Goldman Sachs may yet win its legal battle against the government over charges it defrauded investors. But it may already have lost the war over a broad package of regulations designed to curb some of the practices that helped the giant investment bank generate $3.3 billion in profits in just the latest quarter.
The latest salvo comes Thursday, when President Barack Obama returns to Cooper Union in New York, where as a presidential candidate in March 2008 he argued that the deregulation of Wall Street in the 1990s “encouraged a winner-take-all, anything-goes environment that helped foster devastating dislocations in our economy.”
Six months later those “dislocations” brought the near-collapse of the global financial system. Now, two years later, Congress is in the midst of a debate over new rules that would, among other things, create an independent agency to look out for consumers, develop a system to unwind big failing banks without threatening the entire financial system and require risky derivatives to be traded on regulated exchanges.
That could take a big bite out of Goldman’s profits, much of which come from its own trading in those derivatives.
“That source of profits at Goldman is the area that the regulations are going to hit the hardest,” said Robert Parker, vice chairman of asset management at Credit Suisse.
A Senate panel on Wednesday approved legislation that would ban banks from the lucrative derivatives market , a measure expected to be added to a broader financial overhaul bill that the Senate could take up next week. Obama said last week he would veto any bill that didn’t regulate derivatives.
The White House argues that, left unregulated, derivatives continue to pose a threat to the financial system if banks are allowed to take on more risk than they can handle. The widely interconnected web of derivatives trades is the major reason that a handful of the largest banks have come to be seen as “too big to fail,” according to White House economist Austan Goulsbee.
“If derivatives were regulated and out in the open, and there wasn't any counterparty risk, we say, ‘It has been a tough year for you guys. Too bad, you're about to go under,’” he said. “And they wouldn't be too big to fail because they wouldn't be connected to all the other banks.”
Opponents of the new regulations are battling back. Last week, all 41 Senate Republicans signed a letter vowing to oppose the bill unless changes were made.
Among their objections: the bill does nothing to address ongoing losses at government mortgage giants Fannie Mae and Freddie Mac, and smaller banks that didn’t get involved in risky mortgage bets will have to bear the expense of tighter regulation. They also argue that a proposed fund to unwind failing banks will only encourage bankers to take more risk, and that consumer protection is already handled by various agencies.
“We’re just adding another agency that isn’t going to do that much,” Orrin Hatch, R-Utah, said Tuesday.
Many of the opponents' arguments have been overshadowed by the government’s fraud allegations against Goldman Sachs — the latest in a series of disclosures that will help bolster the administration’s case that new rules are needed.
Even if it wins the case brought by the Securities and Exchange Commission, Goldman Sachs faces the prospect of a protracted, public battle over a transaction that is shining a spotlight on the way Wall Street packages, sells and manages risk.
In its complaint, the SEC says Goldman allowed a hedge fund manager to help package a group of mortgage backed securities — knowing he was going to bet the bonds would fail — before selling those bonds to investors. Goldman insists the investors who bought the bonds had all the information they needed to understand the risks.
The case — against a single, midlevel Goldman executive concerning a single deal — may be just the tip of the iceberg.
"The SEC made very clear that this is not a limited situation that they're looking at," said Elizabeth Nowicki, a Boston University law professor and former SEC attorney. "The enforcement director made very clear that they're investigating other situations and investigating other cases at Goldman and investigating other banks."
Goldman faces legal challenges on other fronts. On Tuesday, Britain's financial regulator said it was investigating Goldman Sachs International, the bank's London-based unit. Some investors expect more legal headaches.
"It will trigger piling on," said David Kotok, chief investment officer of Cumberland Advisors. “You're going to see class action lawsuits against Goldman. You're going to see (New York Attorney General) Andrew Cuomo looking at this case and other states attorneys general. Goldman is now a target."
Goldman isn’t the only bank in investigators' crosshairs. Last week Washington Mutual, the biggest U.S. bank ever to fail, was the subject of a Senate hearing on deceptive practices uncovered by an investigation into the bank's mortgage lending operations. The investigative panel of the Senate Homeland Security and Governmental Affairs Committee found that WaMu rewarded loan officers for the volume and speed of the subprime mortgage loans generated and paid bonuses to loan officers who overcharged borrowers or levied stiff penalties for prepayment.
Investigators are also sifting through the books of Lehman Bros., which a court-appointed auditor recently found had used an accounting trick to keep some $50 billion in debt off its books. By doing so, Lehman was able to hide its financial weakness from investors, the auditor said.
On Tuesday, SEC Chairman Mary Schapiro told a congressional panel investigating Lehman’s collapse that the commission is looking into whether any of the 19 largest U.S. banks are using the same accounting trick.
Support for financial regulation comes as the banking industry reports growing profits — even as the economic recovery remains fragile and state and local governments struggle to pay the bills. Some of those local governments found themselves on the wrong side of a Wall Street trade.
At Tuesday’s hearing on Lehman Bros., two lawmakers testified that the bank’s meltdown cost school districts, local governments and hospitals millions, forcing them to make cutbacks. Rep. Anna Eshoo, D-Calif., said 40 municipalities nationwide lost about $1.7 billion after the firm went under.
Defending past practices will keep Wall Street bankers and lawyers busy, possibly for years to come. But recent disclosures about those practices already have produced substantial momentum for changing the way Wall Street does business.
"Wall Street's interests are different than Main Street," said Gary Gensler, chairman of the Commodity Futures Trading Commission. "Wall Street is about the profits and the compensation and the clients, but it is not about America's interests. We have to look after America right now."