"Just
as Al Capone was indirectly convicted and taken out of circulation because of
tax evasion, the remaining investment banks will likely be attacked in a roundabout
way rather than a frontal assault. The indictment of Goldman Sachs is therefore
one of the most important moments of the entire financial crisis."
Al Capone: the murderous Chicago bootlegger was brought down by charges of tax evasion. Is this indirect approach the way to go at the remaining investment banks?
The death of a president [of
Poland] and the spread of a volcanic cloud are the events that have
overshadowed everything else in recent days and weeks. But the indictment of
Goldman Sachs is by far the most important economic news of the year - perhaps
along with the looming bankruptcy of Greece.
This is an important message,
because for first time since the crisis broke, two things have appeared on the immediate
radar screens of authorities: the dubious role of the shadow banking system and
the construction of perverse financial products. Goldman, the prosecution
alleges, created a product with the goal of achieving losses, so that a major client
would be able to benefit from these losses.
I have no information and
certainly no opinion on the legal specifics of the case. Whether Goldman Sachs
is guilty is a matter for the American civil courts. But regardless of how the
actual legal situation is assessed, this affair has important implications for
the future regulation of the financial markets - an issue on which only minimal
progress has been made so far. Up to now, the responsible parties have for the
most part been beating around the bush and discussing the regulation of capital
and bonus payments.
The two central questions
that arise from the Goldman case are: should we eliminate the shadow banking
system? And should we prohibit toxic financial products?
OUT OF CONTROL SHADOW BANKS
My answers to these two
questions are: yes and yes. The problem with the shadow banking system is the
lack of regulation. Since in the case of a larger contamination risk, the government
will always be called in - in the end it has a right to be in control. It must
therefore have the right to subject private banks to supervision. Shadow banks
operate outside of these control structures.
Posted
by WORLDMEETS.US
Goldman Sachs is for now, still
very large and powerful. Wherever large sums of money are being moved from one
place to another, the American investment bank is involved. When Greece cut its
deficit with opaque currency swap contracts, Goldman Sachs played the roll of
emcee. The bank is omnipresent. It has access to so much insider legal knowledge
that it has a natural advantage as an investor - without having to break any
laws.
But Goldman isn't only “too
big,” it's also “too big to fail” - even more so than Lehman Brothers. A
hypothetical collapse of Goldman would be a cataclysmic event for the global
economy. That's more than just an argument for regulation. After all, atomic
bombs aren’t “regulated” either. Basically, it’s impossible to justify the fact
that a financial weapon of mass destruction like the shadow banking system is
in the hands of private individuals at all.
Lehman Brothers is now gone
and Bear Stearns and Merrill Lynch are divisions of other banks. Only two
classic investment banks remain: Goldman Sachs and Morgan Stanley. I don’t
think it'll be possible to regulate these banks out of existence, but the air
is getting thinner. Just as Al
Capone was indirectly convicted and taken out of circulation because of tax
evasion, the remaining investment banks will likely be attacked in a roundabout
manner rather than a frontal assault. The indictment of Goldman Sachs is the
symbolic beginning of this process and is therefore one of the most important
moments of the entire financial crisis.
But I believe that in
addition to this, it is necessary to tackle the products themselves. A few
months ago I argued that credit default swaps
(CDS) should be completely prohibited. The mischief they can wreak is enormous. Technically, there are similarities between purchasing
a CDS and shorting a bond. That's true on a superficial level, but a CDS is
more heavily leveraged and has a far greater potential to deceive investors. I heard
recently that an American hedge fund has created a product with a complex
structure intentionally based on bad loans. The hedge fund then used credit
default insurance to speculate against its own product. This was profitable
because the product received the highest overall rating of “AAA,” making the
cost of the premiums for credit default insurance unrealistically cheap. The
buyers of the product were the dumb ones - and these were often naive European
banks.
UNETHICAL, BUT LEGAL
According to the charges,
Goldman Sachs followed a similar principle. The bank deliberately created a bad
product and took advantage of its insider knowledge and a structural ratings
distortion to reap guaranteed profits. There is no question that this sort of thing
is unethical, and there's also no question that this sort of thing should be banned.
But the fact is that shenanigans like this were probably legal.
Of course it’s possible to
create complex regulations that ultimately all end up being circumvented. I
would make it really simple. “Naked” credit default swaps - the purchase of
credit default insurance without ownership of the securities to be insured -
should be altogether prohibited. The burden of proof should lie with the
purchaser, not with the regulator. This means that the buyer must deposit his
bonds when purchasing a CDS. This type of regulation would likely destroy most
of the CDS market. While that’s not my goal, it wouldn’t cause me to lose any
sleep.
