A price worth paying

A price worth paying

by The Economist online | NEW YORK

IT HAD been widely expected, but not so soon. On July 15th—as it happened, the day that America’s Senate passed a sweeping financial-reform bill—Goldman Sachs settled fraud charges brought by the Securities and Exchange Commission (SEC), alleging that it misled investors in a structured product linked to subprime mortgages. Most analysts had expected the settlement talks to drag on for at least another couple of months.

The cost to Goldman is $550m, making this the largest penalty ever paid by a Wall Street firm. Some $250m of the total will be returned to harmed investors and the remainder will go to the Treasury. In a statement, Robert Khuzami, head of the SEC’s enforcement division, said that the settlement, which must be approved by a judge, was “a stark lesson to Wall Street firms that no product is too complex, and no investor too sophisticated, to avoid a heavy price if a firm violates the fundamental principles of honest treatment and fair dealing.”

Goldman agreed to settle without admitting or denying the charges. It has merely had to acknowledge that the marketing materials for the offending product, a collateralised debt obligation (CDO), were incomplete and should have revealed the role in the transaction of Paulson & Co, a hedge fund that had helped to select the underlying securities and was planning to “short” the CDO, ie, bet that it would fall in value.

The settlement, however, also requires the firm to reform some of its business practices. It must overhaul the way it reviews and approves offerings of certain mortgage securities, including the role of internal and outside legal counsel, and its compliance personnel, in drafting and checking marketing materials. It will also have to strengthen the education and training of its employees in structured products. The SEC, though, has said it will take account of ongoing soul-searching. A “business-standards committee” is in the middle of an internal, firm-wide review that will examine everything from Goldman’s management of conflicts of interest to product suitability for clients. A quarter of the firm’s 400 partners will contribute to the report, which will be handed to a board committee in December. The findings will be made public.

There had been speculation that either Lloyd Blankfein, Goldman’s chief executive, or Gary Cohn, his most senior lieutenant, or both (pictured above), would step down as part of the settlement. But the firm was spared that embarrassment. Mr Blankfein remains popular with shareholders (95% of whom voted to re-elect him as chairman in May) and, by and large, with colleagues (though there has been the odd rumbling of discontent of late). Nevertheless, some still think he will go later this year to give Goldman a chance of burying its image problems, which are unlikely to disappear just because it has got the SEC off its back. A less dramatic possibility would be to split the roles of chief executive and chairman.

Both parties get something out of the deal. The SEC shows that it can land a blow on even the most prestigious financial firm. The sin of omission to which Goldman has confessed, meanwhile, will look far from nefarious to most.

Spared embarrassment
But many will conclude that Goldman came off better. Not only does it avoid losing one of its top brass or having hundreds of potentially embarrassing documents aired in court, but the fine is a mere half of what most analysts had expected it to receive. As Brad Hintz of Alliance Bernstein put it, speaking on CNBC, the SEC may be able to claim a political win but Goldman scored an economic win.

Still, there may be more to fork out. The settlement does not cover other SEC probes of the firm’s practices—and there are thought to be several. (The Commission’s litigation against Fabrice Tourre, the trader at the centre of the case, also continues.) Goldman faces numerous lawsuits from investors and clients, too. The latest was filed last week by Liberty Mutual, an insurer that had bought Goldman-underwritten preferred stock in Fannie Mae, which is now virtually worthless.

More worryingly, Goldman’s business model is under pressure. Intense scrutiny of conflicts of interest, like the sort exposed in this case, will make it harder for the firm to act as adviser, financier and marketmaker for clients while at the same time investing aggressively for its own account. The provision in America’s financial-reform bill targeting conflicts in securitisations is aimed primarily at Goldman.

Furthermore, the new law will place limits on the amount of proprietary business Goldman can do—though the degree of stringency will depend on rules that are yet to be written or interpreted by regulators. Trading and principal investments (in private equity, property and the like) have become the firm’s lifeblood, accounting for 80% of its net revenues in the first quarter of 2010. Goldman says that pure proprietary trading, which regulators are likely to ban, accounts for 10% of its revenues. The rest of its trading income comes from hedging and “client facilitation” (taking the other side of customer trades), which will still be allowed.

Nevertheless, Goldman will be glad to have put its biggest short-term problem behind it. Its share price, which has taken a battering in recent months, jumped by 10% on the news. For that, half a billion dollars and the admission of an omission might seem like a price worth paying.