By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)
Barclays Bank’s admission that they “fixed” money markets rates and JP Morgan’s admission that so called hedges were “incorrect” are merely symptoms of a deeply compromised global financial system. Significantly, even The Economist, sympathetic to capitalism and finance generally, resorted to the word “banksters”. Something is rotten it the state of global finance.
In his 1933 inauguration address, Franklin Delano Roosevelt attacked the “callow and selfish wrongdoing” in banking and business. Roosevelt told the crowd of over 100,000 that attended that the “rulers of the exchange of mankind’s goods have failed” and that “unscrupulous money changers stand indicted in the court of public opinion”. Some 80 years later, the money changers have not “fled their high seats in the temple of our civilisation”. “Ancient truths” have not been restored to that temple. Something corrupt and rotten continues to fester at the heart of high finance, economic life and, indirectly, modern society.
Mr. Smith Speaks….
On 14 April 2012, former Goldman Sachs Executive Director Greg Smith recorded a very public and sensational exit interview in the opinion pages of the New York Times.
The letter criticised “toxic and destructive” practices and cultures within Goldman Sachs, one of the world’s largest, most important and influential investment banks. The criticism focused on practices that exploited clients and put the interests of the bank first. It alleged a culture that was focused on getting clients to invest in securities or products that Goldman was interested in getting rid off. The letter highlighted the use of complexity to confuse clients and the focus on highly profitable and (sometimes) unsophisticated clients who did not fully understand the risks of the transactions that they were being encouraged to enter into.
The most-noteworthy farewell speech since the film Jerry Maguire has been parsed as an expose of the alleged practices of his former employer. It is more subtle, highlighting a deeply flawed financial system as well as the poisonous and brutal culture of modern financial institutions.
Unfortunately, it is doubtful that it will follow the same trajectory as Frank Capra’s 1938 film Mr. Smith Goes to Washington, about a single honest man’s effect on American politics.
Questioning Mr. Smith….
Following publication, most press coverage focused on the use by Goldman Sachs staff of the term “Muppets” to describe clients. In reality, the term is mild. In his book about his experiences at Morgan Stanley, former derivative salesman Frank Partnoy captured the relationship between bankers and their clients more colourfully: “The sell side [banks] hang up and say ‘f*** you’! The buy side [clients] say ‘f*** you!’ and then hang up.”
Mr. Smith’s primary concern -the failure of Goldman Sachs to give priority to the interest of its clients- appears naive. He ignored the firm’s history, perhaps choosing to believe the statement of Goldman Sachs CEO Lloyd Blankfein that the firm does “God’s work”.
After the 1929 crash, a US Senate hearing investigated the Goldman Sachs Trading Corporation, a listed investment trust floated by the firm to its clients:
Senator Couzens At what price [was it sold to the public]?
Mr Sachs $104 …
Senator Couzens And what is the price of the stock now?
Mr Sachs Approximately 1¾.
In June 1970, when Penn Central Transportation Company, the nation’s largest railroad, defaulted on its debt, Goldman Sachs was found to have sold the company’s debt to clients at face value when aware that the borrower’s financial position was deteriorating. The investment bank forced the company to buy back its own holding of Penn Central debt. None of Goldman Sachs’ customers were made a similar offer.
In 2010, a Senate investigation and SEC action highlighted suspect practices surrounding the sale of mortgage backed securities, known as the ABACUS and TIMBERWOLF, to “widows and orphans”. The firm paid a record $550 million fine to the US Securities and Exchange Commission (“SEC”) to settle the allegations. In April 2012, Goldman Sachs paid $22 million to the SEC to settle charges that it allowed select clients to receive non-public information about stocks – a practice known as “huddles” or “Asymmetric Service Initiative”.
In both transactions, Goldman Sachs appeared to display a familiar disregard for client interests.
Mr. Smith appears not to have done proper due diligence on his employer. It is also surprising that it took him some 12 years to identify the problems of Goldman Sachs.
Mr. Smith’s personal motivation –stated as “a wake-up call to the board of directors”- is unclear.
The timing of his resignation in March 2012 was presumably to ensure that his bonus check cleared. It suggests that Mr. Smith did not dislike the firm or its practices enough to give the money back.
The opinion piece reads like a job application. It recites Mr’s Smith’s personal credentials – Stanford University (on a scholarship), a Rhodes Scholar finalist, a bronze medal for table tennis at the Maccabiah Games in Israel. It also recites his professional achievements – advising clients with total assets of more than $1 trillion including two of the largest hedge funds on the planet, five of the largest asset managers in the United States, and three of the most prominent sovereign wealth funds in the Middle East and Asia. He fails to mention that his outburst may contravene non-disclosure and non-disparagement provisions in his employment contract.
