Commentaries

Goldman Sachs says sorry

Wall Street’s response to public criticism has mainly been exercises in “never apologize, never explain.”

Which makes today’s mea culpa by Lloyd Blankfein all the more extraordinary. Bloomberg News reports:

“We participated in things that were clearly wrong and have reason to regret,” Blankfein, 55, said at a conference in New York hosted by the Directorship magazine. “We apologize.”

Such a simple and direct admission should have been made by a number of financial executives months ago, but it is to Blankfein’s credit that he has made it even as the pressure on Wall Street from Washington seems to be diminishing.

Reining in bonus pay and doing more on the charitable front would go a long way toward improving the image of a firm that is still associated in the public’s mind with a large vampire squid. But these words from Blankfein will be felt just as keenly.

The commitments committee

The bursting of the dot-com bubble pales in comparision to the financial crisis. In retrospect, it seems a comic-book lesson about the all-too-obvious consequences of irrational exuberance: What were they thinking?

Yet the Internet bubble was in many ways a warm-up for the much larger credit bubble. The common thread, Jonathan Knee, a senior managing director at Evercore Partners, writes in DealBook, is the enabling role played by financial institutions.

In both crises, a bank had to agree to sponsor the poisonous security, whether shares of a profitless dot-com or a risky debt instrument. Banks leave such decisions to the commitments committee, a “once-hallowed, almost sacred institution.” Knee says:

The seriousness with which these firms undertook decisions to underwrite reflected not only a self-interested preoccupation with the long-term value of their own reputations but a genuine belief that they were playing an important role in protecting the overall integrity of the financial markets.

The fundamental question asked by commitments committees was: should their respective institutions sponsor a particular security? It was not just a cynical assessment of whether there was a market for the stock or bond issuance at hand.

“The Internet boom,” Knee contends, “marked a wholesale break with this tradition.”

Knee, the author of “The Accidental Investment Banker,” sounds almost misty-eyed in recounting the standards of yore. Was Wall Street ever so upright and just? He is also not very convincing in suggesting that the recent consolidation in the financial industry should mean a return to standards because the institutions that remain “have a more deeply vested interested in ensuring the health of the overall system.” Wasn’t that also true in 2007?

Still, he is right to note that regulatory reforms in the wake of the dot-com bust failed because “none spoke to the core question of maintaining underwriting standards.”

The liquidity canard

It’s often said on Wall Street that the more liquidity there is in a given market, the better things are for investors trading stocks, bonds or commodities. And while there’s a lot of truth to that, there are times when too much liquidity can be just the wrong tonic.

After all, Wall Street’s churning-out of one subprime-mortgage backed security after another pumped a lot of liquidity into the U.S. housing market, and that simply encouraged a lot of reckless — even fraudulent — lending.

That’s why I’m not impressed with the securities industry’s main defense of computer-driven high-frequency trading, which essentially is that all this lightning-fast trading provides liquidity and better prices for investors.

It’s a hard argument to swallow when you consider that many high-frequency trading programs are simply engaged in trading the same stock thousands of times a day in less than penny increments. Now maybe all those rapid-fire automated trades are getting better prices for some investors. But when a broker excessively buys and sells securities to generate higher commissions, it’s called churning, and that can result in an investor lawsuit or a regulatory sanction.

Indeed, when fast-fingered day traders were doing much the same thing as today’s high-frequency traders — albeit without the benefit of a sophisticated algorithmic program to guide them — Wall Street’s biggest firms were quick to dismiss them as either amateurs or rogues who were causing unnecessary volatility in the price of tech stocks.

So with critics raising legitimate concerns about the potential of a rogue algorithm sparking an unintentional market meltdown, the notion that high-frequency trading is OK because it creates more liquidity simply won’t wash.

If the main purpose of all that extra liquidity is to simply make fat profits for high-frequency traders at Goldman Sachs, UBS, GETCO, Citadel Investment Group and Interactive Brokers, that’s liquidity the markets can do without.

