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Fraud Charges Feed Financial Reform Debate

April 19, 2010 at 12:00 AM EST
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With the SEC filing a civil charge against Wall Street powerhouse Goldman Sachs, accusing it of defrauding investors, Jeffrey Brown speaks with University of Maryland law professor Michael Greenberger and attorney John Singer about the fallout for the firm and the effect on the financial reform debate in Washington.
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JEFFREY BROWN: Now: the fallout from the government’s decision to take on one of Wall Street’s most powerful investment banking firms.

WOMAN: Is the Goldman issue a temporary blip for the markets or a catalyst for a real sell-off?

JEFFREY BROWN: That question and others were very much in the air today, even as stocks recovered a bit, as the civil fraud charges against Goldman Sachs raised concerns about how far the government would go.

In fact, The Wall Street Journal reported today the Securities and Exchange Commission is investigating other major financial firms. On Friday, the SEC accused Goldman of defrauding investors by failing to disclose that it was marketing subprime mortgage securities, while, at the same time, betting against them through a large hedge fund.

Essentially, the agency claims, Goldman was setting up some clients in a bet that was designed to fail. The SEC said hedge fund manager John Paulson helped create the securities and made millions on the deal himself.

In Washington, the case quickly entered the debate on financial regulation reform.

Senate Banking Committee Chair Christopher Dodd:

SEN. CHRISTOPHER DODD, D-Conn.: Let there be no doubt in my mind, our bill would have prevented that kind of events from happening, in my view. And that’s what the public needs to know.

JEFFREY BROWN: Meanwhile, scrutiny of Goldman moved beyond the U.S. British and German authorities said they would investigate further whether their banks were victims of wrongdoing.

And more on all this now from John Singer, an attorney with the law firm Singer Deutsch, who’s represented many clients in cases against the Securities and Exchange Commission, and Michael Greenberger, University of Maryland law professor and an official at the Commodities Futures Trading Commission during the Clinton administration.

Welcome to both of you.

Professor Greenberger, start with the particulars of the Goldman case. Why do you think it was important for the SEC to bring it, and what’s the essence of their argument?

MICHAEL GREENBERGER, professor, University of Maryland Law School: Well, it’s important because it unveils to the American taxpayer, who has — who has funded this entire casino operation, that, aside from the fact that there were mortgages that should never have been entered into, maybe by fraud themselves, the bigger part of the meltdown is the betting that took place on whether the mortgages were to be paid.

And, in this situation, John Paulson, the hedge fund manager, made the perfectly logical conclusion that he wanted to bet against people paying mortgages, and he wanted to pick the most likely mortgages, group of mortgages in what are technically called collateralized debt obligations, that would fail.

It was, in better’s term, almost a lock. But the trouble is, they had to find someone who would take the bet. And the allegation the SEC has here is that Goldman was the intermediary that found investors to take the opposite side of the bet, not realizing they had a very, very long shot — that is, they were betting that people who couldn’t afford their mortgages would pay their mortgages.

JEFFREY BROWN: Well, John Singer, is the — is the line of legality clear here? What do you see in the SEC case?

JOHN SINGER, Singer Deutsch, LLP.: Oh, I don’t think so at all.

I think that the SEC has a very, very difficult uphill battle ahead of them, because there are certain elements that they have to prove, such as materiality and intent, that I think they’re going to have a very difficult time proving.

There’s no question that there’s an ethical issue and perhaps a moral issue. And, in the court of public opinion, Goldman would certainly be convicted. But it’s a different story to get — to get found civilly liable under the securities laws. And I think that, ultimately, Goldman will prevail.

JEFFREY BROWN: Well, what’s the — what — expand a little bit on that ethical-vs.-legal issue.

On the one hand, creating side bets is standard procedure for — on Wall Street. A lot of the — the institutional investors involved here are part of these trades routinely. So, what — what happened in this case that suggests the question of ethics?

JOHN SINGER: Well, the question here is whether or not Goldman had a disclosure obligation to make to the institutional investors. In other words, if Paulson — if it’s true that Paulson and company was helping to select the underlying mortgage-backed securities that were into this collateralized debt obligation, then perhaps that should have been disclosed.

But, at the end of the day, that probably wouldn’t have been a material fact to these institutional investors, because, at — at this time, in late ’06, early ’07, Paulson was a bit player. They were more or less an irrelevance. They are not what they are seen today as, you know, the guru who saw this whole thing coming.

Back then, in late ’06, early ’07, pretty much everybody was long real estate. And that’s why you had this insatiable appetite to keep creating these types of instruments. So, I think that any institutional investor who may have known that Paulson was participating in the creation of these securities probably wouldn’t have cared. And I think that’s the biggest hurdle the SEC has to overcome.

