Nuns take aim at Street's moral dilemma

Goldman scandal spurs effort to shed light on derivatives

May 2, 2010 @ 12:01 am

By Aaron Elstein

At Goldman Sachs' annual stockholders meeting May 7, a group of nuns will raise some uncomfortable issues.

The Maryknoll Sisters of St. Dominic won't be asking chief executive Lloyd Blankfein what lies in his soul. Nor will they inquire into what in heaven's name executives of the The Goldman Sachs Group Inc. were thinking when they allegedly failed to alert clients that they had been sold a mortgage investment which had been designed to blow up.

Rather, the sisters are asking other shareholders to approve a resolution requiring Goldman Sachs to disclose more information about derivatives.

“The financial crisis has hurt so many people all over the world in profound ways, and derivatives were a key part of it,” said Cathy Rowan, a lay consultant who will be presenting the nuns' measure at Goldman Sachs' meeting.

Goldman Sachs opposes the sisters' resolution. It said that the disclosure being sought “would not provide useful information to our shareholders and would not be a worthwhile use of our firm's resources.”

But the nuns' concerns are shared by many, not least members of Congress, who appear close to imposing tougher legislation on the unregulated world of derivatives and reining in one of Wall Street's most profitable lines of business.

Although derivatives have been around for nearly 25 years, the amount outstanding has doubled in value over the past five years as Wall Street's equivalent of mad scientists devised all sorts of funky new instruments so investors could wager on everything from falling house prices, the steepness of the bond yield curve's slope, or the value of the Latvian lat and the Thai baht.

The derivatives market has a notional value of $464 trillion, according to the International Swaps and Derivatives Association. That is about 10 times the market value of all of the companies listed on the world's stock exchanges.

Trading in these instruments is concentrated among a handful of big banks, including JPMorgan Chase & Co., Goldman Sachs, Morgan Stanley, Credit Suisse Group AG and Deutsche Bank AG. The banks collectively generated an estimated $28 billion in revenue last year and about $9 billion in profits from derivatives, according to Bloomberg.

For its part, Goldman Sachs generated about $5.4 billion in revenue from derivatives and about $1.6 billion in profits, according to research firm Sanford C. Bernstein & Co. Inc. Put another way, Goldman Sachs made $700 million more in revenue from crafting derivatives last year than from underwriting stocks or bonds for corporate clients, or from advising them on mergers and acquisitions.

Of course, activity in these more traditional lines of business was depressed last year. What's more, derivatives revenue will fall by half if Congress passes a tough reform bill, said Bernstein analyst Brad Hintz.

Lawmakers are considering forcing many, if not most, derivatives to trade on an exchange so buyers can readily find prices for the instruments. Currently, banks can charge hefty markups because there is no central marketplace for derivatives.

In addition, Congress is looking at having derivatives trades settled at a central clearinghouse, depriving banks of another revenue source.

For Wall Street, the most dire scenario was laid out by Sen. Blanche Lincoln, D-Ark., whose proposal to force banks to spin off their derivatives desks was approved by a Senate committee last month.

“Derivatives regulation will have teeth, no matter which scenario goes forward,” Steve McBee, chief executive of lobbying firm McBee Strategic Insight, wrote in a note to financial services clients.

The derivatives debate “has swung widely recently,” he wrote, adding that Congress appears inclined to toughen derivatives legislation even as members seem inclined to compromise on two other issues — the creation of an independent consumer financial protection agency and the so-called Volcker Rule, which would limit proprietary trading at banks.

Wall Street appeared to have succeeded in watering down derivatives reform — until the government's suit against Goldman Sachs last month.

The Securities and Exchange Commission said that Goldman Sachs committed fraud by failing to tell investors in a derivative instrument that it had allowed a hedge fund manager to pick mortgages that he deemed most likely to default so that his bearish bet against the derivative would pay off. Goldman Sachs insists that it didn't do anything wrong.

Sister Barbara Aires acutely senses the change in momentum.

At Citigroup Inc.'s annual meeting last month, her order, the Sisters of Charity of St. Elizabeth, asked the bank to disclose more information about derivatives, just as the sisters at Maryknoll are seeking from Goldman Sachs. The resolution won the support of 30% of Citigroup shareholders, about triple the level that the nuns had expected.

“It's a moral victory that sends a strong message to Wall Street,” she said.

Aaron Elstein is a senior reporter at sister publication Crain's New York Business.

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