19 April 2010

Goldman Sachs: A Pattern of Organized Criminal Behaviour?

Chris Whalen provides some excellent commentary on the Goldman Sachs fraud inquiry by the SEC at the beginning of his weekly newsletter, The Institutional Risk Analyst.

In addition to the information he provides about other deals, including those that specifically targeted AIG, he puts an interesting twist on this. He intimates that at times the Hedge Funds were acting in concert with the Big Banks as off-balance-sheet accomplices in crafting these complex frauds. And the Paulson - Goldman scandal may only be one of a type, and not perhaps the best or most flagrant example.

A reaction from many is that this is just the tip of the iceberg, a single point in a much larger picture of calculated fraud involving many more deals and significantly more money up to and including the bailout of AIG.

It is not enough to throw a few token fines on some selective deals, and then dismiss them as outliers, and then suggest we 'move on' to reform the market. The spin will be that what Goldman did was 'legal' but immoral. And for many today, morality is simply a matter of taste. And Paulson will be served up as the fall guy. It will take a serious investigation to uncover all the facts, and make the case stick. And the SEC is not competent to do this, for a variety of reasons.

And the reforms that the Congress will create as a result of this, at the least the ones permitted by Jamie and Lloyd, will quickly be circumvented with new fraudulent devices and it will quickly be business as usual. Its hard to say that the business has never stopped, even now. The Big Banks continue to manipulate markets and abuse derivatives as instruments of financial fraud.

The absolute worst place to conduct a serious investigation will be in front of the Congress is a show trial, designed to give some of the Senators and Representatives an opportunity to create sound bytes of anger, to be played in commercials for their re-election, and then at then end of the day, continue to collect fat campaign contributions, and then do nothing.

It does not require Republican permission for President Obama to direct the FBI and the Justice Department to begin a serious inquiry with an eye to RICO violations in what may be one of the largest financial frauds in history, dwarfing the Madoff Ponzi scheme in terms of value and number of victims.

Oh, and by the way, we hate to say we told you so, but please fire Larry Summers now that Bill Clinton has thrown him under the bus, and have him take Rubin's other protégé, Turbo Timmy, along with him.

My concern is that the American people even now do not understand how serious this crisis is. They are quickly distracted into ridiculous partisan spirit and frivolous diversions. This is the freedom and the welfare of their country that is at risk, and it is time to put aside childish things, and begin the serious work of reforming their financial system, the ownership of their media, and the political campaign process.

Institutional Risk Analyst
Goldman SEC Litigation: The End of OTC?

By Chris Whalen
April 19, 12010

Last Friday's announcement by the SEC of a civil lawsuit against Goldman Sachs (GS) for securities fraud did not surprise us. Nor were we surprised to see the markets
trade off large on the news, evidence to us that there is a certain lack of conviction in the financials.

Q: How can you have "normalized earnings" in an abnormal industry?

No, what surprised us about the SEC action is that it took as long as it did. Maybe surprised isn't precisely the right word, but you know what we mean. The inertia in the system seems to dampen reactions to extreme outlier behavior to a far too great a degree. This week in The IRA Advisory Service we discuss the implications of the SEC action and the likely impact on the OTC dealer community in the months and years ahead.

Readers of The IRA will recall back in 2004 when were started to talk about the regulatory focus on complex structured financial products and the perceived reputational risk to the big firms arising from these unregulated, OTC instruments. Big thank you to Chuck Muckenfuss at Gibson Dunn for the heads up. The "advice" issued by all of the regulators ("Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities") was focused almost entirely on protecting the dealers from reputational risk and not on protecting investors.

The fact of the 2004 notice by the SEC and other regulators illustrates the problem. Regulators clearly knew that a problem existed back then, yet the SEC waited until April of 2010 to actually do something constructive to rebalance the equation, to lean just a bit more in the direction of investors and abit less in favor of the dealers. Keep in mind that it's not like the games played by GS and the Paulson organization were remotely unique. Just about every OTC dealer worthy of the description has at least one deal comp to this thing of beauty.

On March 31, 2010, Bob Ivry and Jody Shenn at Bloomberg published a very important article on American International Group and its losses from insuring collateralized debt obligations structured by, you guessed it, GS. Entitled "How Lou Lucido Let AIG Lose $35 Billion With Goldman Sachs CDOs," the article outlines the process whereby AIG was left on the hook for billions in losses on CDOs sold to TCW Group in Los Angeles.

Whereas in the trades with Paulson GS was helping a client create and then sell short a CDO that was being sold to another client, in the case of TCW the GS firm was helping a client buy toxic loans to be contributed to a CDO in the knowledge that doing so would cause losses to a regulated insurer, AIG. The activities of GS to harm AIG make the subsequent payments by AIG to GS, using money from the US Treasury, seem all the more outrageous.

But the other thing that really bothers us about both the TCW transactions and the more recent revelations about GS and the Paulson firm is the fact that the SEC apparently still does not fully understand the symbiotic relationship between the dealer and the hedge fund. In our view, the funds that were involved with these
transactions and many, many more examples in the OTC marketplace, did not have an arm's length relationship with the dealer. Hedge funds exist at the sufferance of the dealers, who finance and execute and act as custodian for their various strategies and use the funds as short-term storage for inventory

In the case of Paulson, the information provided by the SEC makes it seem as though Paulson was the party which initiated these transactions and, according to the SEC, paid GS $15 million to arrange and market these CDOs to investors. Paulson was also apparently working as an advisor to GS and collaborating with GS regarding investment strategy. A spokesman for Paulson told The New York Times that all of their dealings with GS and other parties were on "an arm's length basis." We believe that reasonable people can differ on this issue. We also suspect that the nature and the extent of the relationship between GS and Paulson will be the subject of extensive legal and political inquiry in the weeks and months ahead.

But for us, the bottom line is that hedge funds often times are merely extensions of the dealers with which they interact. It is often difficult if not impossible to tell where the dealer's interests end and those of the hedge fund begin, especially when the dealer and the fund seem to be working in concert to create securities that are being sold to third parties. This episode is a terrible mess and, to us at least, illustrates why the OTC markets for securities and derivatives need to be regulated out of existence -- or at least into compliance with norms of disclosure and fair dealing that would render such strategies impossible. If the global financial markets have been reduced to nothing more than beggar thy neighbor, then we all have a big problem.