Don’t bank on clients to punish Goldman

April 20, 2010

So remind me, why will clients continue to do business with Goldman Sachs?

I know, it is a stupid question; investors and corporations will continue to do business with Goldman even after the bank has been charged with an alleged fraud for the same reasons they always have: because they hope, like every gambler, to beat stacked odds and because they flatter themselves that they are not the sucker at the table.

There is also the small matter that for most of the clients of Goldman — or more particularly the people at those institutions making decisions — the money really isn’t theirs but the rewards definitely will be.

Goldman has been charged by the Securities and Exchange Commission with alleged civil fraud for, among other things, failing to disclose a juicy detail to investors in a security it helped to create — that a hedge fund firm that was betting against the security also played an important role in selecting the underlying instruments on which its performance was based. A bit like selling tickets for a ride to the moon on a rocket designed by an engineer who had bought insurance that would pay off when the rocket exploded, as it did, more or less on the launch pad. It meets my definition of material.

Goldman appears to understand its clients and their motivations and thus has decided to fight the case, maintaining that the way in which it operated in this instance is just fine. The strategy, I would guess, is to hope to beat the rap on the basis that this is how business is done and wait until outrage is, as it always is, overtaken by greed. Either that or the people who are making the decision to fight are the same ones who would have to step down if they admitted they did not or could not manage the risks of a large complex institution.

“I do not believe that institutions will stop trading with Goldman Sachs over this issue. The company’s presence, systems, capital, and expertise in trading markets make it number one in the world in this activity. It cannot be easily replaced. Similarly, I do not believe that the company will lose its corporate customers,” Dick Bove, bank analyst at Rochdale Securities, wrote in a note to clients.

Regardless of whether the actions of Goldman meet a legal hurdle of fraud, they very easily clear a very low hurdle of immoral and unethical behavior. Seriously, would you let these guys repair your car or treat your house for termites? And yet, still they come.

THERE OUGHT TO BE A LAW

This all reminds me of one of the many impossible things that Alan Greenspan used to believe every day before breakfast; that markets would self regulate because firms would value their own reputations and that other market participants would, if they did not, shun them for failing to behave well.

That may work in small communities or in areas where buyers and sellers of services don’t earn life-changing money in short periods. Perhaps Greenspan’s old world view worked, if at all, only back when Glass-Steagall and other regulation kept investment banking and banking separate and minimized complexity. In those days the fortunes that could be made were substantial but most of the value, especially for people working at a partnership, lay in the long term, which made reputation important.

So, Goldman’s behavior, and that of its feckless clients too, demonstrates that more regulation and enforcement is needed. That perhaps, is where the Goldman as bad guys narrative threatens to mislead.

The incident in question is classic late-stage behavior, it is the kind of bad actions that happen in the waning days of a bubble when all of the easy trades and deals have already been done. Trust me, the industry will soon be making the case that this was a one-off done by a bad apple, that it is covered by existing regulation, or even that disclosure laws for the creation of certain highly complex securities should be tightened up. All of which may well be true and none of which will matter much until we are nine-tenths of the way through the next bubble.

The real prize, and there is not much evidence that the Goldman affair leaves us much closer to it, is wide-ranging and deep regulatory reform that limits size, limits leverage, separates — with an ax preferably — investment banking from utility banking, and, not least, removes conclusively the presumption of public insurance of private risk taking.

What is currently on the table is so far from that that Goldman’s woes will probably prove only to be a sideshow, or, if you like, a circus.

11 comments

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Good article James,

Eventually, those who lose money will do something about it, one way or another.

Societies can function very well without investment bankers, but no society can make it without trust and basic ethics.
Financiers should take this into consideration.
Lawmakers seem to have understood it already.

Posted by yr2009 | Report as abusive

Limited risk (i.e., backed by the full faith of the U.S. Government) coupled with the potential for unlimited reward (i.e., no profit caps) makes for a very broken system.

Posted by lcabrera80 | Report as abusive

That anyone would still throw in their lot with Goldman – or any other similar white-collar clip joint – bespeaks greed, indeed.

But not just any old greed: the sort of greed that’s, putting it mildly, morally indictable. Such people and every vestige of the system contaminated by them in the wake of Glass-Steagall’s repeal are beyond redemption.

Posted by HBC | Report as abusive

The moon rocket analogy is the best in a long time, in fact the best.

Posted by Ghandiolfini | Report as abusive

Great article!

Posted by DanToronto | Report as abusive

Any financial manager that doesn’t have a Life Without Goldmsn plan in the works today needs the electric cattle prod motivator. This is going to spread, not go away. People are really mad ..

Posted by Woltmann | Report as abusive

What continues to amaze me is that governments continue to use GS. Rather than “handwringing” and name calling a simple step that all G20 governments could do is bar GS from government contracts/advisory/market making in government stock until they come into line.

Posted by smudger9 | Report as abusive

It is fraud pure and simple. Text book case of fraud if the facts are as stated.

Lets not let our love of GS cloud our thinking and want to stand up for them no matter what they do.

The SEC always starts cases out this way and end with the DOJ with criminal cases as criminal cases require a higher standard of proof and are much harder to prosecute. The tactic is to always start with the simplest easy to understand case, since this will be a jury case.

But regardless of the SEC case those who lost because of this deal can now go for damages against GS based on the more simple information the SEC has gathered, that could altogether exceed $1bn. They don’t have to prove fraud, only that GS was negligent in their duty as a provider of a service.

Posted by Kina | Report as abusive

$1bn versus an earnings of $how much per annum, double up from last year ?

It’s like environmental restitution fines, they have no upfront intent of fixing up the mess, unless of course in the Canadian Tundra, but the threat there is ice road truckers with their haunting laughs.

Posted by Ghandiolfini | Report as abusive

James,

Do you know anything about CDOs? It is said to be quite normal for investors in a CDO to take opposite sides of the trade. Quite normal for the investor taking the short side to also influence the form of the security. Also, the underlying clients wouldn’t expect to be told the identities of the other parties taking a position in the security.

This piece recalls an earlier article by this gentleman (still visible on the Reuters website) when James Saft was, in a rather crude and unsuccessful attempt at being amusing manner, blaming Wall Street’s errors on Asperger’s Syndrome. What these articles from Mr. Saft achieve is, in effect, simply take whatever the current hysteria is circulating amongst popular opinion without question and then make up a story.

The reason that Goldman clients will continue to support the firm is that there is no issue, no scandal, nothing here.

Posted by BarryLyndon | Report as abusive

Nice article James. What GS did was by any means unethical. Having said that, please take a moment to consider this: -

Were the firms (or people making decisions there) which bought these complex products from GS not greedy – wanting to make quick buck on exotic products? Most of these executives had a mandate: Maximum Profit. That is why they chose these products in the first place. I doubt many of them would have re-considered their decisions, for the same reason as you mentioned above – “because they hope, like every gambler, to beat stacked odds and because they flatter themselves that they are not the sucker at the table.”

When a celebrity endorses a product in the Media, but is seen publicly using a competitors product, does that not give rise to an ethical question? One may answer they are doing it for the money or any other reason – but all of that would again apply to the larger Financial system.

When a trader sells a security, it’s because he doesn’t see value in it – while the one buying it sees potential returns from the same product! Isn’t that strange?

Again, I would like to state that what GS did is unethical at best and definitely wouldn’t amount to anything more for the simple reason that – “this is how business is done”

Posted by SumantaDey | Report as abusive