The bank's recent settlement with the SEC could come into play in more ways than one
On Thursday, we learned that the Manhattan district attorney and New York state had subpoenaed Goldman Sachs. Some commentators have suggested that the action may be part an attempt to set up a criminal investigation based on a recent Senate report that accuses the banking behemoth of having acted improperly in its efforts to short the mortgage market as the bubble began to burst. Will the bank be able to wiggle out of these allegations if a criminal case is brought?
For a fairly detailed explanation of the law likely to be involved in a case against Goldman, check out the post I wrote on Thursday. It boils down to this: if a court deems its mortgage market shorting strategy as "material information" that investors should have been provided when Goldman sold them mortgage exposure, then Goldman might be in trouble. There are a few ways to look at this question.
Will the SEC Settlement Come Back to Haunt Goldman?
First, a similar issue was actually at the heart of last year's Securities and Exchange Commission lawsuit against Goldman. In that case, the SEC said that Goldman should have notified an investor (ACA Management) that it sold mortgage exposure to through a complex security that a prominent hedge fund manager (Paulson & Co.) helped to select the assets that the security referenced. The SEC asserted that this information was material. As a part of the settlement, Goldman didn't exactly concede wrongdoing, but said:
The firm entered into the settlement without admitting or denying the SEC's allegations. As part of the settlement, however, we acknowledged "that the marketing materials for the ABACUS 2007-ACI transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was 'selected by' ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson's economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure."
Now think about the mortgage securities that Goldman sold to investors on which it took the other side of the bet. If it didn't disclose that Goldman's "economic interests were adverse" to those investments, isn't that a similar problem?
This gets a little bit sticky. In the SEC case, the specific sort of security sold was created in part based on the recommendation of an investor who was betting that it would fail. This might not be the case with the short positions from which Goldman profited. But if they underwrote some securities as a part of their shorting strategy, and didn't notify the investors that they sold those securities to of that strategy, isn't that the same wrongdoing that they conceded in the SEC case?
If so, the Goldman might have set itself up for a very tough road if it created securities that it kept the short interest on as part of its investment strategy and not its usual market making activities, but failed to disclose that to investors to whom it sold those securities. It may have been better off fighting the SEC lawsuit, rather than settling it. That settlement essentially concedes that an investor buying a security has a right to know if anyone having an interest in seeing the security decline in value had a role in its creation.
A Different Kind of Bailout
But let's place that aside for a moment. There's an intriguing theory that says no matter how badly Goldman screwed up, a criminal charge won't result. Brad Hintz, an analyst at Sanford C. Bernstein & Co. wrote in a note to clients -- before the subpoena became public knowledge -- wrote that Goldman won't be prosecuted. Via Christine Harper at Bloomberg:
"If an alleged violation is identified during a Goldman investigation, we expect a reasoned response from the Justice Department," Hintz wrote. "In a worst case environment, we would expect a 'too big to fail' bank such as Goldman to be offered a deferred-prosecution agreement, pay a significant fine and submit to a federal monitor in lieu of a criminal charge."
In other words, Goldman could get a different kind of bailout. Instead of a multi-billion dollar rescue, it could be provided a "get out of jail for a fee" card. If federal regulators fear that a criminal charge would bring down the bank, then it may want to avoid another financial crisis and allow its transgressions to slide.