This is a post I wrote earlier today at Credit Writedowns.
As I said yesterday, investment banks are institutions which do fulfil a useful role in society. I would define their role as companies where large institutions and governments receive financial advice and raise capital. Goldman Sachs is an investment bank. As such, Goldman must offer financial advisory services, capital markets origination, and secondary market support to maintain an orderly market in the markets in which it originates deals. That is what a full-service investment bank does and has always done.
In my view, the advisory business and the sales and trading functions are black and white issues.
Advisory Business
When Goldman gives financial advice to a client and executes a transaction or deal on the back of this advice, it must do so only in the best interests of the client. There are no ifs ands or buts here. The client comes first. I went into the moral and ethical obligations in my post "Inside the mind of an investment banker: Greece, Goldman and derivatives," so I will let you read that post to get a full picture there. I will just reiterate that this is a black and white issue. You simply cannot execute transactions or do deals that you know are not in your client’s interests. Full stop.
Sales & Trading
On the sales and trading side, Goldman Sachs is a market maker. That means their traditional role is to buy and sell securities principally to facilitate liquidity in the market. They are not a principal actor in this regard. As such, caveat emptor applies to their counterparties. Goldman is under no obligation to reveal its positions to counterparties in the market it makes. In fact, doing so compromises a firm’s ability to make a market. If you want to do a trade, Goldman’s only obligation is to show you a price because that’s what broker/dealers do. Lloyd Blankfein said as much in his Senate testimony. I see this as a black and white issue. They have no obligation to reveal their positions. Full stop.
Capital Markets
Then there is origination, an area where I have worked. Origination is what many firms call their ‘Capital Markets’ group. Here is where the problems begin because the origination groups are at once advisors and market-makers in their function. Your role as Capital Markets professional is to originate equity, debt, or structured product (derivative) deals for institutional clients, sell those deals to ‘buy-side’ clients, and to make a market in those instruments in the after market.
So, the capital markets guys must do deals that are in the best interests of the institutions, originating those deals. But, do they have an obligation to inform ‘buy-side’ clients of the pitfalls of those deals? Yes. 100%. This is where the problems lie in the Abacus AC1 deal that is the subject of alleged fraud. This was not a deal without a client. Paulson was the client. The synthetic CDO never would have been created had Paulson & Co. not asked for its creation. Goldman originated this Abacus deal at the behest of its institutional client, Paulson & Co. Therefore, Goldman’s obligation in the deal was to structure a deal which was in Paulson’s best interest.
The problem, therefore, is that in originating this transaction, Goldman was obligated to disclose to its initial buy-side clients what Paulson’s role in the deal was. Goldman was not selling a structured product without a client nor was it making a market in a security already originated. It was originating a deal purposely put together for a specific institution, Paulson & Co.. If Goldman did not fully disclose Paulson’s exact role – and all indications are it did not – then, at a minimum, it was not fulfilling its public purpose. The SEC has indicated this goes further – to fraud i.e. making ‘material’ misrepresentations to its buy-side clients and the company structuring the deal.
Proprietary Positions
Moving to a different track, let’s talk about ‘proprietary trading’ and the Volcker Rule for a second. What is novel in financial services is what is known in the business as "risking one’s own capital as a principal." Every major bank now is not just in the business of servicing clients in the ways I described above but also in making money as a principal actor.
This began during the 1980s when firms would risk their own capital in making bridge financing to corporate raiders like Carl Icahn during the Predator’s Ball days. One reason investment banks became so leveraged is that commercial banks had a natural advantage in this business due to their enormous balance sheet. So you saw firms like UBS, Deutsche Bank and JPMorgan muscling their way into mergers and acquisition and origination via this channel.
At some point, the banks realized that deregulation meant they didn’t have to risk their capital just for other people. They didn’t have to do deals where the profit accrued only to their clients. They could become principals, taking what they deemed to be prudent risks for their own benefit. In essence, the banks all became hedge funds and private equity groups, often competing with their clients for business.
Now, the capital markets business already presents an ethical dilemma because of the opportunity for duplicity i.e. flogging off garbage as AAA to sell-side clients just to make a buck. This goes as far as getting bad assets off the bank’s balance sheet and sticking it with buy-side clients.
But, proprietary activity raises the potential conflicts to a new level by pitting a potential client against the bank for the very same business. The bank goes from market-maker or advisor to rival who cannot be trusted. This is why the Volcker Rule has been posited. The goal of the Volcker Rule is to fashion a way to separate these proprietary activities which are replete with conflicts of interest from the more public purpose role of banks. I don’t think the legislation based on the rule drafted makes a lot of sense given how difficult it is to define what a proprietary trade is. But the concept is grounded in the knowledge that these conflicts of interest pose a risk to the financial system.