Wall Street’s $4 trillion kitty

The Obama administration’s plan for reining in derivatives leaves unchecked one of Wall Street’s dirty little secrets: the ability of a derivatives dealer to redeploy cash collateral that gets posted by one of its trading partners.

On Wall Street, this practice of taking collateral and reusing it is called rehypothecation. In essence, it’s a form of free money for derivatives dealers to use as they please — even to repost it as collateral to finance their parent company’s own borrowings.

And we’re talking big bucks. The International Swaps and Derivatives Association recently reported that derivatives dealers have taken in $4 trillion in collateral from their trading partners. That’s an 86 percent increase over the $2.1 trillion in cash collateral those same dealers reported having on their books in early 2008.

Now it’s not surprising that investment firms took in more collateral from their trading partners over the last year, when the financial markets were in turmoil. Cash collateral is one way for derivatives dealers to protect themselves against the risk of a trading partner defaulting on one of these sophisticated financial contracts.

There’s nothing wrong with a dealer taking legitimate steps to insure an orderly unwind of a busted trade.

But Wall Street firms should not have free license to reuse this collateral any way they see fit. The Obama administration should revise its proposal to require derivatives dealers to hold all cash collateral in segregated escrow accounts that can’t be reused or touched by the dealer.

The same rule should also apply with any collateral that is posted with a regulated exchange on which a derivative contract gets traded.

Shock! Goldman favours big clients

Susanne Craig uses 2,200 words in today’s Wall Street Journal that state the obvious: Goldman Sachs treats big clients better than small ones.

In any other industry, a company giving favourable treatment to its best customers would stand accused of nothing more than sound business practice.

So it is a measure of the dysfunctional state of Wall Street investment research – not to mention the frenzy of interest in the vampire squid – that Goldman’s activities are considered worthy of such scrutiny.

Here’s the nub of Craig’s case:

Every week, Goldman analysts offer stock tips at a gathering the firm calls a “trading huddle.” But few of the thousands of clients who receive Goldman’s written research reports ever hear about the recommendations.

At the meetings, Goldman analysts identify stocks they think are likely to rise or fall due to earnings announcements, the direction of the overall market or other short-term developments. Some of their recommendations differ from ratings printed in Goldman’s widely circulated research reports. Some Goldman traders who make bets with the firm’s own money attend the meetings.

Investment analysts who say one thing and write something else risk comparison with Henry Blodget, the Merrill analyst who achieved infamy by slapping “buy” recommendations on internet stocks he privately admitted were worthless. Blodget’s private emails were vital in Eliot Spitzer’s crusade against analysts that led to the Global Settlement with Wall Street.

The Spitzer reforms meant analysts could no longer help their employers in drumming lucrative corporate finance work. So they had to justify their existence by generating research that would help clients make profitable trades.

July: It rained, the deals didn’t

With stock markets on the rise and some signs of economies steadying, if not recovering, investment bankers have recently sounded more optimistic about the prospect for deal-making for the second half of the year.

This month? Not so good.

July, with just $96 billion in announced deals around the globe, is the first month to have less than $100 billion in worldwide M&A since September 2004, reports Thomson Reuters Deal Intelligence. No deal was more than $5 billion, the first time that has happened in a month in nearly six years. (The biggest announced merger was in Japan, the $4.4 billion acquisition of Nipponkoa Insurance by Sompo Japan Insurance. The biggest U.S. acquisition was Sanofi-Aventis’ $4 billion offer for Merial.)

This August – especially after two consecutive summers of financial crisis – is certain to be slow as well as Wall Street and other financial centers go on vacation. Any pickup in M&A activity in the second half will have to start with a flurry in September.

For the entire first half, worldwide M&A totaled $1.1 trillion, a decline of 43 percent from the same period in 2008. More details from the Thomson Reuters data can be found in this post on DealZone.

