by Eric Fry

If you shine a light on a cluster of cockroaches, they scatter and hide. But when you shine a light on a cluster of investment banking con men, they simply stare back and reply, "The SEC's charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation."

As the entire investing world knows by now, Goldman Sachs is the latest cockroach to scuttle under the spotlight. Last Friday, the Securities and Exchange Commission accused Goldman of defrauding investors out of $1 billion.

The details of the SEC's complaint allege that Goldman failed to disclose "vital information" about a mortgage-back security called Abacus. The SEC said: "Unbeknownst to investors, Paulson & Co. [a hedge fund]...which was posed to benefit if the [securities in Abacus] defaulted, played a significant role in selecting which [securities] should make up the portfolio...In sum, Goldman Sachs arranged a transaction at Paulson's request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests."

Goldman responded in classic fashion - crying "Foul!" and claiming that it is the victim of a gross misunderstanding. Does anyone really believe them? To rephrase the question, does anyone really believe that this single instance of alleged fraud is the only such instance?

This question reminds us of another truism about cockroaches: There's never just one. Any financial firm that is capable of committing a fraud as egregious and flagrant as the one the SEC's complaint describes is certainly capable of committing a second fraud...and maybe even a third or a fourth...or a fortieth.

The fraud the SEC identifies in its complaint against Goldman is not a mere "Oops!" It is a fraud that every licensed stockbroker in the land would recognize as a career-ending no-no.

"The product was new and complex," explained Robert Khuzami, a director from the SEC's Division of Enforcement, "but the deception and conflicts were old and simple."

In other words, a lie is a lie.

Nevertheless, I'm content to let due process run its course...and to wait as long as necessary for the guilty verdict to arrive.

Whatever the ultimate verdict, Goldman is already "guilty by association" in the eyes of most Americans. It is guilty by its close association with the practices that precipitated the financial crisis of 2008. It is also guilty by its close association with the powers in Washington who decided which firms would receive billions of dollars of emergency assistance (i.e. Goldman Sachs) and which would be allowed to fail (i.e., Lehman Bros.). And most of all, it is guilty by its close association with the obscene sense of entitlement that characterizes Wall Street pay practices.

In short, America hates Goldman Sachs.

So the fact that Goldman may have actually committed a large-scale fraud is a very big deal.
Suddenly, the Goldman-haters are carrying loaded weapons...and the ensuing firefight might produce some significant volatility in the financial markets.

For starters, this event might produce a very convenient excuse for a very pronounced selloff. But Goldman is not merely an excuse for a stock market selloff; Goldman is the stock market...and it is also the commodity market and the Treasury market. Goldman is the biggest market maker in the US stock market and among the biggest players in every major commodity market. Goldman is also one of the largest primary dealers of Treasury Securities.

So maybe it is no fluke that most commodities tumbled Friday, right along with the stock market. Gold and crude oil both tumbled more than 2%. And as this new week begins, Goldman's troubles are mounting.

Citing Goldman's "moral bankruptcy," Britain's Prime Minister Gordon Brown called for a full inquiry by Britain's Financial Services Authority in conjunction with the SEC. Germany also said it would ask for detailed information about the case. Both governments had to bail out banks that lost hundreds of millions of dollars on investments marketed by Goldman.

None of this will be good news for the stock markets of the world. And yet, none of this is really a surprise either. Nearly two years ago, in a column entitled, "The Goldman Sachs Phenomenon," I  said, "The American financial system still possesses too much talent and creativity to operate prudently... Consider yourselves forewarned!" We are re-publishing this column in today's edition of Money Morning.

Just two months before this column first appeared, JP Morgan Chase had acquired the failing Bear Stearns. As part of the deal the Federal Reserve took responsibility for $29 billion in toxic assets from the Bear Stearns portfolio - effectively handing a $29 billion subsidy to JP Morgan, and establishing a precedent for the hundred-billion-dollar subsidies that would flow to Wall Street's largest firms just six months later.

We smelled a rat back then...and the rat doesn't smell any better now...

By Eric Fry

Now that the American financial sector is safe and unsound once again, has the threat of serious economic crisis genuinely passed? And has the structure of American capitalism actually improved? Or did the Fed merely dress a sow in lingerie and call her a raving beauty?

In other words, what did the Fed accomplish by lavishing billions of dollars upon the financial sector? Was the Fed's inflationary rescue mission really worth all the trouble? Or would the nation have been better off if Bernanke and Paulson had simply gone golfing while Bear Stearns failed?

At first glance, the Fed's rescue seems to have halted a serious crisis in its tracks. The rescue also seems to have preserved the viability of the American banking system. But upon closer inspection, we discover that the Fed's rescue also preserved at least one dysfunctional characteristic of our economic system - namely, an over-reliance on "asset-swapping" activities, rather than "asset-producing" activities.

Australian author, James Cumes, asserts that the US economy has become overly dependent on trading things back and forth, rather than manufacturing goods and selling them. He calls this new reality the "Goldman Sachs Phenomenon."

