Goldman Hits Back At Fraud Charges

Published in Investing on 19 April 2010

Goldman Sachs reacts to its critics, which include Gordon Brown...

The waste hit the air-conditioning last Friday at about 3.30pm, when world stock markets started to fall. This followed an announcement from US financial watchdog the Securities and Exchange Commission (SEC) that it had charged elite investment bank Goldman Sachs and one of its vice-presidents with civil fraud.

Goldman takes a bath

Of course, this lawsuit caused Goldman's shares to fall off a cliff; on Friday, they closed down 13% at $160.50. However, this potential liability now seems to be priced in, as the shares look to fall only slightly on Monday.

Nevertheless, this news shocked world markets and caused the S&P 500 Financials Index to slide 4% on Friday, with every constituent of this index closing down.

Sachs attacks

Apparently, the SEC has been probing the world's most admired (and hated) investment bank for 20 months, but Goldman categorically denied any wrongdoing in September 2009. Clearly wound up, the regulator chose to issue legal charges, rather than negotiate a settlement.

On Friday, Goldman issued an aggressive rebuttal of the SEC's claims, arguing that it lost $75 million on the ABACUS 2007-AC1 collateralised debt obligation (CDO) deal. Hence, there was no incentive or intent for the bank to issue a 'designed to fail' CDO.

As you'd expect, news of potential conflicts of interest at Goldman brought the bank-bashers out en masse. For example, Gordon Brown accused the investment bank of 'moral bankruptcy' in its dealings with its clients. Also, Brown urged the Financial Services Authority to launch a similar enquiry into banking excesses during the credit bubble.

One of the three investors in the collapsed CDO was German bank IKB Deutsche Industriebank (IKB), which was bailed out by the German government after becoming an early victim of the credit crunch. Hence, the German government is considering legal action to recover the $150 million IKB lost.

Likewise, the UK government may take action to recover the $850 million Royal Bank of Scotland (LSE: RBS) lost by investing in the failed CDO.

Buffett: Oh no, not again!

One person who must be fuming is investment guru Warren Buffett. The billionaire's firm, Berkshire Hathaway, put more than $5 billion into Goldman Sachs in September 2008, in the aftermath of the collapse of Lehman Brothers.

The 'Oracle of Omaha' owns $5 billion of perpetual preferred shares in Goldman which pay a coupon of 10%. In addition, he has 43.5 million warrants to buy further shares at $115 a share. On paper, Buffett looks to have lost a cool billion dollars on Friday. However, his preferred shares and warrants are less volatile than Goldman's common stock, so his likely loss is sure to be much lower (one estimate is $120 million).

Nevertheless, the world's greatest investor is unlikely to be too happy, because he's been embarrassed before, both personally and financially, by Wall Street scandals.

In September 1987, Buffett's firm Berkshire Hathaway bought $700 million of Salomon convertible preferred stock paying a coupon of 9%. This 12% stake instantly made Berkshire the largest investor in Salomon, with Buffett seen as a 'white knight' repelling predators surrounding the bank.

Alas, in August 1991, the US Treasury banned Salomon from bidding in auctions for US government bonds after the bond dealer rigged previous auctions. This ban would have meant the end for the bond dealer, but Buffett's actions -- he took the helm of the bank from August 1991 to June 1992 -- saved the firm.

Hence, to protect his investment in, and restore the reputation of, Salomon Brothers, Buffett became chairman of the investment bank. Salomon settled the bond-rigging case by paying a fine of $290 million.

In time, the 'Wisdom of Salomon' prevailed and the firm was sold to Travelers Group for $9.3 billion in November 1997. Overall, Berkshire walked away with a profit of roughly $1 billion from its roller-coaster ride on Salomon.

What next for Goldman?

Although Buffett has yet to show his public support for Goldman, he has lots of options. One worry on Wall Street is that this scandal could spell the end of Goldman's besieged Chairman and CEO, Lloyd Blankfein. Then again, were Buffett to step into Blankfein's shoes, Goldman shares would rocket.

Of course, it's very early days, the case is far from clear-cut, and the SEC could well lose. After all, with $5 billion to spend on pay and bonuses in the first quarter of 2010, Goldman can afford the very best legal representation.

What's more, Goldman is sure to argue that it dealt almost exclusively with professional investment firms when it structured and sold CDOs and other securitised derivatives. Frankly, these firms should know about 'buyer beware' when dealing with investment banks -- and particularly when buying from Goldman!

Goldman's first-quarter results, due out on Tuesday, should make interesting reading. In the meantime, Buffett famously said, "Be fearful when others are greedy and greedy when others are fearful". On this basis, Goldman Sachs shares may be worth buying for a short-term bounce-back...

The first of many?

