In the biggest shot at Wall Street since the 2008 financial crisis, the U.S. Securities and Exchange Commission (SEC) has accused banking giant Goldman Sachs Group Inc. of fraud over a financial product tied to sub-prime mortgages. The SEC, in a civil complaint, alleges Goldman didn’t tell investors that Paulson & Co., a hedge fund betting against sub-prime, helped select the pool of mortgages in a synthetic collateralized debt obligation. Goldman says it did nothing illegal. Professor Seyhun says the reputations of both Goldman Sachs and the SEC hinge on the outcome. The problem for both is that neither side has an open-and-shut case. Seyhun, the Jerome B. and Eilene M. York Professor of Business Administration, thinks the SEC’s move and the way it was announced make it clear the Obama administration is serious about financial regulation.
What kind of effect will the SEC’s accusation have on Goldman’s reputation?
Seyhun: I think it depends on the eventual outcome of the case. If Goldman wins, it will be a temporary or zero effect. If Goldman loses, it could be devastating. Goldman could lose a lot of clients, its reputation could be sullied, it could lose a lot of money, and it could see employee defections. A loss also would mean a lot of derivative shareholder lawsuits and/or lawsuits from others who bought these financial products. It also could spread to other banks, since Goldman wasn’t the only one creating these products.
This complaint centers on a CDO based on credit default swaps tied to sub-prime mortgages. What kind of effect will this have on those kinds of investment vehicles?
Seyhun: I don’t know if it will have any effect on the products. The issue here isn’t about the product but about representations of it. I don’t think there’s anything wrong with the product. It’s a synthetic CDO, and the prices move up and down with the prices of the underlying pool of mortgage products. It’s a basic product that’s been around for a while.
The SEC’s complaint is pretty narrow — focusing on simple non-disclosure on a specific CDO — and it’s their biggest case since the recent financial crisis. Are they looking for a kind of test case here?
Seyhun: I think the SEC is feeling pressure from the fact that it was sleeping when people were accusing Bernie Madoff of defrauding investors with a Ponzi scheme. The SEC, even as it received specific allegations, did nothing. Now they may be overly aggressive trying to prove they are a regulatory agency that means business. I think this probably has something to do with the SEC’s worries about its own image.
How should the SEC balance the public’s ire over what happened to cause the financial crisis and ferreting out true cases of wrongdoing?
Seyhun: The fact that some investors lost money is no reason to pursue a particular case. If fraudulent allegations are true, then the SEC is justified in pursuing the case. If they are not, we will wait and see. On the face of it, without all the facts, I can’t tell if the SEC did something proper or improper with this case. But the SEC is making a bet there was fraud and that they’ll win this case. If not, some people at the SEC will have to bear the consequences. If they lose this case, the SEC’s own reputation will take a hit. There’s a lot at stake for both sides.
Given the complexity of CDOs, especially synthetic CDOs, how hard will it be to convince a jury? The SEC is saying that while the products are complex, the fraud was simple — it was non-disclosure and misrepresentation. But the backdrop can be mind-boggling.
Seyhun: I think it can be explained in a very simple way, as I explain it to my students. The SEC does not need to go into all the technical valuation aspects of CDOs. The issue is that what these investors were getting involved in was a simple bet. There was no underlying product. Nothing was being bought or sold. This is not like a traditional mortgage product or a car being sold. This is a naked bet. Some people are betting that these mortgages will increase in value while others are betting they will decrease in value. It’s as simple as that. Both sides are making a naked bet on the direction of the price of the underlying mortgage products. It’s no different than a horse race. One side is betting on this horse to win, another side is betting on some other horse to win and that first horse to lose.
And that seems to be one of Goldman’s points. They were selling pieces of this synthetic CDO to players who knew the market well. By virtue of it being a synthetic CDO based on credit default swaps, they knew there was somebody betting against it.
Seyhun: That is correct. For that product to exist, somebody must have created it, which means somebody is taking a short position. So for each long position there is a short. Also, this deal involves big, sophisticated players. On the short side, Paulson & Co. is a sophisticated player. On the long side, ACA Management is a sophisticated player. The issue here is whether Goldman disclosed all the material information that is legally required. The SEC is claiming Goldman had a duty to disclose that Paulson & Co. was on the other side and decided which mortgages went into the CDO. Goldman is saying it was simply an intermediary for clients Paulson and ACA, and they’re allowed to take long or short positions. The bank also claims both sides had a say over which mortgages were in the pool, and both sides had the same access to the mortgage details. Goldman also is saying they took the long position on these contracts and lost $90 million. They’re arguing, “If we believed the deck was stacked against the long side, why would we take the long side?” It’s going to be an interesting case. I would like to see how the facts come out. On the face of it, it doesn’t look like it’s an open and shut case in either direction.
