Published on July 26, 2010

Despite paying the largest penalty ever assessed against a financial firm by the Securities and Exchange Commission, Goldman Sachs is still an attractive target for government panels investigating the financial crisis. Goldman agreed to pay a $550 million settlement on July 15 in connection with the Abacus case in which the SEC alleged that Goldman failed to disclose key information regarding the portfolio selection process.  Today, the Financial Times reported that Goldman is facing a separate inquiry by the Financial Crisis Inquiry Commission (FCIC) regarding the company’s use of derivatives.

FCIC Chairman Phil Angelides believes that Goldman Sachs is not being honest regarding the manner in which the company tracks revenues generated from derivatives trading.  At a recent hearing, two Goldman executives told the FCIC panel that the bank does not break out trading revenue generated strictly from derivatives:

They maintained that such information would give little insight into the bank’s trading risks as many trades involving a derivative contract also include an offsetting cash security. For instance, Goldman might buy a credit default swap to hedge against the possible default of a company where the bank also has a position in its debt. Tracking the revenue of one slice of a trade would ignore whatever gains or losses were booked on the other side, the bank said.

This seems entirely reasonable given the manner in which derivatives are used by large financial institutions.  The FCIC is threatening to send auditors to examine the raw data at Goldman and it is possible that programmers could extract only derivatives trades from the vast databases that the firm keeps to track trading activity.  However, without looking at such trades in the overall context of what they were intended to accomplish, the exercise would appear to be more likely to confuse the issue than to provide any insight for investigators.

It is unclear whether the FCIC understands how financial institutions use derivatives in modern markets:

Mr Angelides said he remained skeptical that Goldman did not have the derivatives information, given the bank’s reputation for risk management and its discipline in marking the value of every position daily. “It’s not credible that that’s a black hole,” Mr Angelides said. “It defies logic that these institutions have no clue of how much money they are making or losing from these derivatives.”

Goldman Sachs is known for risk management and it would in fact “defy logic” if the bank had no mechanisms in place to measure risk.  However, looking at a part of a transaction made up of a derivatives position while failing to examine offsetting transactions does not constitute “risk management”.  Rather, it seems to be a political exercise meant to vilify a financial instrument rather than a credible attempt to examine the overall risks being taken by financial institutions in a more holistic manner.

It is unclear whether government officials understand the nature of how derivatives are actually used and what risks emanate from such use, or if they do understand the issues but are attempting to make some political point by falsely isolating the impact of derivatives books from broader transactions.  In either case, loud announcements threatening audits will not help reassure markets regarding the stability of the financial system.

Disclosure:  The author has no direct position in Goldman Sachs but owns shares of Berkshire Hathaway, a large investor in Goldman Sachs securities.

Goldman’s Problems Continue with Threat of FCIC Derivatives Audit
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