Goldman fraud charge invigorates EU derivatives crackdown

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Lawmakers in Brussels see more cause to pass laws to curb derivatives trading, as the only bank to yield profits during the financial crisis is charged with knowingly reselling shoddy mortgages to benefit a hedge fund counting on their demise.

If a fraud charge against American bank Goldman Sachs is proved, the issues raised would "strengthen the belief and determination that Europe needs to act in the area of derivatives," a spokesperson for EU Internal Market Commissioner Michel Barnier said in a statement yesterday (19 April).

"The commissioner strongly believes that we need to put an end to years of murkiness and opacity and secretive behaviour in this area," read a statement from the EU executive.

Investment bank Goldman Sachs stands accused by the American regulator, the Securities and Exchange Commission, of allowing the Paulson & Co hedge fund to pick and choose below standard sub-prime mortgages to underwrite a financial product called a Collateralised Debt Obligation (CDO).

The hedge fund, which had taken out an insurance policy in the form of derivatives against the package, was waiting to reap the rewards once the CDO had defaulted on the market, alleges the SEC.

The European Commission is expected to unveil proposals to make derivatives trading more transparent in June.

The EU legislation would ensure that all products have the same standard, that they are registered with an authority and that they are given a seal of approval from a trading exchange like the Central Clearing Parties (CCP), according to early drafts of the rules (EURACTIV 19/01/10).

Barnier's terse words come a month after his announcement that the EU is also on the cusp of writing legislation to curb speculation in sovereign derivatives, namely Credit Default Swaps (CDS), after Greek debt came under pressure in bond markets (EURACTIV 10/03/10).

Determination echoed in Germany, France and US

Both the British and German leaders, Gordon Brown and Angela Merkel, reacted promptly to the SEC's charge, requesting information from the American regulator to evaluate whether they too should file suits against the bank.

Britain's Brown, who lambasted the bank for being "morally bankrupt," also said he would consider stopping the bank's upcoming bonus payments, which would reportedly comprise $5billion.

"It makes me absolutely determined we are going to have a new global constitution for the banking system which I am pressing for, a global financial levy for the banks that all countries that are major financial centres pay, and we quash remuneration packages such as Goldman Sachs," the prime minister told the British press.

The case is also seen as a boost to the US Democrats' pleas to pass the controversial Dodd bill, which among other things would put the derivatives market under the authority of the Commodity Futures Trading Commission.

However, the US pro-regulation contingent faces staunch opposition from all 41 Republican members of the US Senate.

The biggest loser in the whole debacle is the Royal Bank of Scotland, with total losses estimated at $841 million.

German bank IKB says it has lost $150 million in the sale while losses at the erstwhile mortgages arm of the Dutch bank ABN Amro are $841 million.

Those losses were subsequently passed onto RBS, Fortis and Santander, who bought the ABN subsidiary that administered the transactions in 2007.

EU Internal Market Commissioner Charlie McCreevy opened an investigation into the derivatives sector in October 2008, a month after the collapse of Lehman Brothers, a bank heavily involved in the $600 trillion global derivatives market.

Establishing central clearing houses is considered a moderate way of reducing systemic risk related to derivatives. Instead of being exchanged privately ('over the counter'), they could be processed through an intermediary, a move which is expected to improve transparency and reduce risk.

The European Commission clearly supported this approach in a communication published in July 2009 (EURACTIV 06/07/09).

Collateralised Debt Obligations (CDO), such as the ones sold by Goldman Sachs (see story), are bundles of underlying assets bought by investors for their more flexible payment policies, which vary depending on the asset class of each component.

  • June: Commission to publish draft derivatives legislation.
  • October: Commission to publish draft legislation to curb Credit Default Swaps.

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