Risk Professional: Has the SEC spooked markets to protect its own reputation?

On Friday 16th April 2010, the Office of the Inspector General issued a report saying that the USA's Securities and Investments Commission, a government body, had failed to act on warnings that Sir Allen Stanford and his group of financial companies may be involved in a massive ponzi scheme. It was not the first time that a similar allegation had been made: it has been proved that the SEC had been made aware, on more than one occasion, that Bernard Madoff was up to no good in a similar scheme. It had sashayed out of any major trouble over that but the Stanford allegations would provide a media storm and that the old wounds would be re-opened.

The SEC knew that the report was coming and that it had no defence to the OIG's report, that it would have to admit its faults and to say, in effect, "but we've improved a lot since then."

But that's a weak response and would not deflect criticism that would build in weekend newspapers.

The announcement of a large, high profile, case would, however, attract attention and take up primary space in the financial industry parts of weekend newspapers, relegating the OIG's report to little more than a footnote.

And so, a terse statement was made in response to the OIG's report "This report recounts events that occurred at the Commission between 1997 and 2005. Since that time, much has changed and continues to change regarding the agency's leadership, its internal procedures and its culture of collaboration. The report makes seven recommendations, most of which have been implemented since 2005."

And then it unleashed its big guns in a media release headed "SEC Charges Goldman Sachs With Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages." The capitals are those applied by the SEC.

The release says "The Securities and Exchange Commission today charged Goldman, Sachs & Co. and one of its vice presidents for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter."

It goes on ""Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party."

There is nothing new about the general allegations, levelled at many investment banks across the world. There is nothing new about actions being brought in respect of similar allegations: the SEC has others on foot. What is new is the size and profile of the target: most regulators, the SEC included, do not attack major, high-profile institutions - they pick on the small and weak and hope the big guys learn the lessons. After all, Robert Morgenthau, when he was District Attorney for Manhattan, said he would not prosecute a major US bank for money laundering; his justification was that to do so would undermine confidence in the credibility of US markets.

The SEC announced its decision during Friday's trading hours: US markets plunged. Bloggers started talking nonsense about a "black swan" describing the Goldmans case as "out of the blue." But it was no such thing. But shareholders remain jittery about the entire banking sector of which Goldmans is, truth, a small part but of significant psychological importance.

And the SEC has limited its complaint to what Goldmans describes as "a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact." On Saturday, Goldmans released a detailed comment on the allegations. By then it was too late. The news had spread like wildfire across financial markets and the SEC had achieved the objective: everyone was talking about Goldmans and the Stanford incident was relegated to sidebars or short notes.

Gordon Brown, the UK's Prime Minister - for whom banker-bashing is his personal hobby-horse in an election campaign begun last week, waded in on Sunday. He had learned that Goldmans - which published very profitable results - will pay substantial bonuses. He took the chance, on Sunday, to announce that the UK Government would launch an investigation into the conduct of the bank and in particular into its results and bonuses.

By Monday morning, starting in Australia, shareholders began to be spooked with banking shares taking big hits. Across South East Asia, markets opened down some by more than 1% this morning with more falls as the morning went on.

The SEC appears to have chosen Goldmans precisely because of its psychological importance: an attack on yet another small name would not have diverted the attention from the OIG report.

It is a small step from that to wilfully putting markets at risk to protect its own reputation.

Did the SEC wilfully take that step?

It is inconceivable that the SEC would not know that its announcement would spook confidence in the banking sector.