CDO backlash a worry for all investment banks

April 19, 2010

Goldman Sachs’  competitors may have initially relished last week’s shock news of civil fraud charges against the firm. But shareholders in investment banks don’t see any reason for cheer. They are rightly concerned that regulators will be trawling through the records of any bank involved in the collateralised debt business during the boom. Shares in investment banks have fallen around 5 percent since the U.S. Securities and Exchange Commission said it was probing an infamous Goldman CDO trade on Friday.

That may seem like an overreaction. The SEC has already been investigating the CDO space for some time; there is no official suggestion that other firms did anything wrong. Moreover, the accusations against Goldman relate to just one specific transaction.

But the CDO backlash appears to be building a head of steam. The UK and German governments have called for an inquiry into Goldman’s Abacus transaction, which saddled their taxpayers with large losses. Rabobank has used the Goldman case to reinvigorate a claim against Merrill Lynch. The Dutch lender has accused the U.S. investment bank of failing to disclose fully the role of hedge fund Magnetar in structuring a CDO it bought — a similar allegation to that at the centre of the Goldman case.

Goldman was a big player in CDOs, but not the biggest. Merrill Lynch, Citigroup and UBS  underwrote more such securities, according to Nomura. With elections around the corner in both the UK and Germany, trades by these firms would be an obvious target for scrutiny.

But the fallout could be much more widespread. Synthetic CDOs are potentially fertile territory for regulators, due to the tension between the long and short side of the trade and the potential conflicts for the structuring investment bank. If regulators look hard enough across the industry, it is surely probable that they could turn up evidence of disreputable activity given the sheer volumes involved.

The question is precisely how hard the regulators wish to look. All investment banks had significant exposure to the CDO business. Perversely, that is also the one — awkward — consolation for the industry.

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The rest of the world is fed up of all the fraudulent financial products coming out of the USA, and will soon refuse anything from the USA. That day is fast approaching and it wont be pleasant.

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