WASHINGTON — A plan to ban proprietary trading — once considered a long shot — is now almost certain to be enacted as part of a regulatory reform bill, thanks in part to a hearing Tuesday where Goldman Sachs Group Inc. executives came under withering allegations of betting against the firm's own clients.
When President Obama first endorsed the "Volcker Rule" in January, lawmakers were skeptical because many saw it as largely unrelated to the mortgage practices that spurred the crisis.
But the Goldman hearing and a lawsuit filed by the Securities and Exchange Commission against the firm have brought the issue home for lawmakers from both parties, who agreed Tuesday that the current system is flawed.
"It is unsettling to read e-mails of Goldman executives celebrating the collapse of the housing market when the reality for millions of Americans is lost homes and disappearing jobs," Sen. Susan Collins, R-Maine, said at a hearing of the Senate Permanent Subcommittee on Investigations. "Clearly the system needs to be reformed."
Although many lawmakers, particularly Republicans, steered clear of specifically endorsing the Volcker Rule, their comments made it clear that proprietary trading, at least, needed to be addressed in the reform bill.
"The key question is whether Goldman Sachs was making proprietary trades that were contrary to the financial interests of their clients and customers," said Sen. Tom Coburn, the lead Republican on the panel. "Sorting out these potential conflicts is central to understanding how we move forward with financial reform."
Analysts said there was little doubt that at least some form of the Volcker Rule, named for former Federal Reserve Chairman Paul Volcker, would be included in the final bill, and may even get tougher as the legislative process continues.
"It definitely provides momentum to the Volcker Rule," said Doug Elliot, a fellow at the Brookings Institution. "It's just one of the things that affects the political environment. It clearly has an impact at having people mad at Wall Street and giving Democrats momentum for reform."
Kevin Jacques, a finance professor at Baldwin-Wallace College, said the impact could go beyond Volcker and build momentum to restore the Glass-Steagall Act, which created firewalls between banking and securities in the 1930s and was repealed in 1999.
"It goes above and beyond the Volcker Rule," he said. "It's another peg in that argument that we've got to separate banking from other stuff. You are starting to see more and more of that language of let's bring back Glass-Steagall. The Goldman case is a piece of that puzzle. The Volcker Rule is a piece of that puzzle."
Goldman executives testified Tuesday that they had done nothing illegal or unethical, insisting that the short positions against the housing market were simply a matter of risk management.
But many observers said that defense appeared weak, with Goldman appearing to have worked against its own clients.
"To a lot of people's eye, Goldman was taking a short position, so that's a proprietary trading issue," said Simon Johnson, an economics professor at the Massachusetts Institute of Technology and a co-founder of Baselinescenario.com. "The Goldman hearing does strengthen the case for reg reform."
Collins asked the Goldman executives whether the reform bill should include a provision that would require investment bankers to have a fiduciary responsibility to their clients. While the executives refused to endorse such a provision, Johnson said such a move would have broad political support. "Fiduciary responsibility to the client, I think that's going to be huge," he said. "Investment banks don't have that. I think they are going to have it after today."
Sen. Carl Levin, the subcommittee chairman, attempted to use the hearing as a platform to push for an even tougher version of the Volcker Rule.
Under the current reform bill written by Senate Banking Committee Chairman Chris Dodd, regulators would be asked to write rules banning proprietary trading and restricting banks' investments with private-equity firms and hedge funds. Levin's version would explicitly ban proprietary trading in the law.
Levin has received support for his amendment from John Reed, the former chairman and chief executive of Citigroup Inc.
In a letter dated April 23, Reed said that "when a firm is focused on market gain through proprietary trading, it too often will employ every available device to achieve those gains — including taking advantages of clients and putting the firm at risk."
"Refocusing our financial firms on client services will help them restore the global leadership position that has been seriously undermined by the recent crisis," Reed wrote.
But Goldman executives opposed the Volcker Rule.
"There are issues with the Volcker Rule ... issues with what it would do with the competitiveness of U.S. financial institutions," said David Viniar, the firm's chief financial officer.
During the hearing, Levin harshly criticized the Goldman executives, some of whom appeared to have trouble defending their actions.
"Instead of doing well when its clients did well, Goldman Sachs did well when its clients lost money," Levin said. "Goldman clients were seen as objects for its profit."
Lawmakers accused Goldman of failing to alert clients to adverse deals and questioned whether it had a duty to let them know what kind of investments they were buying.
One exchange was particularly remarkable if only for the fact that a senator repeatedly used profanity. "You didn't tell them you thought it was a 'shitty deal'? " Levin told one witness, referring to an e-mail from a Goldman colleague that described it that way. "You knew it was a 'shitty deal.' … Should Goldman Sachs be trying to sell a 'shitty deal'? "
In its defense, Goldman's managing director of the mortgage department, Michael Swenson, said the investment bank's activities did not cause the financial crisis. "There are things we wish we could have done better, but I don't think we did anything wrong," Swenson said.
Lloyd Blankfein, Goldman's chairman and chief executive, defended the company in his written testimony: "We didn't have a massive short against the housing market and we certainly did not bet against our clients. Rather we believe that we managed our risk as our shareholders and our regulators would expect."
The regulatory reform bill is stalled but still expected to pass the Senate soon. Democrats tried again Tuesday to bring the bill up for debate on the Senate floor, but Republicans remained opposed. (See related story.)