Let Goldman Sachs Interrogate the SEC

Since April 16, 2010, when the Securities and Exchange Commission (SEC) indicted Goldman Sachs (GS) on fraud charges, the bank must approach each day wishing it could stay in bed. New charges and rumors of lawsuits swirl around the firm. Goldman will have its day (or, years) in court, but the government agency that rolled the snowball down the mountain should also sit in the dock.

The SEC aided and abetted the credit bubble in several instances, one of which will be discussed here.

The Securities and Exchange Commission removed the 12:1 leverage limit on broker/dealers in 2004. (The 12:1 limit is a rough figure calculated from SEC Final Rule, 17 CFR Parts 200 and 240, “Alternative Net Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities.”) When Wall Street collapsed in 2008, Goldman Sachs, Lehman Brothers, Merrill Lynch, Bear Stearns, and Morgan Stanley were leveraged at 30:1, and sometimes at over 60:1 between their quarterly financial reports.

In the whirlpool of bank reform discussion, the extent to which banks were leveraged before the deluge is underappreciated. (Nor, is current leverage appreciated, either.) Economists, for instance, did not – and do not – pay attention to leverage, and since the country is run by these specimens of constricted imagination, their holy models did not capture the inevitability of Wall Street’s collapse (or, of the one to come.)

What follows is an exercise that turns the tables. Goldman Sachs is given the opportunity to interrogate its regulator. Goldman’s legal counsel might recommend, if the firm were given such an opportunity, that the bank’s line of questioning be more diplomatic. There is no need for that here:

“Why did you remove limits to our leverage when the whole economy was already operating as a highly leveraged carry trade? Houses, for instance, were being sold on terms that no bank in its right mind would offer – unless they could dump mortgages in our lap. Chairman Greenspan even gave a speech imploring Americans to buy adjustable-rate loans in February 2004.

“Our economists scratched their heads at the time: why did he need to do that? In the state with the most speculative housing market, California, the percentage of adjustable-rate mortgages (ARMs) had already risen from 2% in 2002 to 47% in when he spoke. Median house prices in California had shot up from $237,060 in 2000 to $443,148 at the time Greenspan made his plea. Median incomes had been falling, so more mortgages were being written with no money down. Nevertheless, ARMs jumped to 61% of California mortgages by the spring of 2005, and prices reached $542,720.

“You knew that Goldman Sachs and other brokers were securitizing these mortgages that the banks and mortgage brokers would not hold. Yet, you blew open our leverage constraints. You were practically ensuring we would increase the volume of securitization. What was left to securitize other than loans to borrowers with little chance of paying off their debt? Our more fevered participation inevitably raised the volume and prices of house sales.

“What else did you think we would do with this new freedom? Putting our investment banking hat on, what were we going to finance? Productive companies couldn’t get out of the country fast enough. Manufacturing profits had fallen from $144 billion in 2000 to $96 billion in 2003. Corporate financing was being channeled into the [irresponsible, highly leveraged, destructive – Goldman legal counsel: leave this out!!!!] private equity market.

“The Bush administration wanted more jobs and housing was making them. In 2003, we found that over the previous two years 750,000 high-tech jobs had been lost and 125,000 Americans became real-estate agents. By 2006, at least 600,000 people were selling mortgages in California. Goldman Sachs was building a more employed, although highly distorted, America. Why did you encourage us to turn the United States into an ancient Egyptian pyramid-building empire?

“We will tell you why we thought at the time, and still think now, that you removed the leverage limit: you wanted us to securitize mortgages at a faster pace. Maybe this was not the SEC’s goal, but you do what you’re told in the political arena. The United States could no longer fund its trade deficit without shipping boatloads of mortgages overseas. In 2000, the U.S. imported about $400 billion more goods and services than it exported. By 2006, this doubled to $800 billion. How could Americans – with falling median incomes – spend at such an accelerating rate and how could foreigners finance our lifestyles?