Crazy money

Wall Street pay is so extreme, so removed from what nearly everyone else thinks is within the boundaries of reasonable compensation, that one can be jaded by the continued talk of sky-high bonuses. Even when the absurdity of the pay practices are pointed out — as it is in a new report from the New York attorney general’s office:

..even a cursory examination of the data suggests that in these challenging economic times, compensation for bank employees has become unmoored from the banks’ financial performance.

– some may still shrug. Wall Street will be Wall Street.

Yet the madness of the bonus culture is starkly revealed by a chart in the AG’s report that details how the nine banks that received TARP funds paid out bonuses in 2008. The huge amounts of bonus money in some cases dwarfed firms’ profits. And it’s not just the size of the payouts, but how extensive they were.

For example, Merrill Lynch paid bonuses of more than $3 million to 149 employees; bonuses of more than $1 million to 696 employees. This from a firm that lost nearly a half-million dollars per employee in 2008.

The zombie bank that is Citigroup paid bonuses of more than $3 million to 124 employees; more than $2 million to 176 employees, and more than $1 million to 738 employees. And presumbably that does not include the $100 million compensation being sought by a Citi trader.

Tax Wall Street trades

Reports of the death of the investment bank have been greatly exaggerated, as Mark Twain might have put it.

Now all the chatter is about how little things have changed on Wall Street, with trading revenues and fees from underwriting stock deals padding the bottom lines of both banks. Back in September, The New York Times ran a lengthy article headlined “Wall Street, R.I.P.: The End of an Era.”

But this week the paper of record is writing about the return of the gilded pay package at Goldman.

Of course, things are different on Wall Street. Two big investment banking competitors are gone, leaving more opportunities for the remaining players. Banks like Goldman and Morgan Stanley owe a large debt of gratitude — and maybe their very existence — to the federal government.

In particular, Goldman, Morgan Stanley and JPMorgan collectively sold more than $80 billion in government-guaranteed debt. The government-backed bond sales enabled the banks to raise desperately needed capital at a time when investor confidence was at an all-time low.

It’s amazing what a big bank can do when it’s all but got the full faith and credit of the U.S. government behind it.

The big trading gains at Goldman and JPMorgan also should put to rest the notion that banks can’t generate hefty trading revenues, if forced to operate with lower levels of leverage. The gross leverage ratio — a measure of a bank’s debt to assets — dropped to 14.2 at Goldman, nearly half of what it was at the start of the financial crisis.

Leaving a house of cards with a good hand

Wall Street’s gatekeepers often make their displeasure known when reporters and columnists refer to investment decisions as “bets” or taking on risk as a “gamble,” and God forbid should you liken the entire business to a “casino.”

And yet are the skills really so different?

A case in point is Steve Begleiter, who is currently having a better run of luck at the World Series of Poker in Las Vegas than he did more than a year ago as head of corporate strategy at Bear Stearns. He is one of 27 remaining players on the final three tables, in third place with $11.9 million in chips.  Play resumes today to winnow the field down to 9.

At Bear Stearns, of course, bridge, not poker, was the preferred card game.  As Bear Stearns was melting down, James Cayne was in Detroit, playing in the spring 2008 North American Bridge Championships.

Goldman Sachs earnings call

Goldman Sachs had a blowout second quarter, exceeding high expectations on its strong trading gains.

At a time when much of the financial industry is still struggling with the legacies of debt and leverage, the success of Goldman is riveting.  Yet as Matthew Goldstein has written, exactly how Goldman makes its huge gains remains largely a mystery.   Maybe, just maybe, some light will be shed when the firm holds a conference call on the results at 11 a.m. today.  Reuters columnists will be live blogging the call here.

Member of the public can listen in by 1-888-281-7154 (sorry, I earlier gave the replay number).

And the fascination with Goldman is also about the role the firm plays in the mind of the public — as emblematic of all that is successful, powerful and suspicious about Wall Street.  Indeed as Felix Salmon noted the other day, thanks to Matt Taibbi’s Rolling Stone article,  “It’s pretty much impossible now to talk or even think about Goldman without a squid springing to mind.”

 Think squid.