Goldman Sachs: Banker or Bookie?

Late last week, the Securities and Exchange Commission charged Goldman Sachs with investor fraud.  It seems that they chose not to disclose all of the terms of one of their own financial products.  After reading the analysis of the events, I have just got to ask:  Are these bankers or bookies?  Goldman Sachs, among other large Wall Street firms, appears to be running a legal bookie operation, catering to clients who wanted to place large bets on the outcome of certain financial events.  You’ve heard the expression, if it walks like a duck and talks like a duck… The real question: was the game rigged?  We’ll have to wait and see.

Last month, in a post about Greed and Delusion on Wall Street, I said

It’s difficult to appreciate the amount of backstabbing, mistrust and cynicism that is endemic at Wall Street firms. “Wall Street doesn’t care what it sells.” Investment banks exploited their institutional customers (pension funds, mutual funds, banks). The same firm that is advising them on what to invest in (the sell side) also has an in-house operation that is trading for its own account. Why is this blatant conflict of interest allowed?

Incredibly, I may have actually understated the problem!  It seems to me that it is patently impossible to be cynical enough, at least about some Wall Street firms.

Why do I say that?  Well, the suit filed by the SEC alleges that Goldman Sachs put together a package of derivatives based on subprime mortgages and did not disclose that the components were selected by the party who wanted to bet against the investment, i.e. sell short.  The claim is that the security was “designed to fail.”  Please take note of the word “alleged,” meaning that they may or may not have done something illegal.  Because it’s a civil lawsuit which may take years to adjudicate, Goldman Sachs will have ample opportunity to present its side of the story.  I have complete confidence that they will hire the best lawyers that megabucks can buy.

Even if Goldman Sachs “wins” that lawsuit, they may have lost something infinitely more valuable – their reputation.  To my mind, this is no small thing, since confidence in your advisor is (or should be) of paramount importance to investment bankers, including Goldman Sachs.  I am compelled to ask one more question, though, did these bankers aim to protect investors’ interests or were they just determined to make a profit at all costs? 

What Is the Public Value of Trading in Synthetic Securities?

But as investors and citizens, it is worth pondering whether all of this trading activity has a social purpose or is it merely gambling in a more refined form.  The topic of synthetic financial derivatives is highly complex and difficult for most ordinary mortals to understand.  But Roger Lowenstein’s column, Gambling With the Economy in the April 20^th edition of The New York Times, offers an excellent summary of the arguments:

Wall Street’s purpose, you will recall, is to raise money for industry: to finance steel mills and technology companies and, yes, even mortgages. But the collateralized debt obligations involved in the Goldman trades, like billions of dollars of similar trades sponsored by most every Wall Street firm, raised nothing for nobody. In essence, they were simply a side bet — like those in a casino — that allowed speculators to increase society’s mortgage wager without financing a single house.

The mortgage investment that is the focus of the S.E.C.’s civil lawsuit against Goldman, Abacus 2007-AC1, didn’t contain any actual mortgage bonds. Rather, it was made up of credit default swaps that “referenced” such bonds. Thus the investors weren’t truly “investing” — they were gambling on the success or failure of the bonds that actually did own mortgages. Some parties bet that the mortgage bonds would pay off; others (notably the hedge fund manager John Paulson) bet that they would fail. But no actual bonds — and no actual mortgages — were created or owned by the parties involved.

The S.E.C. suit charges that the bonds referenced in Goldman’s Abacus deal were hand-picked (by Mr. Paulson) to fail. Goldman says that Abacus merely allowed Mr. Paulson to bet one way and investors to bet the other. But either way, is this the proper function of Wall Street? Is this the sort of activity we want within regulated (and implicitly Federal Reserve-protected) banks like Goldman?

While such investments added nothing of value to the mortgage industry, they weren’t harmless. They were one reason the housing bust turned out to be more destructive than anyone predicted. Initially, remember, the Federal Reserve chairman, Ben Bernanke, and others insisted that the damage would be confined largely to subprime loans, which made up only a small part of the mortgage market. But credit default swaps greatly multiplied the subprime bet. In some cases, a single mortgage bond was referenced in dozens of synthetic securities. The net effect: investments like Abacus raised society’s risk for no productive gain.

Conclusion

I find Lowenstein’s points very convincing, and I totally agree with his recommendations.
“ …the financial bailout has demonstrated that big Wall Street banks … (have) implicit bailout protection. Protected entities should not be using (potentially) public capital to run non-productive gambling tables.
… Congress should take up the question of whether parties with no stake in the underlying instrument should be allowed to buy or sell credit default swaps. If it doesn’t ban the practice, it should at least mandate that regulators set stiff capital requirements on swaps for such parties so that they will not overleverage themselves again to society’s detriment. …”

Proposed reforms by the Obama administration will hopefully rein in the questionable activities of Wall Street bankers, although, Wall Street lobbyists will naturally attempt to defeat any such reform. As I said previously, we’ll have to wait and see, but nearly a week later, no further charges from the SEC have been forthcoming. Of note, however, several European countries have commenced the filing of similar charges against Goldman Sachs.

Criticism of the U.S. Bailout Plan, Part 4

Economics Unplugged: A conversation with Professors Allan Meltzer and Marvin Goodfriend is a just released 60 minute interview which took place on April 22, 2008. Meltzer and Goodfreind, two professors of Economics at Carnegie Mellon, discuss the current financial crisis and how we got here.

As free market economists, they continue to be very skeptical that increased federal regulation and oversight will be enough to avert future problems. In their opinion, increased regulation will not work, because although lawyers write regulations and accountants enforce them, the management of banks and investment banks will always find a way to circumvent them (regulations).

Bank management has an incentive to take big risks to earn large rewards, and the rewards are incorrectly based on short term results. Meltzer thinks bank executives should be paid “on the average of their performance over five years, not quarter by quarter. There are other ways of doing that, but we have to change their incentives, otherwise we are going to have these problems.”

If you believe that better regulation is the solution to the financial crisis, you might find a different viewpoint interesting.

Their key points are:

• The main problem is that financial institutions lend on a long term basis, but borrow on a short term one. Periodically, there is going to be a problem.
• Regulation has a limited role to play in disciplining markets.
• Think about incentives when writing regulations.

Other observations are:

• The current situation is very different from the Great Depression.
• Banks have to recognize their losses and raise more capital.
• We will not know how bad the economy will get, until we see how far housing prices will fall.
• We are seeing the end of the American Century, where the United States had a dominant influence on what happened in the rest of the world.

Although this interview is almost 6 months old, Professor Meltzer recently expressed similar conclusions. On September 23rd on a PBS News Hour program, he was asked whether he thought the bailout plan was a good idea. His response, “It’s a terrible idea. It’s undemocratic. It’s bad economic policy, and it’s bad social policy. And it has a very little chance of solving the problem in a meaningful way.”

photo credit: Matti Mattila