“We will abbreviate the answers to these questions with two simple examples.

“In 2005, Americans withdrew $800 billion of home equity from the rising values of their houses, about half of this was spent on consumer purchases. We will add that if it were not for our highly innovative mortgage securities that had evolved from the simple asset-backed derivatives to CDOs, to synthetic CDOs, to CPDOs, to Russian-doll CDOs, [each innovation even more profitable to us, since they were more inscrutable to the hapless buyer – Goldman legal counsel – stop this!!!!!], we could not have attracted the wider customer base necessary to unload this garbage. [Goldman legal counsel – OK, the sloppiness is so obviously true and gives the impression of sincerity].

“In 2005, foreigners bought 53% more Fannie Mae and Freddie Mac securities than they had in 2004. They had to buy them if they wanted America to buy all their junk. (Given the poor quality of imported socks that ripped the first time we put them on, the poor quality of our exported subprime CDOs did not cost us much sleep.) Americans couldn’t buy the debt securities we issued since we were spending at such a furious rate. Foreigners had pulled back from the U.S. stock market after the Internet bubble burst. The Treasury could not issue enough securities, so we had to unload subprime loans on them.

“In conclusion is Exhibit A. This is from Goldman Sachs Global Investment Research, 2007 Issues & Outlook, published on December 10, 2006. Your decision – or, indecision – to permit brokerage debt to keep spiraling upward is unforgivable. And, don’t say we didn’t warn you:

The world is flooded with too much capital. It is virtually impossible to find any asset class that offers attractive value to investors. When the little black dress that Audrey Hepburn wore back in 1961 as Holly Golightly in ‘Breakfast at Tiffany’s’ sells at auction for $917,000, or the 1907 Gustav Klimt painting Adele Bloch-Bauer sells for $135 million, or a fully-occupied office building on 48th and Park Avenue in New York City with no leases expiring for ten years changes hands for $1.2 billion at a cash yield of 4% (Treasuries less 0.50% !) before deferred maintenance reserve, or the financial markets believe for a day that a major national retailer is about to receive a $100 billion LBO offer, then the touchstones and benchmarks of what represents value seem [like] anachronisms of a time long ago.

About Frederick Sheehan 53 Articles

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009). He is the co-author of Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve.

Mr. Sheehan was Director of Asset Allocation Services at John Hancock Financial Services in Boston. In this capacity, he set investment policy and asset allocation for institutional pension plans. For more than a decade, Mr. Sheehan wrote the monthly "Market Outlook" and quarterly "Market Review" for clients.

He is a frequent contributor to Marc Faber's "Gloom, Boom & Doom Report." He also has written articles for "Whiskey & Gunpowder" and the Prudent Bear website, among others. He currently serves as an advisor to an investment firm and a non-profit foundation.

A Chartered Financial Analyst, Mr. Sheehan is a graduate of Columbia Business School.

Visit: Frederick Sheehan's Website

2 Comments on Let Goldman Sachs Interrogate the SEC

  1. Mr. Sheehan-
    Wasn’t it inherently inadvisable for Goldman to leverage to such an extent even if the SEC permitted it?

    Changes in government regulations don’t occur in a vacuum. It would be helpful to point out why the SEC lowered capital requirements at that time. Who was pushing for it? Why? Why hadn’t the SEC done it before.

    I believe the Bank of England was going to regulate the U.S. investment banks’ English operations unless they could find a U.S. regulator to serve as worldwide regulator.

  2. You make it sound as if Goldman and co were forced to take more leverage – I agree regulators had done a poor job of policing markets over past few years but partly that was because of intense lobbying pressure by market participants to relax rules. That clearly turned out to be erroneous in hindsight and the tide is turning towards greater (and hopefully, more effective) regulation. So, what is so wrong about it?

    What you are saying is that the mob which had been paying off cops all these years to turn a blind eye should have an equal right to question the cops once the cops get back to the job of policing – some convoluted thinking.

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