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Goldman, As Scapegoat
By: Dr. Charles Lieberman
Date: 4/19/2010
It is hard not to conclude that the SEC is targeting Goldman partly as recompense for failing to regulate the financial system effectively. We certainly favor going after the bad apples who knowingly contributed to the financial crisis by making loans to people who they knew could not pay, or filed false statements, or otherwise broke laws. Goldman's crime, which appears to be more of a technicality than the kind of truly nasty crimes that were being committed by some financial market players, seems to be targeting the name, not the crime. This suggests it is more of a show event, perhaps in anticipation of the elections, than a real effort to punish miscreants, such as lenders at Countrywide or New Century. This show may fill the media over the coming months and quarters, but fortunately, it will not derail the economic recovery.
The financial crisis was the result of many mistakes and bad behavior by many different players. There is no doubt that some lenders made loans to people who they knew could not possibly service their mortgages. Moreover, some of these lenders turned a blind eye or actively collaborated in falsifying loan applications. Even worse, this kind of activity appears to have been sanctioned by institutions, so it wasn't just a few loan officers who engaged in this activity. Senior people at these firms ignored activity they knew was taking place or certainly should have known and chose to ignore it. Plenty of borrowers were also complicit. They were happy to take the money or buy the house, when they knew they couldn't make the payments. Inappropriate behavior was widespread and the authorities should be going after the bad players wherever possible.
All of this bad behavior makes the case brought against Goldman very strange. The SEC charged Goldman with failing to divulge to professional investors, who were hardly novices, that John Paulson, who was largely unknown at the time, may have played a role in selecting the loans that were included in a synthetic CDO. Such instruments were sold only to institutional investors. In fact, information on the loans included in the synthetic CDO was available to any interested investor and Paulson became highly regarded and a star because his bets against these investments paid off so handsomely. Was it a coincidence that the lawsuit was announced the same day that the SEC Inspector General acknowledged that it had been aware that Alan Stanford was promoting a Ponzi scheme for more than a decade before that operation was shut down? With the Madoff Ponzi scheme, the SEC could plead ignorance and some incompetence. With Stanford, the SEC was aware of the fraud and failed to act, as astonishing breach of public trust that was overshadowed by the suit against Goldman. Was it also a coincidence that the SEC lawsuit against Goldman was filed just as financial reform legislation is being pushed in the Congress? Many of the legislative initiatives included in the bill have nothing to do with the causes of the credit crisis, just as the case against Goldman is surprisingly weak to serve as an example of the SEC getting tough with those who engaged in illegal behavior.
The investment implications of the SEC's lawsuit are also unclear for the financial industry, but likely not particularly significant for the economic recovery. Financial firms may be subject to more regulation, although most of the mistakes made were already illegal or were the result of poor judgment and greed, which are not easy to legislate away. Punishing poor judgment or excess greed is desirable to encourage market players to think twice before they carelessly engage in risky activity. But, greed will not disappear. Legislation should be focused on changing some institutional structures to enable large firms to fold without creating ripples elsewhere in the system; the too big to fail problem. AIG and Lehman were not banks, so neither would have been affected by the legislation being considered, which is targeted at banks. So, this legislation is also about show and control, not necessarily fixing problems that really need to be addressed.
All of the above makes for great theater, but will likely have little impact on the economic recovery or the prospects for the equity or bond market. Consumers have begun to crawl out of their bunkers and to spend once again, which is forcing firms to replenish inventories and to start hiring. As firms hire, household income growth picks up, which provides the basis for increased spending, putting the expansion onto a virtuous circle. Thus, we expect the pace of economic growth to rise over the course of the year. In the meantime, corporate profits are exceeding market expectations yet again. Even the big banks are making money, as their loan losses decline, which augers for even larger profit gains in future quarters. As a result, we remain quite bullish on the prospects for the equity market and rather cautious, even fearful, with the outlook for the bond market.
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