My own view is that none of this will be resolved because banks make too much money in proprietary activities. They will lobby Congress until they get legislation more palatable to their interests. Only when the financial system does collapse will Congress be forced to turn away from the banking special interests. And at that point, with populist fervour against banks much greater than it is today, much more draconian remedies will be in store.
Of course, between now and then, there will still be a lot of money to be made by individual bankers.
Update: one of the comments mentioned asset management. This is another area into which the legacy investment banks have expanded, but that isn’t a part of their traditional role.
13 comments
Comments are closed.
Heard about Ritholz’s commentary on Goldie through Honest Abe in Barron’s…
He makes 1 point, ‘The claim Paulson & Co. were long $200 million dollars when they were actually short is a material misrepresentation — that’s Rule 10b-5, and its a no brainer. The rest is gravy.’
My understanding was that the equity tranche was not part of the final deal, so not sure what the point is. The reference to Paulson being long was conditional, in some initial memo. Yes? Was it in the final structure? Don’t think so. That’s damn weak stuff. Folks didn’t read the final deal? Seriously?
The late great Mark Pittman once wryly noted that almost no one in the media knew what yield was. What do you think the odds are that these same folks have any clue as to how a structured offering is circled?
What other point does Ritholz make?
‘What you don’t see are all the emails, depositions, interrogations, phone taps, etc. that the prosecutors know about and GS does not’. Uh.. well neither does Ritholz, so again, what is the point?
For folks that have never participated in a structured bond offering, who never saw the gurus whip up iterations on the back of napkins, who never witnessed slivers of equity being presented as burnt offerings to the rating agency Gods, the current pablum narrative would appear to be unassailable.
Now I wasn’t privy to this deal getting circled but will hazard a guess as to what the equity tranche (Paulson going long in the intial) was all about…
Paulson was more than willing to put down a sliver of equity in order to secure the AAA, but once it was confirmed that the rating agencies would give the pixie dust lipstick without it, it went buh-bye…
The ratings agencies are the enemies of the people, the rest was ‘enabled’ noise.
The ‘selection’ process on almost any comparable structured product was a reverse engineering of the rating agencies ‘models’ that had been tinkered over time in collusion with their fee-paying clients for the end goal of getting the AAA on the selected pig.
Will Goldie be found greedy before guilty by an impartial jury? That first assumes you can get an impartial jury, but yeh sure why not? The whole system was guilty of this. This was the game.
However if every other bankster is not brought up on similar charges than this episode is nothing more than a political diversion, the political palliative of misdirection through scapegoating in order to quell the ‘counterproductive’ populism of bankster bashing.
Another likely scenario is that all the profitable trading moves off balance sheets and the banks will be left as govt supported conduits for the shadow banking system. Hence the next systemic failure will be the central bank and the govt.
Thanks for this clear explanation of these various conflicting roles that have proved so ‘profitable’ for the ‘credit-creation’ sector.
It seems possible that the scale and speed of transaction, along with the chaotic/complexity of the global financial network make its inevitable collapse potentially much more catastrophic than similar events that have occurred in the entire history of currencies. That’s simply a ‘swag’ hypothesis… (scientific wild-ass guess) but It seems possible that developing secondary systems would be a good idea.
While it’s not certain to be an emergent characteristic, I believe the Individually-controlled/Commons-dedicated Account and the resultant network has potential to act as such a seed structure without directly interfering with the current systems (which remain essential).
Speaking of financial system collapse…
I recommend my friend David Brin’s prophetic novel “Earth” which takes place in about 2035 which assumes a previous “Helvetian War” arising out of a sort of global cathartic realization that the whole money system was a house of very biased cards.
BTW, along with Dr. Brin, I’m starting to have hope that a fairly bright group are starting to take my little idea seriously with the recent joining to my linkedIn network of founders at the Sunlight Foundation and the Personal Democracy Forum (at least as regards its potential in networked citizen lobbying) . But I’m not experienced as an entrepreneur and if there are any here with experience in that I’m going to need help with it soon I think. Or a helpful explanation of why I’m an idiot for the idea…
http://www.linkedin.com/in/culturalengineer
One thing Goldman didn’t mention was their asset management and investment banking divisions. All the guys testifying were talking about being market makers. It made whole of Goldman look like they didn’t care about their clients. shame
Note the disclosure posted for this deal earlier here. http://www.nakedcapitalism.com/2010/04/leaked-goldman-presentation-on-abacus-trade.html (on page 9) Which essentially says Goldman can take any position on the securities it wishes and create any derivates on the position with anyone it wants to as well as ACA can. After you read the disclosure, it becomes unclear why anyone would do business with goldman who had 1/2 of a brain. Essentially it says we can screw you in any way we want to in the market and thats life. The purchasers were supposed to be sophisticated investors, but evidently as the big short suggests no one reads the disclosures as they are only for the autistic to read.
