Punishing investment bankers: the nanny-state goes global

April 19, 2010

Laurence_Copeland- Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. -

In a previous blog, I expressed the fear that in the aftermath of the financial crisis we were going to see either the innocent punished or guilty men convicted of the wrong crimes, or maybe both.

A topical case is Goldman Sachs, an investment bank which weathered the crisis better than most, only taking Fed money when all the other dominos had already fallen, repaying it extremely quickly, and facing accusations ever since of having been too clever for its own good.

The latest charge is that they foisted a type of complex securities known as Collateralised Debt Obligations – essentially, securitised mortgage packages – on their unwitting clients, in spite of the fact that the underlying assets were of extremely poor quality, as Goldman were allegedly fully aware.

If Goldman is guilty of outright deception, it should face the appropriate penalty. But here, as in many other cases we read of, the charge amounts to one of simply catering to the greed of corporate clients who ought to have known better.

As Gillian Tett says in today’s FT:

“It has long been an open secret that the [CDO] sector was so murky that it was easy for banks and hedge funds to engage in shady practices that enabled them to make a fast buck.”

If this is true, it raises the question: why were the buyers unaware of this open secret?

After all, Goldman did not sell these instruments to passers-by in the local shopping mall, or through adverts on eBay. They were sold almost exclusively to major financial institutions, often, we now find, to ordinary commercial (“High Street”) banks – the people who market themselves to the public as a source of sound, informed, disinterested advice on all matters relating to finance.

Yet they themselves appear not to have understood the most basic rule of investment prudence – don’t invest in anything you don’t understand. At the other end of the housing finance food chain stand house buyers, often from the lower tail of the distribution of wealth and financial sophistication, many of whom have since lost their homes because they were unable or unwilling to get to grips with the details of such arcane instruments as adjustable-rate and negative-amortization mortgages.

Why should financial institutions, with their armies of finance professionals, quants specialists and lawyers, be exempt from the caveat emptor principle which so often applies to ordinary folk?

Among the losers on these dodgy derivative instruments were a German bank and the Royal Bank of Scotland, which acquired them in 2007 when it finally captured ABN-AMRO after months of competitive bidding (mostly against Barclays). Even though the U.S. housing market was clearly in trouble by the time RBS triumphed in the bidding war, its due diligence still failed to spot the problem.

This is very far from being the only example of nanny state protection being demanded by outfits that ought to be capable of standing on their own two feet. A number of local governments across the Western world are said to be contemplating legal action against investment banks on the grounds that they were steered into investments that were inappropriate, given their status.

There is a precedent dating back to the late 1980s, when the London Borough of Hammersmith, which had lost a fortune on its speculative position in interest rate swaps, managed to persuade the courts to declare the contracts illegal. Again, the question arises: why can those in charge of local government treasuries not take responsibility for their own decisions?

The same question could be asked about many of those who lost money in Icelandic banks. Why did they think the Icelanders were offering deposit rates 1 percent or more higher than anyone else? The aggrieved depositors appear to have thought they could enjoy the rewards for risk-bearing without actually carrying any risk.

It is easy to understand the Icelanders’ anger at being asked to foot the bill for educating British and Dutch investors in the basics of finance – and even easier to understand why they should be incandescent at the use of Anti-Terrorist legislation against them (surely the most shameful episode of all in this Government’s handling of the financial crisis).

Let me be clear: I am not condoning deceit by investment banks or anyone else, nor am I suggesting that local authorities, retail banks, pension funds etc ought to incur the cost of acquiring inhouse expertise in derivatives. I am only saying that, if they cannot afford the stake money, they keep away from the table. If they don’t, they have to be willing to carry the risk that goes with the reward.


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