Will the Goldman Sachs fraud case shake the market? A SmartCompany Q&A

News that investment banking giant Goldman Sachs had been charged with fraud by the US sharemarket regulator, the Securities and Exchange Commission, swept through global markets over the weekend like wildfire.

While many commentators have attempted to sheet some blame for the subprime crisis back to dodgy practices on Wall Street, this case will represent the first time an official regulator has made specific claims against one of the big banks.

But what will the case mean for investors? Could it shake the confidence of markets, or force the introduction of even tougher legislation?

Time for a SmartCompany Q&A.

I don’t really understand exactly what Goldman Sachs is accused of doing. Can you take me through it?

The case involves the creation of a special investment vehicle called a CDO (which stands for collateralised debt obligation) which was made up of a bunch of mortgage-backed securities (that is, securities backed by sub-prime home loans).

It is alleged that Wall Street hedge fund manager Paulson and Co (backed by billionaire hedge fund manager John Paulson, who is said to have made billions betting that mortgages would go bad during the GFC) identified 123 mortgage backed securities that it thought would fall in value, and approached Goldman about creating a CDO that would track the value of those securities.

Paulson (the firm or the man are not charged with any wrongdoing) then intends to bet against the CDO by buying credit-default swaps, also sold by Goldman Sachs.

Goldman Sachs, with the help up a company called ACA Management, designed the CDO (allegedly with the help of Paulson’s firm) and sells it to a group of investors – mainly banks, several of which were from Europe.

These buyers think they are getting a CDO that will offer consistent returns from mortgages. They are not told by Goldman Sachs that Paulson’s firm will be betting against the CDO in the belief it will fall – which it does, netting Paulson a $US1 billion profit, according to prosecutors.

Wow, it’s very complicated.

It is, but essentially Goldman is accused of fraud in that it deceived the investors who bought the CDO into thinking it was a good investment, when in fact it knew that the CDO was a dud that Paulson was going to bet against.

Okay, that’s a bit clearer. How has Goldman Sachs reacted?

The bank will defend itself vigorously. “The SEC’s charges are completed unfounded in law and fact,” it said in a statement on the weekend.

Any idea of how likely the charges are to succeed?

Too early to say at this stage. There have been suggestions that Goldman could face a $US2 billion fine if they were to fight and lose the case, although some pundits suggest the bank may try to limit any further damage to its reputation by looking for a quick settlement, as the case could take years to resolve.

The worst case scenario would be that the SEC widens its investigation into bank and uncovers more examples of what it considers to be questionable deals.

What about the impact on the markets? It’s not a good look to have one of the biggest players on Wall Street on trial.

Not at all, and Wall Street fell 125 points or about 1% on Friday night after news of the case hit the markets. Investment banks were particularly hard hit, with Goldman shares off 13%, Citigroup shares down 7.5% and Morgan Stanley shares 5.5% lower.

Will Australian markets take a hit?

Local stocks fell 1.2% shortly after the opening bell, but it’s probably not worth worrying too much about a big short-term decline. It does not appear that our banks and financial services companies were either exposed or involved in similar types of deals, so the direct fallout should be pretty minimal.

The whole thing is a bit of a shock, but it’s likely to be a fairly short-term one.

But are there some longer term implications out of all this? Particularly if the SEC proves its case?

The first question is whether the probe might be widened to other banks and other deals. If it is, we could see some real fireworks as the regulator goes to war with Wall Street.

But the timing of this case is also politically important, coming as it does as US president Barack Obama tries to build support for his new financial services regulation that is seen as crucial in clamping down on the worst excesses of Wall Street. This case – regardless of how it finishes up – should provide him with some real ammunition in getting those reforms through.

New financial regulation in the US is likely to lead to new financial regulation around the world. And that could have a real, long-lasting impact on how financial markets operate around the world.