"In the larger Anglo-Saxon economies," says Cumes, "transfer of ownership [has] supplanted fixed-capital investment as the most common form of what purported to be 'investment.' Investment has become a means of making a fast buck, not by entrepreneurial effort, construction of factories and installation of productive equipment, but by gambling to add market value through mergers and acquisitions...that would lead to higher shareholder value in the marketplace...

"Despite the higher, short-term market values [that might ensue], they would not necessarily add anything to productivity or to the volume or value of final output" - "Inevitably," Cumes continues, "there are social impacts from this deal-maker, day-trader, casino-like type of ownership investment, especially to the extent that it spreads over a more and more major part of the economy...Inequality is dramatically intensified by generous bonuses for senior executives and others in financial firms in the United States and such other financial centres as London."

The Fed's bailout of the financial sector seems to have supercharged the Goldman Sachs phenomenon. Not only do the top dogs at publicly traded financial firms "make bank," they continue to make bank even after destroying billions of dollars of shareholder wealth. And the top dogs enjoy their privileged positions under the watchful, doting eyes of the Federal Reserve and Treasury. No bad deed goes unrewarded.

"Of course, there is justice in rewarding effort and enterprise," Cumes concludes. "That is historically one of the ways in which a capitalist system has justified and maintained itself; but there are other considerations too. "Indeed, if our present essentially democratic capitalism is to survive - and survive securely - it must pay attention to social outcomes. Poverty in the midst of plenty is not a comfortable social situation. Some inequality there will always be but gross and growing inequalities must, over time, be a threat to social, political and even strategic stability, as well as economic and financial stability."

But these "big picture" concerns do not seem to concern the head of the Fed and Treasury. In fact, throughout this crisis, Bernanke and Paulson have assiduously avoided implementing (or even suggesting) any regulatory changes that would impinge upon the limitless liberties of Wall Street's investment banks. The perpetrators of the crisis remain in power and the corporate structures that supported their recklessness remain in place. Instead, incredibly, Treasury Secretary Paulson wags his regulatory finger at hedge funds.

Huh? Why? Hedge funds did not create the crisis, they merely profited from it. Aren't the investment banks the ones who created trillions of dollars of crazy derivatives? And aren't they the ones who loaded their balance sheets with suicidal quantities of leverage? And aren't they the ones who are now receiving billions of dollars of government support?

So here's a radical idea: How about regulating the perpetrators of the crisis, rather than the profiteers? Or maybe the Fed should require all the top-ranking officers of every company that receives a bailout to resign? Or how about one upper-level resignation for every $1 billion a Wall Street investment bank borrows from the Fed's discount window.

This isn't complex stuff, folks. If the Treasury Secretary sincerely wished to clean up and re-regulate the banking system, his new regulations would only require about 50 words:

1. No officer of any publicly traded financial institution may receive more than $10 million per year in total compensation.

2. No financial institution may borrow more than $10 for every one dollar of readily marketable assets (i.e. "Level I" assets) on its balance sheet.

3. No financial institution may incur any liabilities "off-balance sheet."

4. No exceptions.

Implement these regulations and you would have forever eradicated the DNA of financial catastrophe from the American financial system.

But what would critics say about such "draconian" new regulations? (We'll call these regulations the "Level Playing Field Act of 2008.") After choking on their foie gras, they would probably protest, "That's not nearly enough compensation for top officers! You'd lose the top talent!" Then they would protest: "What! No off-balance sheet financing? Are you crazy? That's where all the juice is! You would lose the ability to ramp up return on equity!"

To which we would reply: "Hallelujah!" and "Amen!"... Finally, we could purge the financial system of all the "talent" that has delivered America's most severe credit crisis since the Great Depression. Finally we could purge the system of the "creative" leverage that the "talent" has amassed over the last several years. Finally, we'd have a banking system that would operate like one - a banking system that would provide capital to entrepreneurial endeavors, rather than to catastrophic speculations.

The American financial system does not need "talent" and "creativity." It needs prudence and perspicacity. It does not need creative bankers. It needs dull bankers.

Why? Because the American financial system needs to safeguard its capacity to finance creative and talented entrepreneurs. It needs to safeguard its capacity to preserve the purchasing power of our currency and to safeguard the legendary America capacity to create wealth from the bottom-up, not to destroy wealth from the top-down.

But the American financial system still possesses too much talent and creativity to operate prudently. In fact, Ben Bernanke and Hank Paulson may be the most creative finance officials in American history.

Consider yourselves forewarned!

Eric J. Fry
for Money Morning

Turning to the markets

The JSE all share index slumped 1.11% yesterday. The gold mining index gained 0.63%. Resources fell 1.58%. Banks and financials weakened 1.6% and 1.62% respectively. Industrials pulled back 0.36% and the platinum mining index decreased 2.91%.

London's FTSE100 climbed 0.4%. The Dow Jones collected 0.67% and the Nasdaq traded flat, down 0.05%.

Tokyo's Nikkei traded flat, down 0.07%. Hong Kong's Hang Seng added 0.83%.

Brent crude is currently trading at $84.77 per barrel.

Spot gold's trading at $1,136.26 and platinum was last quoted at $1,700.00.

And here's how the rand is performing against the major currencies:
R/$ 7.43
R/₤ 11.41
R/€ 10.01