But, proprietary activity raises the potential conflicts to a new level by pitting a potential client against the bank for the very same business. The bank goes from market-maker or advisor to rival who cannot be trusted.
Thanks, Yves.
One of the things that I found fascinating about the Goldman hearings, was the way that Blankfein didn’t even seem to comprehend that this might be perceived as a problem. His subordinates exhibited the same cluelessness.
“Will Goldie be found greedy before guilty by an impartial jury? That first assumes you can get an impartial jury, but yeh sure why not?”
Forget about ‘jury’! Can you find an impartial person in this Society, where 99% of the populace is affected by the ‘Goldie touch’?
I am sure, if there are ANY impartial banker out there, there could be impartial jury!
(LOL!)
There ya go…Goldie needs a jury composed of banksters.
I don’t know, I guess I’m just not as interested as I used to be in a segregation of the allegedly “legitimate” business ventures of a Mafia syndicate from the illegitimate ones.
Let’s see, the Corleones import olive oil and that’s mostly legit, but they also perform contract murder, that one’s iffy….
(I have no doubt at all that olive oil is infinitely more socially useful than anything any purely parasitic hedge fund like Goldman does.)
VV,there is a long history of subprime mortgages.When properly underwritten and appropriately priced they are entirely suitable as an investment.They also traditionally were refinanced into “prime” loans by people who had managed to get their lives back on track.Not as often as the industry claimed,but often enough to make the subprime market a benefit to society.Tanta discussed these issues in her Ubernerd posts,still available on “Calculated Risk”.None of the Mortgage products (except ninja loans which were only about fraud) that have been part of this mess are inherently bad.They were simply used improperly (affordability products?!?),badly if at all underwritten and the risk was mispriced,deliberately.
Edward – this is a great piece. You raise some interesting points.
For example, I had never considered Goldman’s obligation to fulfill its role as a market maker in the debt instruments it created. Yet they were obviously creating assets that they knew would not retain value long enough for a secondary market to develop.
Here’s the evidence:
Economist Gary Gorton is the genius who supposedly aided AIG by creating the program they used to price their credit default swaps. In a report titled The Panic of 2007, Gorton makes this statement:
“The defining characteristic of a subprime mortgage is that it is designed to essentially force a refinancing after two or three years.” (p. 12)
http://www.kc.frb.org/publicat/sympos/2008/gorton.08.04.08.pdf
So the first conclusion we have to draw from this statement is that the defining feature of a subprime loan is that it will either be prepaid, or it will probably default. Those characteristics do not lend themselves to a security that will hold much value over time. Obviously Goldman Sachs had to have known this – especially since the consultant to their CDS counterparty knew it.
This leads to some even more interesting questions, such as did Goldman disclose this fact to investors? (Probably not – who would have bought the securities knowing this in advance?)
Of equal importance is how could Gorton have created a model to price CDSs for AIG that made any sense given the very high probability of either prepayment or default?
Gorton knew these loans would not perform over the long term. Why would he be involved in a venture that exposed AIG to billions of dollars in risk that they clearly had insufficient capital to cover?
Why would Goldman contract with AIG knowing these same facts?
So Goldman Sachs deliberately created securities that they knew would be worthless after two or three years, and conspired with AIG to create synthetic CDSs in order to insure that they – Goldman – would profit from the deals, which naturally meant that everyone else would lose.
Is this not a type of “material misrepresentation” that rises to the level of fraud indicated in the Abacus AC-1 deal? And if so, then ALL of those CDOs were fraud.
This whole thing is absurd. Its like giving a crack addict more money because he said he needs it.
1. Investment banks self deal (ie screw you, your not my client)
2. Rating agencies are in their pocket because they need the fees.
3. Bets go south, taxpayer bailout.
4. All these guys are so smart we need them to get us out and prop up economy so they can pay us back, so keep paying them.
5. Politicians need bankers for big contributions.
6. WAIT!!! Politicians need our votes. ANY POLITICIAN THAT DOES NOT BREAK UP THIS CRAP IS NOT REPRESENTING US.
Bankers you lost your privileges, you have proven you are not that smart( well you are you just went too far and got caught). BAD DOG. Are you really prepared to face the tyranny of the masses, or better yet a bunch of pissed voters and a bunch of Plaintiff’s attorneys?
I think people miss the point about Goldman’s public purpose. They are far, far higher than a public purpose. One could say they have a spiritual purpose, or even a divine role in the Universe. Because, after all, they are “Doin’ the Lord’s work”, aren’t they?…lol
Vinny