Charges of fraud against Wall Street’s most powerful investment bank Goldman Sachs for designing a derivative based on sub-prime mortgages in 2007 that was deliberately meant to lose value because of short selling have caused ripples in international capital markets. The Sensex was caught in the tailspin, snapping out of a nine-week winning streak. With memories of Lehman Brothers’ collapse fresh in the minds of investors the world over, there is reason to be alarmed over new evidence of excesses committed by Wall Street bankers that led to the biggest crash since the Great Depression. The Goldman scrip plunged 13 per cent on Friday and shares of the other leading underwriters of collateralised debt obligations — Deutsche Bank, Morgan Stanley, Bank of America, which owns Merrill Lynch, and Citigroup — declined by between 9 and 5 per cent, although most of their deals included actual mortgage-backed securities and not synthetic derivatives of the Goldman variety.
The unusually strong indictment of Goldman Sachs by an embattled Securities and Exchange Commission feeds into the political mood in Washington to bring derivatives into the regulatory ambit. Draft legislation, supported by President Barack Obama, intends to slap new restrictions on major banks, curtailing their opportunities for profit and revenue growth. The timing of the SEC lawsuit could help drum up support on Capitol Hill for the Democrat Bill, but White House may be able to tone it down to fit with other proposals that form Congress’ efforts to reform the financial regulatory system. Either way, the $450 trillion over-the-counter swaps market in the US will face greater oversight.
Increased public scrutiny of investment banks with big infusion of taxpayer money in the aftermath of the sub-prime crisis should be able to contain the fallout of more such instances of creative deal-making coming to light. International financial markets are still fragile and the nascent recovery could be easily upended. Yet the world is better placed today to deal with a crisis than two years ago. For one, the regulators are extra cautious as new rules are being written to avoid a recurrence of the American flu. Financial institutions are also better capitalised now to be able to withstand any falling dominos. And governments across the globe are primed to push money into the system to avoid a financial meltdown. There may be legitimate fears of a double-dip global recession, but the Goldman Sachs episode is far from being a trigger.