With a book deal in the works, lucrative speaking opportunities and even consulting to his old firm to address identified culture issues, Mr. Smith’s cri du coeur could be seen as an interesting career strategy at a time when anti-Wall Street sentiment is high and financial institutions are shrinking.
An Interesting Conflict…..
Whatever Mr. Smith’s motivation, the accusations raise real issues, just not the ones being discussed. The central problem is the in-built conflict of interest in the current banking system between acting in the interest of a client and trading on the bank’s own account.
In the 1990s, investment banking shifted from a client focused business (providing advice, underwriting securities and executing purchase and sales of financial instruments) to a business trading on the firm’s own account using shareholder capital.
The change was driven by the growth in size and capital resources of investment banks, as they evolved from private partnerships into public companies or units of large commercial banks. It was also driven by shrinking margins on traditional activities, such as lower commissions and underwriting fees, and the need for new sources of revenue to meet investor return expectations.
Investment banks feared that the separation of client business and trading with its own capital would limit their ability to compete. Under CEO Lloyd Blankfein, Goldman Sachs embraced the conflict, emphasizing intelligence from trading with clients and other banks to place bets with its own money.
Major investment banks sought to become “flow monsters”, capturing a dominant proportion of trading volumes to assist their proprietary activities. To achieve this, banks used cross subsidies to attract certain clients. Execution or market-making and credit facilities to finance large hedge funds that were a source of significant trading volumes were provided at subsidised prices. In an insidious process, this created pressure to increase trading volumes even further as well as increasing reliance on proprietary revenues to meet shareholder return targets.
The best research was channelled to support proprietary trading. Client research increasingly became devalued, evolving into mere puffery – a sales aid for selling products or the firm’s inventory to the clients. Products were designed and sold to assist investment bank’s proprietary traders to take positions, sometimes at the expense of clients unaware of the risks.
The shift was cultural as well as economic. In her 1999 book Goldman Sachs: The Culture of Success, Lisa Endlich, a former Goldman Sach employee on the trading side, makes snide comments about the “feeble and hidebound” traditional investment banking culture, with its focus on the client. The trader culture, which Endlich celebrates, involves a transactional business model which is isolated from clients and highly results oriented. Deals and profits dominate at the expense of client interests and relationships, a practice known as “scorched earth banking”.
The success of the trading model can be seen from the fact that the path to the executive suite of an investment bank these days originates in the trading room. Both current Goldman CEO Lloyd Blankfein and his deputy Gary Cohn traded metals earlier in their banking careers.
Implemented in response to the 1929 stock market crash and the collapse of the banking system, the Glass-Steagall Act of 1933 sought to prevent some of these conflicts of interest, separating commercial banking from investment banking and limiting speculation. Removal of these regulations in the 1990s was crucial in allowing the development of the current banking model.
In the early 1990s derivative scandals, such as Procter and Gamble, highlighted the problem. The Internet stock boom exposed the practices of leading investment banks in relation to stock sales and self serving research. But despite numerous enquiries, the problem was not addressed.
In 2002, America’s Sarbanes-Oxley legislation failed to address the real issue – the inherent conflict of interest inherent in integrated financial supermarkets combining commercial and investment banks.
In fact, legislators are rolling back some of the Sarbanes-Oxley provisions. The 2012 Jump-start Our Business Start-ups Act, shortened to JOBS, seeks to make it easier for companies to raise capital. The bill would end the rule that investment banking analysts could not assist in marketing new issues of shares for new offerings, except those involving companies with sales of over $1 billion. Investment banks, underwriting the issues, would not be prevented from making sales pitches or publishing research on a company during the initial public offering. The liability of investments banks will also be weakened.
New regulations, introduced following the financial crisis, do not also deal adequately with the problem. Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, known as the “Volcker rule”, seeks to restrict the ability of regulated entities to undertake proprietary trading, indirectly regulating the identified conflict of interest. The efforts of bank lobbyists have ensured that the final rule will be considerably weakened and riddled with exemptions. One lawyer told banks that “given so much of proprietary trading has a client nexus to it, I’ll be embarrassed if I don’t manage to exempt all your activities from the rule”.
In the UK, the Vickers Report considered separation of certain activities of banks. In the end, the commission did not recommend radical reforms, proposing instead to force banks to ring fence UK retail operations rather than split along different business lines.
