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A few days ago, I published an article on Seeking Alpha titled “Are SEC Charges Against Goldman More Serious Than Market Understands?". As a result, I have been fielding questions as to the reasons why a "collapse event" may take place. Part of the problem, I think, is that the previous article is very long winded, and so many ideas are expressed, that a lot is lost in the mix. In order to globally answer and avoid further confusion, I will clarify the matter here in a clearer, less wordy manner.

If the only allegations against Goldman Sachs (NYSE:GS) were that it failed to disclose the participation of the Paulson Company, Inc. hedge fund to the long participants of one CDO, specifically the Abacus 2007-ACA, the maximum economic damages that would be payable would be about $1 billion, plus maximum regulatory fines of about $700 million, an unspecified amount of prejudgment interest, and a few billion dollars worth of possible punitive damages.

But, the SEC action so far involves only one case. Given that investment banks rarely do only one deal when profit can be made, I doubt that the full extent of Goldman's problem is limited to this one case.

The SEC, and any private litigant who follow in their footsteps, clearlly have a strong case (at least based upon the facts set forth in the SEC’s complaint). Still, Goldman would always have a chance of winning if some of the facts have been exaggerated. They would also, perhaps, have the option to settle, as the SEC has never before shown much stomach to fight politically savvy large opponents.

However, Goldman issued tens of billions of dollars worth of CDOs AFTER having underwritten tens billions of dollars worth of collateralized mortgage bonds. The bonds were probably composed of subprime and other mortgages that they sliced, diced and priced. A lot of investment banks did the same thing. But, Goldman went further than some of the other banks. They began actively betting against the very products that they were peddling to their clients.

I am also guessing that many of the bonds inside the CDOs were originally underwritten by the same investment bank that created the CDOs, in this case, Goldman Sachs. It is an educated guess because Wall Street bankers almost always want to know as much as possible about the things they are betting on or against.

I say that the CDOs were probably composed of bonds Goldman underwrote because, investment banks do not normally bet billions of dollars to go short on a particular security or market after throwing a dart. First, their analysts do intensive research. It is disingenuous to believe that this intensive research did not include material non-public information obtained during the underwriting of the underlying mortgage bonds. In other words, they must have had information about the creditworthiness of the borrowers on particular mortgages, and they probably used that knowledge as the basis of their trade. No one else had this information, and because of its otherwise confidential nature, it was impossible for other participants to obtain it in any legal manner.

Using material confidential non-public information to trade on a security constitutes illegal insider trading. Another guess is that this information was shared with selected clients, such as hedge funds, like Paulson & Company, Inc. which would, again, be illegal insider trading, and a conspiracy to commit illegal insider trading.

The SEC has not yet filed a complaint on the basis of illegal insider trading but that doesn't mean it won't happen. Perhaps, of course, because of the firm’s clout in Washington DC, it never will. Perhaps Goldman had a strict wall between its CDO underwriters and its bond underwriters, but, from what I've seen over the years, that type of impeccable conduct would not be typical of Wall Street investment banks. Whatever the case may be, private financial institutions, who lost huge sums of money as a result of Goldman’s deals, will certainly file such charges at some point.

At the heart of Goldman's probem is the very real prospect that it will be embroiled in litigation over tens of billions of dollars (or even hundreds of billions) in compensatory and punitive damages. The amount of money involved potentialy dwarfs any securities litigation of the past. The firm will not be facing contingency fee lawyers, representing Mom & Pop type investors, who lost a few hundred thousand or a few million dollars. Such lawyers often have limited financial resources to back them up and can be forced to settle. Instead, they will face adversaries hired by financial institutions which, in some cases, are comparable in size to themselves.

These financial institutions are perfectly capable of bankrolling the attorneys and cannot be squeezed into settling for peanuts on the dollar. Each case, and there could be many, has a potential impact on Goldman similar to that which Pennzoil v. Texaco once had on Texaco. In that long ago case, Pennzoil won a $10 billion legal battle, and forced Texaco to declare bankruptcy. Imagine if Texaco was facing 20-30 Pennzoils and you will better understand Goldman's unenviable legal position..

Goldman executives also stand a chance of being charged criminally, especially if some of the civil cases are won at trial. The company seems to be trying to distance itself from Fabrice Tourre, who was directly involved in the Abacus 2007-ACA, but it is impossible to accept that a 27 year old was allowed to do whatever he wanted, without supervision. To make matters more difficult for the company, he seems to have been promoted as a result of the revenue generated from this deal. So, clearly, the company approved of his work.

Dealing with Goldman Sachs, at this point, creates many risks for institutional clients. First, there is the perception that you may not be on the Goldman Sachs’ “favored clients” list. If you are not on the “list”, you may perceive the possibility that, instead of truthful advice, you will either have material information withheld during your deals, or receive overtly false information. Second, there is headline and regulatory risk. Even if you manage overcome your fear of not getting onto Goldman’s “favored” client list, you will have a rational fear of becoming embroiled in Goldman litigation and/or regulatory troubles.

Your rational decision, therefore, as an institutional investor, would usually be to steer clear of Goldman Sachs, and work with someone else.

Losing clients does not usually happen overnight. It took much longer than that for both Bear Stearns and Lehman Brothers. But, it does happen over weeks and months. As a result of the many risks that now exist in doing deals with Goldman Sachs, clients may flee the firm over time. Large numbers of fleeing clients may bring down Goldman Sachs.

But, you counter, Goldman Sachs is “too big to fail”. Don’t count on it! The Federal Reserve and U.S. Treasury have already spent most of their political capital. The promised recovery on Main Street, which was supposed to happen through the bailing out of their friends on Wall Street, never happened. The Fed, in particular, stands to be a big loser if it tries to steal yet more money from Grandma’s CDs in order to subsidize a company accused of fraud. It might find itself ended, permanently, by Congress. The U.S. Treasury, in spite of being populated by so many folks also loyal to Goldman Sachs, cannot act without the consent of Congress.

Where does that leave us?

It is early to call…but I would not be overly surprised if we see another Lehman style collapse. What might matters more interesting, this time, is that Goldman Sachs is several times larger than Lehman Brothers. Those who are so close to Goldman that they will stick to the firm until it is too late (Pauson & Company?) may go down with the ship, as they did with Lehman Brothers, losing the ability to withdraw their own assets after the firm experiences massive withdrawals by other clients.

One thing is sure. It is always wiser to get into the lifeboats, right away, and leave a sinking ship, before it is completely underwater. You can always row back to the ship if it doesn't sink, but, once you're underwater, there's usually no easy way to get to the surface again.

Disclosure: No positions.

Source: Why Goldman Sachs May End in a Lehman Style Collapse