JEFFREY BROWN: I take it, Professor Greenberger, you would certainly accept that there’s an ethical issue here…

MICHAEL GREENBERGER: Yes.

JEFFREY BROWN: … but there may well be, you think, a legal issue?

MICHAEL GREENBERGER: Yes.

I mean, I was a litigator for 25 years. And I’m not going to make a decision based on someone’s complaint. But, if the allegations in the complaint are true, Goldman misled the people that took the opposite end of Paulson’s bet.

By the way, in 2006, right up to September 15, 2008, people didn’t — when Lehman Brothers failed, people didn’t fully understand that this market was going to collapse. And for everybody who thought it was going to collapse and wanted to bet it was going to collapse, there were prominent institutions, many of which has — have been bailed out by the American taxpayer, that were betting that these mortgages would be paid.

What the — the allegation is that Paulson created the bet so it was almost certain he would win, but the people, the companies that took the opposite end of the Paulson bet were never told that Paulson had created the bet. They thought he was going to be investing on their side.

And that’s the allegation here, that Goldman knew these bets were likely to fail that they were selling, and that the person who created the lock, so to speak, was designing the bet, and the investors who accepted Goldman’s offer to engage in this transaction never realized that.

JEFFREY BROWN: Let me try to — I want to ask you both how widespread these practices are, with — starting with you, John Singer.

That Wall Street Journal article I referred to said, “The SEC’s case against Goldman Friday has exposed an open secret on Wall Street, that a lot of these kinds of bets were taking place.”

What do you think of that? How widespread a practice might this be?

JOHN SINGER: Oh, I think that’s — that’s a true statement. Back in ’06 and ’07, as I alluded to earlier, there was really an insatiable appetite for these types of exotic instruments, because everybody, with the exception of a few, were long housing, and believed that the mortgages would get paid. Therefore…

JEFFREY BROWN: Long housing means…

JEFFREY BROWN: I’m sorry. Long housing meaning that they thought the housing boom would continue?

JOHN SINGER: That’s correct.

And I think that it wasn’t only the people who owned homes that thought that, but it was also many of the institutional investors, retail investors and the like. And that’s why there was such a demand for these types of instruments. And that’s why Wall Street got very creative and started building up more of these.

First, there was the CDO. Then there was the synthetic CDO. And I think that, at that time, there were probably billions upon billions of dollars into these instruments. So, you know, you read today probably that Deutsche Bank was creating them, UBS was creating them.

Why they went after Goldman begs the question, if — if everybody was doing it, why Goldman? And I think that really dovetails into the political agenda behind all of this. And that is, is that Goldman is the biggest fish out there. They’re the ones who have engendered most of the populist vitriol towards Wall Street. And that’s why I think they went after Goldman, not so coincidentally, in the midst of this raging debate on Wall Street over financial reform.

But the short answer to your question is, I think it was very widespread, and there’s going to more actions brought, I’m sure.

JEFFREY BROWN: And what do you think, Mr…

MICHAEL GREENBERGER: I think that’s absolutely right. It was very widespread.

I think a lot of other — I think Goldman and other transactions followed the same pattern. Whether it’s fraud or not will be seen. But many — many other institutions were engaged in this. And every time you say that people were betting that housing prices would go up, there has to be another end of that bet. They were betting that housing prices would go down.

And what happened was, this is a completely deregulated market. Congress deregulated in December of 2000. Nobody was supervising it. Nobody knew about it. It was gambling, but it couldn’t be dealt with as gambling because Congress preempted gambling laws.

So, in the end, yes, this is a poster child for the activity that took place. And the inability of those who were banking the bets to be able to pay them is why the American taxpayer and, in this case, the British taxpayer, has put in billions and billions of dollars to rescue gambling casinos.

There’s no real economic benefit to this, any more than a bet that’s issued on who wins a baseball game.

JEFFREY BROWN: Mr. Singer, and briefly, so, you expect that there — we will see more charges in the coming days? And I mentioned that there’s these investigations in Britain and Germany. So, you expect more to come?

JOHN SINGER: I do, because it seems as if many of the Wall Street firms and many of the leading banks were marketing and structuring the exact same types of products.

This was — and you said before it was an open secret. It really was, because there was people on one side of the bet and there were people on the other side of the bet. There were people who were bullish on housing and bearish on housing.

And I think that many of the banks were marketing it in exactly the same way Goldman was. And that’s why you are going to see many more actions brought.

JEFFREY BROWN: All right, we will leave it there.

John Singer, Michael Greenberger, thank you both very much.

MICHAEL GREENBERGER: You’re welcome.

JOHN SINGER: Thank you.