Unless the central conflict of interest is dealt with it, banks will always be tempted to give their own proprietary interests priority to boost earning. In reality, the only way to deal with this is by separation of client and proprietary activities.
The inherent conflicts of interest and a remuneration system based around short term revenues and bonuses create a toxic ecology within banking.
Financiers deride the real world and real people who move far too slowly. Only bankers know how to get things done. In her book Liquidated, ethnographer Karen Ho cites an interviewee: “We’ve made everyone smarter. We know much more…we’re the grease that makes things turn more efficiently.” For bankers, this self-belief in their role and sense of superiority over clients justifies the ruthless and exploitative practices now embedded within finance.
In the 1970s, Pierre Bourdieu, a French sociologist and anthropologist, introduced the concept of habitus -the idea that each society and culture orders its world sub-consciously according to a cognitive framework based on its experiences. In the 16th century, the Spanish conquistadors who conquered the New World brought the ambitions, prejudices, attitudes and values of their culture. Their success shaped their habitus. Achievements were validated with riches, rank and power. Failures brought disease and death, mollified by the consolations of faith and the afterlife.
The financial elite now undertake similar conquest and plunder with scientific and economic pretensions. The Masters of Universe strut through the City of London, Wall Street, the Bahnofstrasse, Finanzplatz Deutschland, Raffles Place and Tokyo’s Marunouchi like god but in a better suit.
In his books and essays, sociologist Zygmunt Bauman uses the metaphors of liquid and solid modernity to capture the shift from a society of producers to a society of consumers. Security gives way to increased freedom to purchase, to consume and to enjoy life. In liquid modernity, social forms and institutions no longer have time to solidify into accepted frames of reference for human actions and long-term plans. Individuals have to be flexible and adaptable, pursuing available opportunities.
Liquid modernity requires calculation of likely gains and losses of acting (or failing to act) under endemic uncertainty. The readiness to discard extends to people who we do not recognise as fellow human beings – migrant workers, immigrants, terrorist suspects or, in banking, clients: “It seems all things, born or made, human or not, are until-further-notice and dispensable.”
Karen Ho in Liquidated documented the brutal culture of modern banking. Hired as the best and brightest expecting royal treatment, graduates work like indentured slaves for up to 140 hours a week. In a brutal world without job security and where performance is constantly assessed, bankers survive by trading things or cutting deals. Ho’s title evokes Bauman’s idea of liquid modernity. Bankers make assets liquid or tradable. As highly liquid assets themselves that could be easily liquidated, they live in constant fear.
For bankers, the environment is challenging, where they must adapt or die. There is an old Wall Street saying: “Never tell anyone on Wall Street your problems. Some don’t care. Most are glad you have them.” In their work, John Lennon’s song Working Class Hero provides the survival script: “There’s room at the top they are telling you still/ But first you must learn how to smile as you kill/ If you want to be like the folks on the hill.”
These forces created a culture where narrow, short-term self-interest dominates. The culture drives creation and sales of products of no intrinsic value to people who do not understand them. Fear of being liquidated eliminates misgivings about profitable transactions that might result in enormous pain for others.
Bernard Madoff preyed upon unwitting members of his religious and ethnic communities, enlisting leading figures to help promote fraudulent investments as legitimate. Pink Floyd had sung about it in Dogs: “You have to be trusted by the people that you lie to/ So that when they turn their backs on you/ You get the chance to put the knife in.”
In a famous series of experiments delivering electric shocks to people, Stanley Milligram found that: “Ordinary people can become agents in a terrible destructive process…. Even when the destructive effects of their work becomes patently clear, and they are asked to carry out actions incompatible with fundamental standards of morality, relatively few people have the resources needed to resist authority.”
In the last 20 years, bankers have become willing agents in a highly destructive process, even when they were aware of the consequences of the action. They are unable or unwilling to resist the peer pressures and ultimately the lure of wealth. It is as Marcel Proust wrote in A la Recherche du Temps Perdu: “… indifference to the sufferings one causes, an indifference which whatever other names one may give to it is the permanent form of cruelty.”
Greg Smith’s statement does not merely point to questionable behaviours at the investment bank, once tagged by Rolling Stones journalist Matt Taibbi as “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money”. As recent events highlight again, the alleged practices are widespread throughout the industry, where competitors ironically see Goldman Sachs as a role model. They are also the result of a deeply flawed and dangerous business model and culture which is poorly understood and rarely challenged.