The SEC announced it was charging Goldman Sachs with fraud, and stocks fell big on Friday—Financials and Goldman itself were particularly hard hit. At issue are collateralized debt obligations (CDOs) based on subprime mortgage-backed securities Goldman structured and marketed. These were among the thinly traded securities banks were forced to mark-to-market that led to devastating rounds of write downs—and in chicken and egg fashion, caused and exacerbated a total freeze in credit markets in Fall 2008.
Fair enough—but lots of investment banks were doing that. Why single out Goldman? Because in 2007, Goldman was paid by a hedge fund—Paulson & Co (headed not by former Treasury Secretary Hank Paulson, but by John A. Paulson, no relation)—to structure the CDOs in question. Paulson & Co. also hand-picked the underlying securities, all with the intention of shorting them—and Goldman knew. It was a massive bet that paid off, and Paulson & Co. made a killing. Interestingly, this bet against subprime mortgages also helped Goldman, nearly unique among its peers, weather the downturn relatively well.
It is a serious charge, if true. The SEC alleges Goldman should have disclosed who was picking the underlying securities for the CDOs and that the party had economic incentive to pick securities likelier to default. We'll not prejudge and let the SEC investigation take its course. But there's not a whole lot much more sacred than the obligation to disclose, disclose, disclose. And when in doubt, err on the side of disclosing more. Too much disclosure has never proven to hurt anybody, but SEC investigations can definitely cast a pall on investor confidence.
Keep in mind, in order to short a security, inherently, someone has to take the other side of that bet. And that happens all day long among clients of big banks and brokerages. There's nothing wrong with Goldman, Merrill, Morgan Stanley, or Al's Stocks ‘n' Stuff having customers on both sides of a trade. The crux of this charge has to do with who knew what when, and whether they appropriately told the interested parties. The devil is in the disclosures.
Stocks were certainly spooked Friday. But keep in mind, nothing fundamentally changed from Thursday to Friday. What's in question are details of a transaction that took place nearly three years ago. Though capital markets are forward-looking discounters, in the very near term, they can do weird and wacky things driven purely by sentiment. Whether Goldman was in the wrong then has nothing to do with the systemic health of either credit or capital markets. It more likely impacts how Goldman (and perhaps other banks) disclose transactions with other clients—and we're all for more transparency.
This is all emblematic of why Financials could lag the broader market going forward. After a sector-led bear, that sector typically is subjected to political scapegoating, the discovery of closeted skeletons, a regulatory backlash, and generally poor sentiment—sometimes for years. Credit is flowing again—even "junk" rated firms are having an easier time accessing credit. And most of the bank TARP recipients have paid back their boodle. With interest! (It's the lousy non-banks who are laggards. We're looking at you, automakers.) But past digressions, real or alleged, aren't a fundamental force that can reverse an otherwise healthy bull market.