people. As recently as 2007, Goldman’s mortgage division was split into 11 subgroups, each with a specialty, according to an internal Goldman document that was provided to The New York Times by a former employee.

Together, these groups stood astride the nation’s real estate market. One group, for instance, handled actual home loans. Another provided mortgage advice. A third syndicated loans among banks. And still another handled commercial real estate.

During the boom, Goldman’s mortgage unit was a leader on Wall Street. In 2006 alone, the bank underwrote $26 billion of collateralized debt obligations, according to Dealogic, a financial data provider. Many C.D.O.’s have since turned out to be bad investments.

But in 2006, some inside Goldman began to worry about the fragile state of housing. Daniel L. Sparks, the Texan who ran the mortgage unit, sided with those who believed the market was safe. Two of his traders, Joshua S. Birnbaum and Michael J. Swenson, had placed a big bet that mortgage bonds would rise in value.

But this camp clashed with Goldman sales staff who were working with hedge funds that wanted to bet against subprime mortgages. Mr. Birnbaum told the team to stop promoting bets against some mortgage investments since such trades were hurting the market and Goldman’s own position, according to two former Goldman employees.

But a few desks away, Mr. Tourre and Mr. Egol were quietly working on the Abacus deals.

They were, former colleagues say, something of an odd couple. A slight man with a flair for salesmanship, Mr. Tourre joined Goldman in 2001, after coming to the United States to study business operations at Stanford. At Goldman, he courted investors like European banks and big hedge funds.

The taller Mr. Egol, a specialist in analytical finance with a quiet but sometimes intimidating demeanor, devised the Abacus investments. He came to Goldman after studying aerospace engineering at Princeton and finance at the Booth School of the University of Chicago.

What united them was an unusually negative view on the mortgage market. As far back as 2005, they clashed with Goldman traders who worked with big mortgage lenders like Countrywide to buy and package loans. Their Abacus deals included insurancelike protection that would pay out if certain mortgage bonds soured. Such credit-default swaps were not worth much in 2005, when housing was flying high, but became highly valuable once the market sputtered.

“Egol and Fabrice were way ahead of their time,” said a former Goldman worker. “They saw the writing on the wall in this market as early as 2005.”

Unlike many of their colleagues at Goldman and other banks, they argued that the nation’s mortgage market was far more interconnected than believed, former Goldman employees said. Their view was that if one group of mortgages or mortgage bonds ran into trouble, the entire market might falter.

Mr. Tourre and Mr. Egol created a way for a prominent hedge fund manager, John A. Paulson, to bet against risky mortgages.

With Mr. Paulson’s help, Goldman created an Abacus investment that, the S.E.C. now says, was devised to fall apart. By betting against that Abacus investment, Mr. Paulson reaped $1 billion in profit, according to the S.E.C. Mr. Paulson was not named in the S.E.C. complaint.

Goldman’s top ranks changed its stance on housing in December 2006. In a meeting in a windowless conference room on the executive floor, Mr. Viniar, the chief financial officer, and Mr. Cohn, the president, gathered about 10 executives for a briefing. Mr. Sparks, the head of the mortgage unit, walked them through the numbers. The group was unanimous: Goldman had to reduce its exposure to the increasingly troubled mortgage market.

A few months later, in February 2007, senior executives began turning up on the trading floor. The message, one former employee said, was clear: management was watching.

“They basically said, ‘What does this department do? Tell us everything about mortgages,’ ” this person said.

The executives told Mr. Sparks to tell his traders to sell Goldman’s positive bets on housing. The traders’ short positions — that is, negative bets, mostly used to hedge other investments — were placed in a central trading account.

Not everyone was happy about it. One trader leaving the firm wrote the mortgage unit a one-word e-mail message: “goodbye.”

Goldman turned over all these negative positions to Mr. Swenson and Mr. Birnbaum, the traders who had previously been positive on the market. Along with Mr. Sparks, they have been credited for managing the short position that yielded a $4 billion profit for Goldman in 2007. Mr. Sparks retired in 2008. Mr. Birnbaum also left in 2008, to start his own hedge fund.

But former Goldman employees said those traders benefited from the short positions that were given to them. And their trading was tightly overseen by senior executives.

At one point in the summer of 2007, for instance, Mr. Birnbaum made a case to Mr. Cohn that some mortgage assets were cheap and that Goldman should let him add $10 billion in positive bets. Mr. Cohn said no.

Meantime, Goldman managers instructed Mr. Egol in early 2007 to add insurance against mortgage bonds.

By the third quarter of 2007, the mortgage unit was minting money, while Goldman’s rivals were losing big.

