This is a post which I originally published at Credit Writedowns earlier today.
I have written a number of posts which point to a shift in the center of power on Wall Street from the client-facing advisory business to the market-making trading business. I think understanding this shift is vital to understanding what caused the financial crisis and to understanding the defense that Goldman Sachs has proffered for its actions in the Abacus AC1 deal.
What has happened is that major international investment banking groups have taken on a sales & trading ethos of caveat emptor where once the client was king. In my view, this is a direct result of the rise of securitization, structured products and derivatives as a profit center in financial services and is the major contributor to Wall Street’s new unfortunate public image as a casino.
I took on different aspects of this shift in these posts:
- Jul 2009: Goldman crushes earnings estimates
- Jul 2009: More on why big capital markets players are unmanageable
- Feb 2010: Inside the mind of an investment banker: Greece, Goldman and derivatives
- Apr 2010: Chris Whalen on "The Age of the Trader"
- Apr 2010: Is Goldman fulfilling its public purpose?
- Apr 2010: Goldman’s public purpose and where I have problems with the Abacus deal
I suggest you read them to get more colour on various aspects of Wall Street culture which have eroded the ethics of bankers and led to self-preservation over client-focus.
Here’s the statement in all of those posts I want to dwell on. It came in my post on Goldman’s earnings announcement from July of last year. I wrote:
The Goldman press release is here. What I find notable is the order in which the press release presents the earnings, with a statement on the advisory business first, followed by equities and then fixed income even though fixed income was where the most revenue and profit came. That is revealing – and shows Goldman execs still consider the advisory business of relatively more importance from a reputational perspective. (emphasis added)
Reputation is one thing, reality is another. Former banker turned journalist Bill Cohan gets at the heart of this in his recent blog post "Goldman: Still Greedy, No Longer Patient." He writes:
Once upon a time, Goldman Sachs’ raison d’etre was to serve the ongoing needs of its clients and be paid fees for helping them raise capital, trade blocks of stock or by providing merger and acquisition advice, a business strategy that made the firm for years the envy of Wall Street and immensely profitable. This strategy forced Goldman’s bankers to be “long-term greedy” — a shopworn phrase coined by a former senior partner, Gus Levy — and to do everything possible to stay in their clients’ good graces in order to have a legitimate shot at the next fee. While it was not exactly backbreaking — or the Lord’s — work, from one year to the next nothing was assured unless the Goldman partnership maintained that fragile bond of trust.
Nowadays — although the firm’s chief executive, Lloyd Blankfein, would never (and probably could never) concede the point — Goldman’s mission, along with its argot, have changed. This shift is not doing the firm or its boss any favors. As was made abundantly clear during Tuesday’s 11-hour Goldman Sachs-athon on Capitol Hill, the bank has eschewed its client-focused ethic in favor of “making markets” for its trading “counterparties.” It is no coincidence that not one of the seven current or former Goldman professionals grilled by senators in the hearing is, or ever was, a banker; most came from the trading floor. A generation ago, it would have been inconceivable that not one of its senior bankers — the people who actually meet with clients and help shape their long-term futures — would be representing the firm on such a critically important public stage.
A quick look at the economics of Goldman’s business explains why things have changed so dramatically. Bringing to a close a multibillion-dollar merger or underwriting a bond issue can take months, if not years, and might entitle the firm to a fee in the millions or tens of millions. By contrast, Goldman’s bet against the mortgage market — engineered in just two months at the end of 2006 and the beginning of 2007 — made the firm a profit of nearly $4 billion alone in 2007. No wonder Team Goldman spent so much time Tuesday speaking the language of traders.
Exactly right. Goldman is run by traders now, not bankers. This shift is evident everywhere else on Wall Street and the City of London. And I would put derivatives front and center. Last month in the Abacus post linked above, I outlined the three core functions of an investment bank, advisory, origination, and sales & trading. I argued that the ethical duties in two of those functions, sales & trading and advisory, are black and white. The third function, origination is more murky because it contains elements of each i.e. the client facing advisory function and the market-making sales & trading function and almost always, this has been where the problems have occurred – specifically because of derivatives.
Back in the 1980s, before we had proprietary trading or asset management or private equity at investment banks, and before big American commercial banks became players in investment banking, investment banks only had those three core functions. And the product offering was small: stocks, bonds, and commodities. SO, the object of a bank was to offer clients corporate advice and then originate deals and securities based on that advice, making a market in those securities in the secondary market. That’s it, folks. It was a profitable and simple business.
But somewhere along the line, securitization and OTC derivatives changed this. What happened is that the origination or capital markets function became more aligned with the sales & trading group than the advisory group.
For example, say you have a client who wants to buy a firm. Your mergers and acquisition group would work with the client to give advice on how to do the deal, working with the capital markets group to issue stock or bonds to facilitate the transaction. The capital markets guys would work with the sales & trading people to find customers for the securities and price the deal. Afterwards, the sales & trading people would make a market in the security, buying and selling for institutional clients in the secondary market. Notice the flow from advisory to capital markets to sales & trading.
As interest rates dropped in the 1980s, two investment banks, Salomon Brothers and Drexel Burnham Lambert, came of age which blurred these lines. Salomon was a trading house. It was not in the same league as a Goldman, Morgan Stanley or First Boston in the advisory side of the business. Salomon made the lion’s share of profits from government and mortgage bonds. Drexel was a second-tier firm, but still more weighted toward the advisory side until Michael Milken’s high yield bond group tilted things toward origination and trading of junk bonds. And, as interest rates dropped, all of these businesses became hugely profitable. Lehman Brothers and Bear Stearns were two other trading-dominated firms which also rose on the back of the cultural shift.
The key in all of this was that a lot of new business was linked to issuing securities even if it originated in the advisory business. The model went from advise- originate- make market to (advise)- originate- make market. And so the origination of securities became aligned with selling and trading them instead of advising clients. And the appetite for new products increased.
Of course, there were only so many bonds and stocks one could sell (think of Pets.com or PSINet), so naturally most of the new products were derivatives. In structured products, the mortgage-backed securities model was expanded into every conceivable asset class – remember David Bowie’s Bowie bond issue? And OTC derivatives became an immense source of revenue when it was clear they would not be regulated.
So, naturally, the traders became more and more dominant. They already were the power center at firms like Bear Stearns and Lehman Brothers. But, eventually they came to dominate all of the major investment banking groups from Goldman to Deutsche Bank to UBS to Merrill Lynch.
So when you hear Lloyd Blankfein, a former trader, saying "I don’t believe there is any obligation" to tell buy-side clients when Goldman is taking a position against them, that’s the genesis of it. When you read Goldman’s quarterly statement and see that the majority of the profit comes from sales & trading, that’s the genesis of it. And when you see Wall Street’s most venerated firm before the Senate lambasted for ethical duplicity, that’s the genesis of it as well.
When Lloyd Blankfein said:
We advise companies and provide them funds to invest in their growth. We work with pension funds, labor unions and university endowments to help build and secure their assets for generations to come. And, we connect buyers and sellers in the securities markets, contributing to the liquidity and vitality of our financial system.
He was hearkening back to the days of glory under John Whitehead. But those days are long gone. Blankfein got the order wrong. He should have said:
We connect buyers and sellers in the securities markets, contributing to the liquidity and vitality of our financial system. And, we advise companies and provide them funds to invest in their growth. We work with pension funds, labor unions and university endowments to help build and secure their assets for generations to come.
Hawking securities to clients and making a profit from trading those very same securities is job number one on Wall Street. Welcome to the Age of the Trader.