For Goldman Sachs Group Inc. , a nightmare has begun.
It's going to be ugly, and it's probably going to be costly, and the rotten-egg stench of it all is going to linger over the world's most powerful investment bank for some time. Why? Because the facts supporting the securities fraud allegations against Goldman align perfectly with what has long been the singular criticism of the firm: that it rarely lets the interests of its customers get in the way of making a dollar for itself.
A wise man once said that a scandal will stick only if it can be explained in a sentence (or three) that an average person can understand. He was talking about politics, but the maxim also applies to business. And this scandal meets that test, if accusations by the U.S. Securities and Exchange Commission prove true.
In essence, Goldman let a high-powered hedge fund pick a bunch of junk mortgage securities, according to the allegations. The underlying loans were big, fat, hairy subprime mortgages taken out by people with poor credit scores, many of whom never should have been allowed to borrow to buy homes in property-bubble states such as Florida, Arizona and Nevada.
Then Goldman repackaged and sold some of this garbage to investors, the SEC says - all the while knowing, but never disclosing, the hedge-fund manager's involvement and his side bet that the mortgages would go bad. (Which they did, of course.)
The hedge fund, Paulson & Co., made about $1-billion (U.S.). The buyers - also Goldman customers - lost about $1-billion.
And Goldman swept up $15-million for its role as a middleman, according to the SEC. Fifteen million dollars, by the way, was 0.03 per cent of Goldman's revenue in 2007, the year of the deal in question. (Late Friday, Goldman said it wound up losing $90-million on the transaction and that "extensive disclosure" was provided.)
Was it worth the trouble?
The potential legal penalty here - spare change for a company of Goldman's size - is beside the point. If the firm could make this go away for a billion or two, it probably would, especially after seeing more than $12-billion carved off its market capitalization following the SEC's announcement. But it has to fight because the allegations strike at the heart of its business model.
Though Goldman operates in three main lines of business - investment banking, managing money, and dealing securities - it's the last of these that dominates. In 2009, three-quarters of the firm's $45-billion in revenue came from trading securities for itself and for its clients.
But the proposed "Volcker rule" threatens to restrict Wall Street firms from trading with their own money. And now the SEC's allegations raise serious questions about how firms should behave when trading for others, and particularly when they're dealing with both the buyer and the seller. This case is about disclosure: Had Goldman told its customers about Paulson's behind-the-scenes role, it wouldn't be in hot water. But then it would have kissed goodbye to its fee, because nobody with a brain would have been willing to buy what Paulson was short-selling.
More than anything, though, the SEC case sabotages Goldman's effort to reposition its tattered public image after the financial crisis.
Just last week, chief executive Lloyd Blankfein and president Gary Cohn published a letter to shareholders in which they defended, at length, the virtuousness of the firm's activities. "We help companies and public institutions to access the capital they need to build, grow and create jobs." On the firm's website, the first image you see is a photo of a commercial jet under construction, beneath bold white letters: "Our work enables growth." In other words, we are not leeches, or a bunch of casino operators in nice suits. What we do is socially useful, moving money from savers to productive enterprises that need it. That is the raison d'être of investment banks, or at least it used to be.
But there is nothing socially useful about creating something called ABACUS 2007-AC1 to facilitate the transfer of $1-billion from some clients to others in return for a fee. If the SEC can prove that is what happened - the Wall Street giant vigorously denies it and promises to fight - there isn't much Lloyd Blankfein will be able to say to lessen the damage to Goldman's reputation, except maybe the words, "I resign."