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Goldman’s Scylla and Charybdis

April 18, 2010

Last July, Goldman Sachs reported its second highest profits ever — largely due to the same type of risk-taking that led to the 2008 financial crisis. The public’s outrage over the bailouts, it seemed at the time, was in vain.

Not anymore. On Friday, the SEC charged Goldman Sachs with fraud, claiming that the bank sold foreign investors mortgage investments it knew to be toxic. Significantly, the news came amidst heated debate in congress over financial regulation. The Goldman scandal — along with whatever else the SEC might be able to dig up in the coming weeks — bodes well for the regulation bill. Which, in turn, bodes well for our democracy.

At the same time, it is a sad fact that it is only when a major Wall Street bank gets into trouble with its investors that our leaders have the clout to demand accountability. Taken alone, the SECs charge could simply be denied by Goldman executives and their well-compensated lawyers (assuming that no hard evidence to the contrary turns up). The SEC, acting on behalf of the public, creates just one horn of Goldman’s dilemma by threatening the bank with criminal and civil penalties. More damning to Goldman is the alternative: claiming that it was simply unaware of the risk involved in collateralized debt obligations. The former would result in a few jail sentences and lost confidence among investors; the financial regulation resulting from the latter would have far more long-term effects — not just on Goldman, but all of Wall Street.

Here is how MIT professor Simon Johnson explains Goldman’s dilemma:

Either Goldman’s executives were well aware of the [fraudulent securities scandal] and its implications – in which case they face serious potential criminal and civil penalties – or they did not have effective control over transactions that posed significant operational and financial risk to their organization.

They will undoubtedly pursue the “we did not know” defense – which of course debunks entirely the position taken by Gerry Corrigan (of Goldman and formerly head of the NY Fed) when I pressed him before the Senate Banking Committee in February. Corrigan claimed that Goldman’s risk management system is the best in the business and simply superb; the former may be true, but the latter claim will be blown up by Lloyd Blankfein’s own lawyers – they must, in order to keep him out of jail.

“Simply not superb” does not sound like a winning slogan to me.

While public outrage is undoubtedly behind the SEC investigation and financial regulation bill, the linchpin of the struggle over Wall Street greed is not the votes cast in congress or by citizens, but the tarnishing of Goldman Sachs’ reputation among investors. Which, at this point, seems inevitable — for either Goldman wittingly deceived investors, or it was unable to manage the risk created by derivatives. Financial regulation comes off looking even better in the latter scenario than the former, which might have merely involved a few “rotten apples.” Supposing Goldman argues the latter point (as seems likely), congressional Democrats can then ask the public: if even the peddlers of derivatives don’t understand them, or their potential to wreak havoc, what good are they?

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