Sunday, April 18, 2010

The Goldman Issue and Financial Markets

A legitimate prospect exists that the SEC's lawsuit against Goldman Sachs will turn out to have a number of implications that considerably exceed the initial noise associated with the announcement itself.

With the extent of the alleged Goldman violations still uncertain due to ongoing investigations, there is some inescapable questions as to how serious the end result of all of this will be for the future of the storied Wall Street firm; that is, whether this will turn out to be a run-of-the-mill financial scandal that will ultimately be settled out-of-court in the true tradition of most such incidents or it will fundamentally shake up the firm with potentially unpredictable consequences.

However, there is more to this affair than the consequences for Goldman Sachs itself.

The contours of the implications for the financial markets of the SEC's lawsuit though are already starting to take shape.

To begin with, the lawsuit is re-injecting a perceptible element of risk into the financial system, given the palpable uneasiness over how systemic such practices, as those alleged in the Goldman case, will turn out to have been among other major (investment) banking institutions. Just at a time when the financial system was viewed as having made significant progress toward healing from the 2008-2009 crisis, old wounds may be re-opened in the form of potential discovery of many more questionable, or downright illegal, practices by financial firms. What makes this prospect more plausible is the current environment where regulators are under growing pressure to reassert themselves as true watchdogs of a financial industry, the perceived abuses of which have attracted an enormous degree of criticism from many corners in the last year and a half.

Lingering anxiety over the outcome of such investigations, now also conducted by both German and U.K. regulatory authorities (, should create an environment conducive to an elevated headline risk, for some time. This will represent a major hurdle not only for bank stocks but for the broader stock market as well, disrupting its irrepressible 13-month rally. Some widening of mortgage-backed and other derivatives products' spreads is likely as well, as those instruments are coming under renewed intense scrutiny.

With the stock market going into a more defensive mode and spread products becoming the target of steadily louder voices of both criticism and suspicion, the Treasury market, by virtue of its safe haven status, is likely to be the clear beneficiary of that dynamic. As a result, this should help mitigate the Treasury market's sensitivity to occasionally strong economic reports in the coming weeks.

Against the backdrop outlined above, any traces of anxiety over an earlier-than-generally assumed implementation of the Fed's exit strategy should be put to rest. The Fed is extremely sensitive to the degree of stability of the financial system and in a period where uneasiness over its integrity and with potentially multiple legal actions against the industry percolating, the Fed's strong preference would be to keep a low profile and avoid any action that could destabilize a system already under intense scrutiny.

For the Goldman affair to have the potential to impact materially the trajectory of the economic recovery, it would require a much broader fallout than the one envisioned at this early stage. Depending on the degree of pressure major banking institutions feel that they may be coming under, extending the period during which their infamous tightening of credit standards of the last two years remain in effect is a plausible outcome. This, alone, though, may not be enough to seriously impact the momentum of the recovery, as the forces propelling the economy forward are by and large self-sustaining and not easily derailed at this point.

Still, on that score, how far the newly found determination of financial regulators is prepared to go to make up for their previously embarrassing lethargy will be a pivotal factor that needs to be watched closely in the foreseeable future.

Anthony Karydakis

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