The agency is taking a big gamble with its own reputation. By Renuka Rayasam, Associate Editor April 21, 2010 The Securities and Exchange Commission’s shot against Goldman Sachs could end up backfiring in a big way. Coming when it does -- as Congress is about to overhaul the U.S. financial regulatory system -- the move raised the stakes all around. The agency seems to have launched the attack in part to repair its image, which was badly bruised after its high-profile bungling of the Bernard Madoff investment scandal and other big cases exposed the agency’s weaknesses in oversight. But the SEC has as much to lose in this battle as Goldman Sachs. After 18 months of investigation, the SEC was only able to charge the Wall Street firm with a civil complaint alleging that the bank left out key information on how one complex financial product was created. Buyers and sellers of the synthetic collateralized debt obligations in question knew that the products were risky. After all, they were securities that returned high yields for mimicking the performance of the riskiest slices of pools of subprime mortgages. Even the SEC isn’t denying that Goldman showed buyers what was in the pools. The commission is taking issue with the fact that Goldman didn’t tell buyers that the hedge fund manager putting together the securities was also betting against them. As objectionable as the behavior may sound, the case won’t be easy for the SEC to win. It’s got to prove that Goldman intentionally misled investors, all while explaining to a jury the intricacies of what information is considered “material” for a collateralized debt obligation. With its lawyers stretched thin, the SEC may not have the resources to fight a court battle against a giant Wall Street firm with deep pockets. Losing would make the SEC look even more hopelessly inept at battling big banks. A settlement is possible, but it’s not a great option for either side. It would make the SEC, which split 3-2 on whether to file the charge, look weak. A recent agreement with Bank of America in the same New York district drew sharp criticism from Judge Jed Rakoff for being far too lax, embarrassing an agency that is trying to show it can be tough. Advertisement Even the timing of the suit, on the eve of the Senate debate on financial reform, calls into question the SEC’s legitimacy as a neutral regulator. In earning short-term points with an outraged public, the agency may be sending the wrong signal to legislators weighing whether to hand it more power. “The SEC is a political beast fighting for its life,” says James Angel, a securities professor at Georgetown University. It’s “under a lot of political pressure to put up or shut up.” However tight the SEC’s bind, it won’t help Goldman much. While the bank has strong arguments in its favor, either a trial or a settlement is sure to cause more damage. The allegations alone expose bank behavior during the run-up in the housing market that many will conclude was reckless. If found guilty, Goldman would only have to pay fees on the product in question, amounting to about $2 billion, according to banking analyst Richard Bove. That’s a paltry sum for a firm that generated $3.46 billion in earnings in just the first quarter of 2010, but a loss would open up Goldman to further lawsuits. Settling, which usually involves the firm admitting wrongdoing, would do the same. Already, English and German regulators are taking aim at the American bank for selling the problem securities to their countries’ banks, which eventually lost hundreds of million of dollars on them. Other buyers of the product could use the findings to embroil the Wall Street firm in legal wrangling lasting for years. Even winning a trial would take years, during which reputation-tarnishing evidence could come to light. Along the way, Goldman’s stock price would be volatile and executive heads could roll. Advertisement There is no doubt that banks of any size should be sternly taken to task for breaking laws. Still, regulators have no place waging wanton political fights to appease populist anger. The SEC is trying to prove a point, cover its own missteps and stretch disclosure laws. By doing so, the commissioners undermine the role of banks as financial intermediaries designed to help disburse credit in the economy. And the SEC is doing nothing to inspire confidence that it can better handle more responsibility. Yet there’s every indication that Congress is not getting that message. Rather than realigning incentives so that banks will pay the price for their own irresponsible actions, lawmakers seem poised to give the job to the same agencies that missed the mark in the first place.