Why the US Really Went After Goldman

04/23/2010 9:18 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

With the Goldman suit, the SEC enhanced its power and created leverage for its congressional allies just as new international banking rules are under consideration.

It might be just coincidence that the Securities and Exchange Commission (SEC) filed civil fraud charges against Goldman Sachs (NYSE: GS) in the midst of a contentious debate in Washington over legislation to reform Wall Street.

But it's sure no coincidence that the SEC announced its charges on the same day that comments closed on what's called Basel III.

You're probably up to your eyeballs in speculation about what the charges against Goldman will mean for the Wall Street bank that everyone fears to hate. And you're probably desperately trying to tune out the empty rhetoric that passes for debate over the financial reform bill in the Senate these days. (Let's just say that when senator Chris Dodd, D-Conn., said his Republican colleagues were acting like teenagers, I sprang to my feet at home to launch an impassioned defense of teenagers from such slander.)

And you've quite possibly never even heard of Basel III. But I think the other two much more public stories are simply sideshows to the action in the main ring that is Basel III.

OK, so what's Basel III, and why is it so important?

This set of new regulations for the international banking industry will determine the profitability of banks for the next decade.

Simple as that. And that's something that neither the SEC charges against Goldman, nor the financial reform legislation in Congress, can claim.

The Price of Safety

The Basel III rules, so named because they follow on sets of international banking rules called Basel I and Basel II, drawn up in the Swiss city of Basel, will set much tougher guidelines for Tier 1 bank capital than the earlier sets of rules. That was inevitable in any set of new rules in the aftermath of the global financial crisis.

No one is sure how tough these rules will be. The comment period on the draft rules closed only April 16. But just about every national banking industry in the world is worried that the rules will, if not put it out of business, crush profits and put it at a deep disadvantage to banks from other countries.

The worry isn't really over how high the Basel Committee on Banking Supervision will set capital requirements. Banks are pretty much resigned to being forced to raise more capital and to keep higher levels of reserves. It's hard to argue that excessive leverage (and inadequate reserves) didn't play a major role in turning a global financial problem into a very close encounter with global financial meltdown.

The Basel committee's members are representatives of central banks from many of the world's largest economies. The committee has no real regulatory power, but sets standards and best practices in the expectation that member countries will take steps to comply.

The need for higher reserves has been bolstered by the example of countries such as Spain, where the real estate market blew up as disastrously as anywhere in the world, but where the banking system walked away from the wreck with relatively minor injuries because the Banco de España, Spain's central bank, had imposed higher reserve requirements as the bubble inflated.

No, what keeps bankers from Tokyo to New York up at night is worry over how Basel III will define Tier 1 capital. The Basel II rules said banks had to hold at least 4% of their risk-adjusted assets (for a bank, an asset is a loan) in Tier 1 capital, supposedly the safest of all capital, and limited Tier 1 capital to equity and equity-like holdings.

One big loophole in Basel II exposed by the global financial crisis was in the nature of these equity-like holdings. Some weren't as safe and liquid as they needed to be. Some equity-like holdings turned out to be, in essence, debt. The effect was to lower Tier 1 capital to as little as 2% of risk-adjusted assets. And that just wasn't enough margin of safety when the global financial crisis hit.

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Impractical Proposal

So the draft proposal would tighten the definition of Tier 1 capital. That's great, in theory. But in practice, the proposed rules would throw out whole asset classes that individual national banking industries depend on for a major part of their capital.

So, for example, the draft rules propose tough new requirements on limiting how much cross-shareholding—that is, when banks own shares of each other—could count toward Tier 1 capital requirements. That proposal comes down really hard on European banks, which routinely own big hunks of each other. The French Banking Federation said in its comments on the rules that the draft proposal would confront euro zone banks with a $503 billion deficit in Tier 1 capital.

US banks would take their own hits from the proposed Tier 1 capital rules in Basel III. For example, the rules would require that banks maintain an amount of long-term loans and deposits equal to their financing needs for 12 months, including off-balance-sheet commitments and anticipated securitization. That would force many US banks to move away from using the capital markets to raise funds and to increase their reliance on deposits. In general, US banks are moving in that direction, but Basel III, now scheduled for implementation by the end of 2012, would speed up the trend.

It's hard to believe some of the numbers being thrown about. Lobbyists for US banks claim that the rules would force banks around the world to raise $6 trillion in new capital. Since the Basel III rules will be enforced by national regulators—who won't rush to put their national banking system out of business—I think that number is nonsense.

I have seen one number that does express the effect of Basel III on banks: According to an analysis by UBS, the stricter definition of capital and higher capital requirements in Basel III would reduce lender's return on equity to 12.9% from an estimated 13.8% in 2012.

That may not seem like a lot, but the difference between the return on equity at JPMorgan Chase (NYSE: JPM) and Bank of America (NYSE: BAC), a very well-run bank and a not-so-well-run bank, respectively, in 2007 was only slightly larger, at 12.9% for JPMorgan to 10.8% for B of A.

Why the Banks Will Bend

Now what does all this have to do with the SEC fraud charge against Goldman and the financial reform bill in Congress?