Mr. Viniar, the chief financial officer, told analysts that the mortgage unit was posting record profits because of its short bets that mortgage investments would lose value.

“Our risk bias in that market was to be short, and that net short position was profitable,” Mr. Viniar said.




Gambling With the Economy
By ROGER LOWENSTEIN
Copyright by The New York Times
Published: April 19, 2010
http://www.nytimes.com/2010/04/20/opinion/20lowenstein.html?th&emc=th


WHILE the Securities and Exchange Commission’s allegations that Goldman Sachs defrauded clients is certainly big news, the case also raises a far broader issue that goes to the heart of how Wall Street has strayed from its intended mission.

Wall Street’s purpose, you will recall, is to raise money for industry: to finance steel mills and technology companies and, yes, even mortgages. But the collateralized debt obligations involved in the Goldman trades, like billions of dollars of similar trades sponsored by most every Wall Street firm, raised nothing for nobody. In essence, they were simply a side bet — like those in a casino — that allowed speculators to increase society’s mortgage wager without financing a single house.

The mortgage investment that is the focus of the S.E.C.’s civil lawsuit against Goldman, Abacus 2007-AC1, didn’t contain any actual mortgage bonds. Rather, it was made up of credit default swaps that “referenced” such bonds. Thus the investors weren’t truly “investing” — they were gambling on the success or failure of the bonds that actually did own mortgages. Some parties bet that the mortgage bonds would pay off; others (notably the hedge fund manager John Paulson) bet that they would fail. But no actual bonds — and no actual mortgages — were created or owned by the parties involved.

The S.E.C. suit charges that the bonds referenced in Goldman’s Abacus deal were hand-picked (by Mr. Paulson) to fail. Goldman says that Abacus merely allowed Mr. Paulson to bet one way and investors to bet the other. But either way, is this the proper function of Wall Street? Is this the sort of activity we want within regulated (and implicitly Federal Reserve-protected) banks like Goldman?

While such investments added nothing of value to the mortgage industry, they weren’t harmless. They were one reason the housing bust turned out to be more destructive than anyone predicted. Initially, remember, the Federal Reserve chairman, Ben Bernanke, and others insisted that the damage would be confined largely to subprime loans, which made up only a small part of the mortgage market. But credit default swaps greatly multiplied the subprime bet. In some cases, a single mortgage bond was referenced in dozens of synthetic securities. The net effect: investments like Abacus raised society’s risk for no productive gain.

In a free-market economy, we want people making considered calculations of risk. But buyers and sellers of credit default swaps often have no stake in the underlying instrument. Such swaps function like an insurance policy. One party collects a fee for promising to, in effect, insure a bond; the other party makes the premium payments, and gets a big payoff if the bond goes bad.

Banks that have lent money to questionable borrowers use swaps as a hedge — if their loans go bad, the bank makes up for the loss by collecting on the swap. The problem is that swaps are open to anyone — even parties with nothing to insure. Allowing speculators to bet on entities in which they have no stake is similar to letting your neighbor take out an insurance policy on your life.

And even when these instruments are used by banks to hedge against potential defaults, they raise a moral hazard. Banks are less likely to scrutinize mortgages and other loans they make if they know they can reduce risk using swaps. The very ease with which derivatives allow each party to “transfer” risk means that no one party worries as much about its own risk. But, irrespective of who is holding the hot potato when the music stops, the net result is a society with more risk overall.

As it considers its financial reform options, Congress’s first priority should be to end the culture that “financializes” every economic outcome, that turns every mortgage or bond issue into a lottery — often with second- and third-order securities that amount to wagers on wagers of numbing complexity.

First, it should insist that all derivatives trade on exchanges and in standard contracts — not in customized, build-to-suit arrangements like the ones Goldman created. Wall Street might have legal grounds to fight this — after all, a derivative is a contract between private parties. But the financial bailout has demonstrated that big Wall Street banks fall firmly within Washington’s regulatory authority, and regulation confers implicit bailout protection. Protected entities should not be using (potentially) public capital to run non-productive gambling tables.

Second, Congress should take up the question of whether parties with no stake in the underlying instrument should be allowed to buy or sell credit default swaps. If it doesn’t ban the practice, it should at least mandate that regulators set stiff capital requirements on swaps for such parties so that they will not overleverage themselves again to society’s detriment. Also, tax policy could be changed to skew heavily against swaps contracts that are held for short-term periods.

The government would not look fondly on Caesar’s Palace if it opened a table for wagering on corporate failure. It should not give greater encouragement for Goldman Sachs to do so.

Roger Lowenstein is a contributing writer for The Times Magazine and the author of “The End of Wall Street.”
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