One thing is certain: the charges laid against Goldman are only the opening shot in the SEC's war to punish investment banks that misled or defrauded clients during the securitisation frenzy of 2005 to 2007.

Indeed, according to Monday's Financial Times, the SEC is looking into CDO deals from just about every major Wall Street player, including Bank of America, Barclays (LSE: BARC), Citigroup, Credit Suisse, Deutsche Bank, Merrill Lynch, Morgan Stanley and UBS.

More from Cliff D'Arcy:

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theRealGrinch 19 Apr 2010 , 2:21pm

Sounds like the goldman sachs and labour party love in has turned sour. What a real real shame.

thebuffoon 19 Apr 2010 , 7:15pm

I can't see that Buffett has lost anything. His prefs are still paying 10%.

Your comment perpetuates the casino chips mentality Cliff.


patricktaylor1 20 Apr 2010 , 1:17pm

Rather easy on GS? Mr Darcy.

Given their high ethical stance your comment about doing business with them seems almost strange.

Goldman Sachs Group use Business Principles rather than a Mission Statement:

"1. Our clients' interests always come first. Our experience shows that if we serve our clients well, our own success will follow.

2. Our assets are our people, capital and reputation. If any of these is ever diminished, the last is the most difficult to restore. We are dedicated to complying fully with the letter and spirit of the laws, rules and ethical principles that govern us. Our continued success depends upon unswerving adherence to this standard."

I cannot believe therefore that GS can possibly be guilty of dishonourable conduct. This extract below should not be seen to apply to such a beacon of probity.

A Paulson employee wrote:
“It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytical tools nor the institutional framework to take action before the losses that one could anticipate based [on] the ‘news’ available everywhere are actually realized.”

julie1230 20 Apr 2010 , 3:05pm

Enough with the anti Gordon Brown propoganda. This is a cheap shot and ought not to be allowed under fair and proper electioneering rules.

gordonbanks42 20 Apr 2010 , 11:45pm


I hope you're joking.

There was a time when a serving PM would comment only in the most guarded terms, if at all, on a legal case in progress - whether within the UK or elsewhere.

GB has gone in with a 2-footed tackle well before the ball ever arrived on the scene. He deserves whatever comment his outburst attracts.

gordonbanks42 20 Apr 2010 , 11:54pm

Investor: "I'd like to buy £10,000 of BP ordinary shares, please."
Broker: "Sorry, you can't."
Investor: "What?"
Broker: "Sorry, you can't buy them. The market maker thinks they're about to go down. He won't sell them to you because he thinks you'd incur a loss."
Investor: "I don't care what the market maker thinks. I think they're going to go up. And I want £10,000 of them. Now."
Broker: "Sorry. After that Goldman's business they have to be very careful, you know. Are you sure you wouldn't like some Tesco instead? Everyone thinks they're going to go up."

leslie48 21 Apr 2010 , 5:39am

Gordon has every right to criticise the investment banks as all western politicians do as as we know this was a western event not as Cameron tries to unpatriotically claim one for the UK only. . Bankers committed misdeeds and they were excessively greedy and they were given a free run for over a decade. It remains obscene that the people who were responsible for the greatest post war recession have generally come through the event prosperous and relatively unaffected.

The deficit was vastly increased and now for the next few years we the public have to pick up the tab of billions used to rescue the banking system. Poor old public sector will of course be hit hardest and they were a long way from the the scene of this crime.

Oxygenate 26 Apr 2010 , 11:55pm

I am surprised at the paucity of comment on this article. After all, here we have a bank which can topple governments (just to answer the democratic principle). In its life it has pursued a personnel policy which only money can buy (my pregnant wife – of 22 years ago, so this is no new aberration), a policy of self gratification in terms of bonuses irrespective of the cost to others, and an investment strategy contingent on the forgoing comment, which has benefited not one soul grovelling in the dust or sweating in a factory or investing his life in a business.

Goldman Sachs is a completely ethically bankrupt organisation whose CEO claims he is doing “God’s Work” and that his company has a moral purpose. If Blankbrain really believes this then his company is the nadir of philosophical thoughts of Hell.

I am unable to understand the basis of julie1230 comment – it seems divorced from the article. I presume Patricktaylor1 works for Goldman or else has left all just purpose out of his life – one equates to the other really.

Regarding leslie48 I disagree. This phenomenon, however you may try and describe it, is largely Anglo-Saxon.

Goldman Sachs has very little to do with capitalism. As with Lehman it left those principles and thoughts behind a long time ago. It is to do with greed, of making money rather than serving a purpose. When did Goldman last invest into a start up business – or indeed any business of purpose?

What is the purpose of Goldman Sachs? On a count of wretchedness it has caused it is due for the axe.

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