06/28/2010 05:12 am ET Updated May 25, 2011

The Rest of Wall Street Is Beginning to Fear the Goldman Spillover

For the past two years, most of the big Wall Street firms have been
joyfully watching Goldman Sachs take most of the hits for their
collective sins: Their three-decade risk-taking binge culminating in a
massive taxpayer bailout, and then less than a year later, handing out
billions upon billions in bonuses to their bailed out bankers.

Amid this bizarre (and sadly true) scenario, Goldman Sachs -- the most
successful of the big banks -- became a disgusted public's Wall Street
whipping boy; something that its CEO Lloyd Blankfein even acknowledged
yesterday to Peter Barnes of the Fox Business Network after being
grilled for a couple of hours by a Senate subcommittee investigating
Goldman's business practices during the financial crisis.

Goldman, in case you haven't heard, is at the center of Wall
Street PR nightmare; just a year after the 2008 financial collapse and
subsequent bailouts, it used low interest rates supplied by the Fed
and guarantees supplied by the federal government to crank out around
$12 billion in profits and a whopping $20 billion in bonuses for its
executives. In addition to the public outrage over its profits and
bonuses, Goldman is also the focus of a civil fraud case brought by
the Securities and Exchange Commission alleging that the firm and a
young trader failed to disclose key information on some bonds it sold
to clients in 2007.

Amid all of this, Goldman's competitors at JP Morgan, Morgan Stanley,
Bank of America and Citigroup, have been silently cheering. They hate
Goldman nearly as much as Rolling Stone magazine, which has lampooned
the firm as the center of all evil on Wall Street.

That is until Tuesday, when the Senate Permanent Subcommittee on
Investigation got into Goldman-basing mode as well with hearings
focusing on firm's business practices, namely how it elevated the
practice of screwing its clients to an art form in the years leading
up to the 2008 banking collapse. During the hearings, a half dozen
Goldman executives including the firm's CEO Lloyd Blankfein were
lawyered-up enough to successfully obfuscate through much of the
questioning, though by the end of the 10-hour ordeal, they had to
acknowledge something that will likely cause Goldman and the rest of
Wall Street a lot of trouble: That in making so much money, before the
financial collapse and now in its aftermath, the firm really doesn't
care about its clients. It really doesn't think twice about selling
customers investments that are "shitty" (a word subcommittee chairman
Carl Levin repeatedly used after he found it referenced in several
Goldman emails) and that as a firm, Goldman has no problem whatsoever
hiding from its clients key details of these shitty investments,
namely that it knew those investments were shitty when it was selling

That point was made perfectly clear by one of the "stars" of
yesterday's proceedings, the now famous trader named Fabrice Tourre,
who is at the center of the recent SEC case against the firm. At issue
is whether Tourre should have disclosed the involvement of a short
seller, John Paulson, in the creation of an investment tied to the
mortgage bond market, known as a collateralized debt obligation.
Paulson, of course, was betting that the bonds were going to fall in
value (as the mortgages fell into default), while two other investors
bet the bonds' prices would appreciate. Paulson was right and made
billions, while the investors were wrong and lost big bucks, and
there's nothing wrong with that.

The problem, according to the SEC, is that Goldman didn't tell
investors of Paulson's involvement in helping to craft the portfolio
in question which, as it turns out, reflected mortgages that Carl Levin
would describe as "shitty." More than that, the SEC also charges that
one of the investors, ACA Capital, actually believed Paulson was
"long" on the portfolio of shitty bonds, thus betting that their prices
would rise.

Tourre, in his wonderful French accent, both denied the SEC
charges and then did something that I believe is very important: He
gave the subcommittee and the rest of the investing public an
education on what on Wall Street counts for full and honest
disclosure. Contrary to the SEC's complaint, Tourre said he actually
alerted ACA that Paulson was going short. How did he do that? By
telling ACA that Paulson was "buying protection" on the deal.
Buying protection is Wall Street speak for going short, he
assured the committee. Maybe so, but as many as five traders yesterday
told me that they use the same term "buying protection" when they are
going short in order to hedge or "protect" a long position. In other
words, Tourre's disclosure could have just as easily confirmed the
belief of ACA, (no matter how absurd that belief might be as Goldman
has argued), that Paulson was in fact long the portfolio of CDOs in

Why didn't Tourre use the most explicit explanation of Paulson's
position and describe it as a "short"? I don't know, and no one on the
committee asked him. But during his testimony he offered a clue. In
response to a question by Senator Susan Collins, Tourre basically said
that he and his colleagues have a very limited responsibility to
clients in terms of disclosing information. Goldman, like the rest of
the Street, is a market maker not a "financial adviser."

This distinction may sound like technical mumbo-jumbo but its
very important. As a market maker, Tourre has no "fiduciary
responsibility" to his clients and their interests. As a financial
adviser he does.

Last week when reports of Tourre's short "disclosures" broke,
several major news organizations declared the SEC case to be weak or
even dead on arrival. I know lawyers or say just the opposite; that
the case is a solid one, though it should be noted that among the many
unanswered questions in the case is why, for instance, ACA believed
Paulson was long the CDOs, as the SEC maintains.

To me a bigger issue and problem for Goldman, and for that
matter the rest of Wall Street, is what the hearings signaled may lie
ahead in the future. Between some of the truly dopey questions asked
by the committee, and the weasel-wording of the Goldman people,
emerged a central truth about the Wall Street business model: It's
designed, albeit legally, to screw clients, and some in Congress are
thinking about changing that business model -- making Wall Street have a
"fiduciary responsibility" to its clients.

And that's why top executives at JP Morgan, Morgan Stanley, Bank
of America and Citigroup are starting to feel Goldman's pain.

The problem for Wall Street is pretty simple: Most of its
profits come from risk-taking trading activities, not giving clients
advice such as how best to float a stock deal, or whether or not the
client should merge with another company. In other words, Wall Street
lives off gambling, as was made perfectly clear during the hearings as
the committee discussed some of the crass emails from Goldman
executives describing just how the gambling takes place.

But when was the last time a Las Vegas casino was bailed out by
the US taxpayer? That's why Wall Street is so concerned about the the
public's hatred of Goldman spilling over to force lawmakers to
consider some drastic reforms. Keep in mind, fraud charges are easy to
settle for firms that earn $12 billion in profits. What's more
potentially threatening (and costly) to Wall Street is the public's
revulsion of a business that does nothing more than sell shitty
investments to investors and make tens of billions in the process.
That's when lawmakers start to take aim.

Susan Collins raised the "fiduciary responsibility" issue in her
questioning with Tourre, but Senator Ted Kaufman of Delaware has
turned it up a notch during an interview with the Fox Business Network
on Wednesday afternoon. Kaufman said that after financial reform is
dealt with, he and other senators will investigate whether the casino
should continue to exist by designating firms as "financial advisers,"
meaning not only will they have a fiduciary responsibility not to
screw their clients, their responsibility will be to make sure their
clients aren't screwed. The SEC, I am told, is looking into the matter
as well.

Wall Street, of course, will fight anything that makes the
casino less profitable as it has the Volcker Rule which prohibits
certain types of trading in the current reform legislation. But what
Kaufman and Collins are talking about won't just make the casino less
profitable, it will end the casino once and for all. Wall Street would
have to turn back the clock to a way of doing business that centers on
providing advice and counsel to it clients. Wall Street will also have
to turn back the clock on its profits, and that will mean a lot less
of them.