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May 12, 2011
Should Goldman Sachs Face Criminal Charges?
    by Robert Kropp

The report on the financial crisis by the Senate Subcommittee on Investigations details how the investment bank created conflicts of interest by profiting from the financial products that caused losses for its clients, and urges regulators to consider possible violations of law.

"In the fall of 2008, America suffered a devastating economic collapse."

Thus begins the 646-page report issued last month by the US Senate's Permanent Subcommittee on Investigations following an 18-month investigation into the causes of the financial crisis.

The report, entitled Wall Street and the Financial Crisis: Anatomy of a Financial Collapse, traced the collapse of Washington Mutual Bank, which on account of its subprime mortgage lending became the largest bank failure in US history, as well as the failure of the Office of Thrift Supervision (OTS) to act on the hundreds of "serious deficiencies" it identified in the bank's lending practices in the years preceding the bank's collapse.

The report also revealed the complicity of Moody's Investors Service and Standard & Poor's Financial Services, whose inflated credit ratings of subprime mortgage securities remained in place for months after "high risk mortgages began incurring delinquencies and defaults at an alarming rate." When, in July 2007, the agencies finally downgraded the status of the securities, the residential mortgage backed securities (RMBS) collapsed.

Noting that "investments holding AAA ratings have had a less than 1% probability of incurring defaults," the report observed that "90% of the AAA ratings given to subprime RMBS securities originated in 2006 and 2007 were later downgraded by the credit rating agencies to junk status," including every one of the 75 issued by Washington Mutual's subprime lending unit.

"Investors like banks, pension funds, and insurance companies, who are by rule barred from owning low rated securities, were forced to sell off their downgraded RMBS and CDO holdings," the report stated; although, when the market collapsed and the subprime securities became unmarketable, many investors were left holding them.

"Perhaps more than any other single event," the report continued, the inaccurate ratings and subsequent downgrading of subprime securities "triggered the beginning of the financial crisis."

Foremost among the factors contributing to the inaccurate ratings issued by Moody's and Standard & Poor's was "the inherent conflict of interest" in a system in which the agencies were paid for their ratings by "the Wall Street firms that sought their ratings and profited from the financial products being rated." The result of such a system, the report observed, "was a race to the bottom."

Finally, in a chapter entitled "Investment Bank Abuses: Case Study of Goldman Sachs and Deutsche Bank," the report described how Goldman Sachs contributed to the financial crisis by designing, marketing, and selling collateralized debt obligations (CDOs) "in ways that created conflicts of interest with the firm's clients and at times led to the bank's profiting from the same products that caused substantial losses for its clients." As Matt Taibbi wrote in an articl e published in Rolling Stone magazine this week, "The evidence has been gift-wrapped and left at the doorstep of federal prosecutors, evidence that doesn't leave much doubt: Goldman Sachs should stand trial."

The Subcommittee also reported that Deutsche Bank allowed its top global CDO trader "to develop a large proprietary short position for the bank in the RMBS Market," which generated a profit of $1.5 billion. However, unlike Goldman Sachs—which, according to the report, "rapidly sold off or wrote down the bulk of its existing subprime RMBS and CDO inventory…when it saw evidence that the high risk mortgages underlying many RMBS and CDO securities were incurring accelerated rates of delinquency and default"—Deutsche Bank lost nearly $4.5 billion from its mortgage-related investments.

As Taibbi wrote in Rolling Stone, Goldman Sachs "used its canny perception of an upcoming disaster (one which it helped create, incidentally) as an opportunity to enrich itself, not only at the expense of clients but ultimately, through the bailouts and the collateral damage of the wrecked economy, at the expense of society."

Concluding that "the US economy has yet to recover from the damage caused by the 2008 financial crisis," the Subcommittee provided a number of recommendations addressing the interrelated factors of high risk lending, regulatory failures, inflated credit ratings, and investment bank abuses. Most of the recommendations call for increased regulatory oversight, at a time when many Republicans in the US House of Representatives are attempting to delay until December 2012 the implementation of oversight of the $583 trillion derivatives market.

Regarding the activities of Goldman Sachs, the report advised regulators to "review the…activities described in this Report to identify any violations of law."

As Taibbi noted in his article, the only "financial big fish" to be successfully prosecuted thus far has been Lee Farkas, a Florida mortgage lender who was convicted last month of fraud and conspiracy. As reported in The New York Times, when asked during the trial if a contractual arrangement allowed his firm "to sell fraudulent, counterfeit, fictitious loans," Tarkas answered, "Yes, I believe it does."

In a press briefing announcing the report's publication, Senator Carl Levin, the Chairman of the Subcommittee, stated, "Our investigation found a financial snake pit rife with greed, conflicts of interest, and wrongdoing. Rampant conflicts of interest are the threads that run through every chapter of this sordid story."

"Blame for this mess lies everywhere," Levin continued, "From federal regulators who cast a blind eye, Wall Street bankers who let greed run wild, and members of Congress who failed to provide oversight."


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