It has been reported that Federal prosecutors are considering the possibility of a criminal indictment of Goldman Sachs (NYSE:GS). It is early yet, but it's worthwhile to contemplate what the consequences of this action would be. In 1988, Drexel Burnham Lambert faced the prospect of RICO charges arising from the Milken issues that would have effectively destroyed the firm. The company plead nolo to avoid that death sentence, but it was mortally wounded and imploded months later, with moderately unpleasant consequences for the financial markets (including the derivatives markets). The mere prospect of a Treasury Department ban on its participation in Treasury auctions due to one of its traders having squeezed the T-note markets (arguably a less severe sanction than anything associated with criminal charges) caused a run on Salomon Brothers that almost destroyed the firm; only Buffett's frantic efforts saved the firm (That article is an interesting read. I smiled at the part where Buffett was talking on a payphone. Was it that long ago?)
Goldman's stock was down hard on the news, and its CDS spread widened. Criminal charges against the firm raises a significant risk of a run (specifically, a withdrawal of short term credit) that could threaten the firm. Goldman is well-capitalized, and in a decent liquidity situation, but not so soundly financed that it is inconceivable that it could fail. Similarly, Buffett's connection to the firm provides an economic cushionj, and perhaps just as importantly, a political one.
It must be remembered that these situations are highly non-linear, due to the substantial feedback and the existence of multiple equilibria. Runs can be self-fulling. If enough creditors believe the rest will run, they will run, which will cause others to run, etc. That is, ironically given that firms like Goldman have been accused of commencing speculative attacks against whole countries, such firms are actually acutely vulnerable themselves to such attacks.
Again, Buffet's presence here may be crucial: if lenders believe that he will inject additional capital into the firm, they will be less likely to run. Bottom line: even a criminal charge against the firm is unlikely to be fatal, but the risk of a non-linear, unstable, destructive response is not out of the question.
And given the centrality of Goldman (NYSE:GS) to the financial system, it going non-linear could cause a destabilizing, non-linear response in the broader markets. If Goldman defaults on derivatives,…