First, notice that while the banks and regulators may be adversaries in the SEC-Goldman suit, they're more like co-conspirators when it comes to Basel III.

If banks are going to head off any parts of Basel III that they find especially onerous, they're going to need national banking regulators to make their case with the Basel Committee on Banking Supervision.

In fact, the US Federal Reserve called just such a meeting in the week before the SEC filed its case. Executives from JPMorgan, Wells Fargo (NYSE: WFC) and Fifth Third Bancorp (NYSE: FITB) met regulators from the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Reserve Bank of New York, who listened as the banks raised their objections to Basel III. None of the regulators defended Basel III, Bloomberg BusinessWeek reported.

But to ensure that the regulators go to bat for them with respect to Basel III, the banks need to agree to a small, but significant list of changes.

Banks can offer to let national regulators—the Federal Reserve, the FDIC, and others—regulate them instead of the international agencies in Basel and at the International Monetary Fund (IMF). No regulator wants to lose authority over any part of the regulated realm.

Banks can offer to make regulators look good by agreeing to significant rules or legislation that would increase the regulators' prestige and visibility.

Banks can offer regulators increased responsibility by agreeing to new regulation of unregulated or underregulated parts of the market.

So think about the financial reform bills, then, as a careful balancing act by banks, regulators, and legislators (who have their own desire for prestige, etc.). Each side wants something of value that they're willing to pay for, but no side is willing to pay too much.

So regulators and legislators want to increase their territory by increasing regulation of derivatives and by forcing trading in some derivatives to exchanges. That will cost banks by increasing collateral requirements and by lowering fees. Banks may not want to pay all that legislators and regulators want here, but they're certainly willing to pay something in exchange for support on Basel III. So we have the current argument over how much of the derivative market will be exempt from regulation.

This is one reason that I'm just about certain that some financial reform bill will pass—something with enough teeth in it so that regulators and legislators can brag, but not so many that it's too painful for banks.

NEXT: What Banks Are Next After Goldman?

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Goldman First, and Then . . .

Think about the SEC civil fraud charges in the context of this triangulation. By bringing the suit, the SEC enhanced its own power, but, more importantly, it created critical leverage for its allies in Congress who were working to extend regulators' powers and reputation.

The cost to the banking industry? Modest pain for a rival that many banks wouldn't mind seeing cut down to size.

And so far, at least, Goldman looks like it's going to get an expensive slap on the wrist, but not one so painful that it will endanger Goldman's place in the Wall Street hierarchy.

It's by no means certain that the SEC will win its suit against Goldman Sachs. The case will rest on proving that hedge fund Paulson, which was betting that the mortgage-backed securities market would drop, had material involvement in deciding which mortgage-backed securities went into the investment, Abacus, and whether Goldman failed to disclose that involvement to the buyers. (Paulson stood to profit if Abacus' value declined, while the other clients profited if Abacus' value rose.)
 
If the SEC prevails, Goldman will face a fine in the range of $100 million to $300 million (petty cash for Goldman), restitution of the $1 billion in losses (real money certainly, but Goldman just reported earnings of $3.5 billion for the first quarter of 2010), and a hard-to-guess level of punitive damages. The punitive damages could be as much as three times the $1 billion loss. And they'd likely to be appealed for years. So this thwack is hardly the kiss of death for Goldman or even major damage to its business model. (For more details on the SEC suit, see this blog post on my Web site.)

Sure, everybody from European financial regulators to attorneys for banks on the losing end of Goldman deals will pile on. I have to believe the SEC picked the case that it thought it was most certain to win. That means other potential plaintiffs, including American International Group (NYSE: AIG) and Royal Bank of Scotland (AIG: RBS), may face cases that they can't win.

But this is a circumstance based on largely unexpressed mutual interest and not on some plan articulated by the participants and then carefully laid out. The momentum of a situation like this can quickly get out of hand if some party gets carried away by the moment and forgets the interests of the other parties or miscalculates its own interests.

There are signs that this could happen.

Anger among voters is so high that some legislators are in danger of actually pushing for reforms that would be exceedingly costly to banks. The Volcker rule, which would require banks to divest their proprietary trading units, is still in the Dodd bill in the Senate, for example.

The SEC is known to have sent subpoenas in 2009 to Bank of America, Citigroup (NYSE: C), Credit Suisse (NYSE: CS), UBS (NYSE: UBS), Morgan Stanley (NYSE: MS), and Deutsche Bank (NYSE: DB). If the agency files suits against a wider swath of the banking industry, banks may find that they're facing a tidal wave of public anger that makes it impossible for them to control the tradeoffs in congressional reform legislation. Two House Democrats, Peter DeFazio of Oregon and Elijah Cummings of Maryland, have asked the SEC to broaden its probe of Goldman Sachs and to refer any criminal misconduct to the Department of Justice. DeFazio and Cummings are especially interested in the $12.9 billion in taxpayer money that AIG paid to Goldman Sachs to settle derivative positions. (For a different take on who might be next, see this blog post of mine.)

This all could still get out of hand. Let's hope, anyway.

At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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