Wall Street Banks: Too Big Blame For Subprime?

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By  EconMatters

Goldman Sachs has historically been one of the more bullish investment houses on Wall Street, but the firm has recently taken a dark macro view.  The Wall Street Journal reported on Sept. 1 that Goldman issued a  54-page report sent to their institutional clientson August 16th arguing that as much as  $1 trillion  in capital may be needed to shore upEuropean banks; that small businesses in the U.S., a past driver of job production, are still languishing; and that  China’s growth may not be sustainable.

The trading ideas suggested by Goldman,

"....a fancy option play that offers a way to  take a bearish position on the euro, and a  bearish bet through an index of insurance contracts on the credit of European financial stocks."

But Goldman is also facilitating sales of Spanish sovereign bonds.  From WSJ:

".....On Wednesday [Aug. 31], Goldman and two other major banks hosted a presentation in London in which the Spanish economics secretary, Jose Manuel Campa, planned to outline Spain’s fiscal austerity measures and pitch Spain’s case to investors, according to an invitation seen by The Wall Street Journal.  Goldman has a leading position among banks in facilitating sales of Spanish sovereign debt."

Furthermore,

"Goldman's own trading positions potentially could benefit if hedge funds and other clients make trades based on the report. Goldman says in bold letters at the top of the report that  other Goldman traders, or "Goldman Sachs personnel," may already have acted on the material in the report."

So what that means is that Goldman is already in positions and is front-running their clients.  Now that's really delivering  the promise of putting the interests of clients first.  Moreover, there could be some potential conflict of interest.   

That is, on one hand, Goldman is getting compensated to market the sovereign bond of Spain, but on the other hand, Goldman has put in positions and advised its big clients to bet against the Euro and European banks, which is, in essence, betting against the Spanish bond the firm is supposed to facilitate sales, albeit indirectly. 

So, it'd be very interesting, to say the least, to be a fly on the wall to listen what Goldman's response would be when challenged by the potential investors of the Spanish bond with questions such as "Are you sure we should buy these bonds?  You guys are very bearish on the Euro and European banks and are supposedly betting against it?" 

An even better question is when Goldman would reverse its recommendation whenever the situation suits as it did within a-month time  on commodities and crude oil in April and May this year leaving the majority of regular investors holding the bag, while the firm is most likely already positioned to benefit from the resulted market reaction.

This came just two months after Goldman has reportedly  received a subpoena in June 2011 from the office of the Manhattan district attorney "stemming from a 650-page Senate report from the Permanent Subcommittee on Investigations that indicated Goldman had misled clients and Congress about its practices related to mortgage-linked securities."

You might recall prior to the 2008 financial crisis, Goldman Sachs, along with some other big Wall Street banks were peddling complex synthetic collateralized debt obligations, or CDO’s (the more infamous one is Goldman's Abacus 2007-AC1).  These big banks then not only made short bets, but also pitched their hedge fund and institution clients to bet against the housing market, and pocketed huge fees and profits. 

In April 2010, the U.S. SEC (Securities and Exchange Commission) did file a civil fraud law suit against Goldman for creating a mortgage product that was intended to fail.  But Goldman  settled with the SEC in June 2010 for mere $550 million (Goldman's gross profit is  $39.16 Billion for the past 12 months)...... without admitting or denying guilt.

But not to worry, along came the latest party pooper of Wall Street banks--the FHFA (Federal Housing Finance Agency)--the federal regulator that placed Fannie and Freddie into conservatorship about three years ago. In a bit to recoup billions of dollars in losses from failed subprime mortgage bond investments, after filing in July against UBS AG, seeking $900 million in damages, the FHFA went on and  sued some of  the biggest banks on Wall Street on Sept. 2 (See the list below from WSJ):

  • Ally Financial (ex-GMAC), $6 billion 
  • Bank of America Corp., $6 billion 
  • Barclays Bank, $4.9 billion 
  • Citigroup, $3.5 billion 
  • Countrywide, $26.6 billion 
  • Credit Suisse Holdings USA, $14.1 billion 
  • Deutsche Bank, $14.2 billion 
  • First Horizon National, $883 million 
  • General Electric, $549 million  
  • Goldman Sachs, $11.1 billion  
  • HSBC North America, $6.2 billion  
  • J.P. Morgan Chase, $33 billion 
  • Merrill Lynch/First Franklin Financial, $24.853 billion  
  • Morgan Stanley, $10.58 billion  
  • Nomura Holding America Inc., $2 billion  
  • Royal Bank of Scotland Group, $30.4 billion  
  • Societe Generale, $1.3 billion

The FHFA waited till the 11.5th hour to file these suits with the filing deadline approaching this month.  I'd imagine the FHFA is taking its time to collect enough ammunition since most of these big banks have some of the country's top lawyers either on staff or on retainer. 

The amounts in the FHFA's suits weighed on the financial stocks on Friday, Sept. 2 (See Chart Below), and could get worse for these banks as things progress.

Chart Source: WSJ.com


In Goldman's case, the firm has one more advantage beyond the high-priced attorneys.  The revolving door between Goldman and the U.S government has resulted in quite a few Goldman alumni and affiliates in high government places....four dozen, according to CBSNews.

Reportedly, there were critics saying the lawsuits represent a "piling on" by federal and state regulators that threaten to crimp credit and undermine a housing recovery.  Granted over-regulation does present impediment to business, but there has to be a check and balance in the system.

WSJ notes the FHFA suits represent "the most sweeping action to date from a federal regulator stemming from the mortgage meltdown."  Since government agencies have resources and power unavailable to regular investors, it'd interesting to see how these FHFA suits unfold. Nevertheless, if history is any indication, the most likely outcome could be settlements without admitting guilt.

And judging from the civil actions brought by the government agencies so far, it would seem that either the U.S. financial regulation system could use a fast and furious overhaul to have some real legal power to hold these big banks accountable for the any future subprime-like mess, or the U.S. banking structure and the sector's political clout has morphed it into one that's too big to regulate or reform. 

©  EconMatters  2011 All Rights Reserved |  Facebook  |  Twitter  |  Post Alert  |  Kindle



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.




Referenced Stocks: BAC , C , JPM

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