Goldman and Finance Reform
Sam Chandan April 21, 2010, 8:20 p.m.
The Securities and Exchange Commission filed a civil suit against Goldman Sachs on April 16, accusing Wall Street’s most profitable securities firm of defrauding a select group of investors. While news of the suit continues to dominate the headlines, the question of Goldman Sachs’ culpability may be irrelevant. In the public estimation, even the suggestion of malfeasance at this venerable institution may necessitate a drumhead response.
The temptation to seize upon public outrage can be overwhelming, both in the United States and abroad. Over the weekend in the United Kingdom, Prime Minister Gordon Brown, whose Labour Party faces an uphill battle for reelection on May 6, described the suit’s allegations in terms of “moral bankruptcy.”
In response to the S.E.C.’s claims, Goldman Sachs stated on Friday that the “accusations are unfounded in law and fact.” As compared to its outsize profits, the firm’s potential direct liability in the civil case is likely limited. The greater challenge for the firm will be in refuting the government’s claims in the court of public opinion and in resolving doubts that will arise about its commitment to honest dealing. These challenges loom large for investors, who slashed $12 billion from Goldman Sachs’ market capitalization by Friday’s market close.
The relevance and implications of the allegations against Goldman Sachs extend well beyond the firm itself. In particular, the S.E.C.’s claims coincide with the anticipated introduction of Senator Chris Dodd’s financial reform bill this week. Failing to achieve bipartisan support for Senator Dodd’s original proposal, Democratic members of the finance committee had passed the bill on a party-line vote on March 22. The Senate’s 41 Republicans have united in opposition to the bill, sending a letter to Majority Leader Harry Reid on Friday encouraging “a bipartisan and inclusive approach, rather than the partisan path you chose on health care.”
The introduction of the bill to the Senate floor just days after the S.E.C.’s actions will almost certainly raise the stakes and political tenor of the imminent debate. Senator Dodd himself tied the Goldman Sachs case to his current legislative efforts. “We don’t need to know the outcome of this case,” he said, “to know that the opaque nature of unregulated asset-backed securities fueled the financial crisis. … We must pass Wall Street reform to bring practices like these into the light of day and protect our economy from another devastating blow.”
While Senators on both sides now warn of the consequences of either passing or not passing the financial reform bill, Treasury Secretary Timothy Geithner has struck a markedly more optimistic tone. In an interview with David Gregory on Sunday, Secretary Geithner said that he was “very confident that we’re going to have the votes for a strong package of financial reforms. … I think we will see Republican and Democrats come together and pass strong reforms.” Likely an overstatement of the bill’s corrective prowess was Secretary Geithner’s suggestion, on April 14, before the Goldman news, that “we’re very close to something that … [will] prevent us from ever seeing this kind of crisis again in the future.”
While declining on Sunday to comment on the case against Goldman Sachs, Secretary Geithner instead offered that the financial crisis has been characterized by “catastrophic failures in judgment by people running these institutions. Catastrophic failures in basic protections governments have to provide.”
AS FOR WHAT FORM the government’s protections will take, there is little evidence that bipartisan compromise will be forthcoming. Major stumbling blocks as of Friday included disagreements about whether to maintain a fund to absorb the cost of bank failures, the regulation of derivatives and the powers accorded to regulators. Conceding on the initial point of contention, the administration is reported to have asked Senate Democrats to drop provisions relating to the liquidation fund. As an alternative, the government would recoup its costs in arrears. In practice, this is likely to prove impractical, since all banks may be weak when one fails under system pressures.
In the case of derivatives regulation, the administration has taken a much harder stance than it has with the divisive liquidation fund. In its current form, the proposed bill would bring derivatives trading under the authority of the Commodity Futures Trading Commission. This move faces strong industry opposition, but the president was adamant on Friday, saying that he will “veto legislation that does not bring the derivatives market under control in some sort of regulatory framework that assures we don’t have the same kind of crisis that we’ve seen in the past.”
The financial reform bill has also raised concerns at the Treasury Department. Seeking to protect regulators’ capacity to assume control of banks and their flexibility in winding down failed institutions, the Treasury opposes some of the bill’s specific provisions. Among the problematic terms, the proposed bill limits the Federal Deposit Insurance Corporation’s credit line with Treasury as relates to the operational costs of managing banks in receivership. Treasury is also reported to oppose provisions that will strengthen requirements for judicial approval of government takeovers.
Among industry participants, the response to the financial reform legislation has been mixed. At community banks and smaller regional banks, stronger regulation of large institutions may be welcome. On March 23, the Independent Community Bankers of America (ICBA) reiterated its support of Senator Dodd’s committee proposal. Incoming ICBA chairman James MacPhee sought to distinguish community banks from their larger peers:
“Our nation’s nearly 8,000 community banks never participated in the risky practices that led to this economic crisis and are clearly the one part of the financial system that truly works. We can no longer tolerate a system where a handful of institutions have the ability to put our entire country at risk. The only way to truly safeguard our financial future is to end too-big-to-fail and enforce rules on the unregulated financial players.”
A week earlier, outgoing ICBA chairman Michael Menzies had proffered his support as well. “[The] ICBA welcomes the draft legislation released today by Chairman Dodd because it moves financial regulatory reform forward and aims to safeguard future generations by reining in the systemically dangerous institutions that were at the heart of this economic catastrophe.”
Thus far, the debate over loftier issues and about the bill’s ambitions for grand market restructuring have overshadowed its specific provisions relating to commercial real estate markets. Nonetheless, key provisions remain a part of the markup bill that is now en route to the Senate floor. If current and expected CMBS deal flow is any guide, markets are unfazed by the potential for more robust regulation of ratings agencies and securitization activity.
As it turns out, financial reform may not be as onerous and counterproductive as one side has warned; nor is it likely to prove a panacea for the market’s excesses, as suggested by its supporters.
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.