Does it come down to what were the exact disclosure rules on transactions where the regulations aren’t as tight as those on stocks and bonds?
Seyhun: It’s a private contract, and they can create whatever product they like. Now, one of the allegations is that Paulson had a hand in determining the underlying pool of mortgages, but it looks like the longs did, too. The longs decided they didn’t like certain assets and threw them out of the pool. So both sides had a hand in determining what pool they were going to bet on. To me, it looks symmetric. They both got to say which assets were in and which assets were out. These were sophisticated players. The product was created with both sides’ active involvement. So what were the requirements on the part of Goldman to disclose, and did they engage in misrepresentations? Those are the main questions. There is some bravado that’s been exposed that they took advantage of one side or another. But Goldman lost money on this deal. So if this Goldman trader, Tourre — who claimed to have sold these “monstrosities” — caused losses for his own employer, I’m not sure what he was boasting about.
Do you think there are going to be more shoes to drop from the SEC?
Seyhun: My guess is the SEC will wait and see how this goes. I think there are a couple of implications here with respect to other banks. Other banks’ stock prices have dropped along with Goldman’s because the market is concerned other banks may be accused of similar misrepresentations. A second issue is the political dimension. Some of the banks were actively opposing any additional regulations of derivatives, so there is some concern the administration and the SEC are using this as a stick over banks to ensure they don’t oppose the new financial regulations too vigorously. Furthermore, this lawsuit may be designed to make it for difficult for Republicans to oppose new financial regulations, as it makes them look like they are taking Goldman’s side in this civil fraud case. My guess is the SEC will wait and see how this plays out. If it looks like they are not going to win the case, then it would be foolish to bring additional charges against other banks.
Some noted the timing here, that the SEC brought this case as Congress starts to move on a financial regulation bill. Was that, in your opinion, intentional?
Seyhun: I think there is some evidence it was. Apparently the SEC has not followed the usual procedures for giving Goldman a chance to comment, a chance to settle, and a chance to prepare the public for these upcoming charges. So charges were brought very suddenly without any chance for Goldman to respond or to offer settlement. To me, it seems the SEC wanted this shock effect. That smacks of some political maneuvering behind the scenes. I think the administration is definitely very serious about passing financial regulations on derivatives. The SEC and the administration view this regulation as critical to the proper functioning of the capital markets, to make sure that we don’t have systemic risks that threaten the entire financial order in the future. They believe some things need to be done to ensure this financial crisis is not repeated. I agree we do have to pass financial regulations to make sure the events of 2008 and 2009 are not repeated, that we’re not facing the collapse of the entire financial system, and I think derivatives are going to be at the center of this new regulation. But I think the SEC’s allegations are the first opening salvo on the part of the administration.
How should the administration handle regulating derivatives like credit default swaps?
Seyhun: I think it needs to be a careful balancing act. The administration should not pass regulations that take away the competitive advantage of the banks, or make it so onerous that the demand for these products decreases sharply or forces trading to go overseas. We need to balance the public’s interest in making sure big institutions suffering enormous losses don’t threaten the entire financial system, and making sure these products serve a useful purpose. As I’ve argued before, I’d like to see some margin requirements for over-the-counter products, so these losses don’t get out of hand and threaten the financial system. One way the administration might try to achieve this is by creating some type of clearinghouse and requiring all derivative over-the-counter trading to be processed through the clearinghouses. What the banks object to is that clearinghouse trading likely will reveal too much information to the financial community. I think it’s possible to keep derivatives over the counter instead of through a clearinghouse, but pass these margin regulations so there is some sort of daily settling between the counterparties. Even though there isn’t daily trading on them, have the parties agree to some sort of valuation formula and data so they have an incentive to value them on a daily basis, come up with a synthetic settlement price, and exchange margins. This kind of a solution could help with both sides’ objectives. For the administration and regulators, it keeps the risk limited so that unrealized losses don’t get to be huge. It would force parties to close their positions if they sustain large losses. But it also meets the banks’ desire that these transactions remain opaque. Thus, banks can maintain their informational advantages and not be tempted to move these transactions overseas. Accordingly, any new regulations need to be sensible, and they should not over-regulate.
H. Nejat Seyhun is Professor of Finance and Jerome B. and Eilene M. York Professor of Business Administration at the Ross School of Business, University of Michigan, where he has twice served as the chairman of the finance department. He holds a Ph.D. in finance (1984) from University of Rochester, Rochester NY. Professor Seyhun’s research has been quoted frequently in the financial press including the Wall Street Journal, New York Times, Washington Post, Newsweek, Business Week, Bloomberg Business News, and Los Angeles Times. Among his past consulting clients are Citigroup, Towneley Capital, Tweedy, Browne, and Vanguard.