(This post appeared at New Deal 2.0.)
This is a criticism of Goldman — or an explanation of Goldman-like behaviour — from a Goldman admirer. I admire the company, its people, and the quality of its work. I think it is a great company and unique for its industry in its ambitions to be a good company. It is probably one of the two best financial businesses in the world. I also think that Goldman’s behaviour and point of view suggests something larger about the finance sector and its place in our economy.
First, the facts around the Goldman/SEC matter don’t seem to be much in doubt. There were a series of issues of synthetic CDOs constructed by Goldman working with John Paulson (the famous hedge fund owner who made no secret of his desire to short sub-prime mortgages). These were sold to investors who were not told very much of Paulson’s role. Paulson did short them; the investors did lose money. Goldman thinks it did nothing out of the ordinary here and that any other finance company would have done the same thing; the SEC says it committed a crime. I agree with Goldman.
Second, it is important to understand the culture of a deal/trading business. These are not the relationship businesses of decades ago built on trust and service. Every older, retired investment banker you talk to will lament the loss of “relationship banking.” Not a single younger banker — say, under 45 — will have a clue what you are even talking about. To say it again, these are deal/trading businesses. There are all kinds of jokes about the cultures of these businesses — “If you want a friend, get a dog”; or “What is a client for, except to stuff bad securities into?”; “I want partners with a feral instinct for profit” — but the ground truth is that these companies are transactions businesses, they are made up of people who do deals; they are, institutionally, a composite of many, many deals; and their cultures are built around the winning and losing of all of these deals. A consequence is that these kinds of companies see the world as divided into predators and prey and, lest you be in any doubt, Goldman partners are not prey.
Playing in this world is a bit like playing with tigers. Every once in a while a child slips through bars of a zoo and goes to play with the tigers and is invariably eaten. The tiger is then shot. But the tiger was just doing what tigers do, and “what tigers do” does not include considering the child’s interests. If you — an investor — choose to play with Goldman, you will get exceptionally good service but understand that the odds of Goldman considering your interests deeply are roughly the same as the child and the tiger. Not to put too fine a point on it, but that kid investment banker who put together the now famous CDO deal did not think his career would turn on how empathetic and caring he was about investors.
Third, it is unlikely that Goldman will lose to the SEC in this dispute or settle with the SEC. The deal was legal, the securities were legal, and the marketing looks to me to have been legal. Everyone who bought into these deals had to know that their only purpose was to provide a way to bet for or against bad mortgages. There was no one hunting for absolute return here. In my mind, given all of this, the legal issue is going to turn on a very subtle question: did Goldman secretly construct this security so that it was much more of a one way bet than investors were led to believe?
That is a very hard case to make and barring clear evidence that makes this case it feels like a stretch to argue that Goldman violated disclosure laws. At the same time I doubt if Goldman will settle. Its reputation has taken a big hit, and it cannot afford just to let this lie there in the background with a vague settlement. The SEC has taken a big risk with this case.
So, fourth, if this is not a legal issue, is that all there is to say about it?
I was going to say in this blog that Goldman — perhaps uniquely, given its ambitions — should be ashamed of itself. But a whole raft of conversations have convinced me not to say that. Goldman doesn’t have permanent interests like clients anymore; like all other trading companies it has deals and trades. (The younger investment bankers I talked to found it incomprehensible that the thought would even arise.) Of course, these companies will trade against their clients; of course they will construct one way bet securities; of course they will work with Lehman to create ways of hiding major balance sheet problems; of course they will help the Greek government report misleading financial statistics; and of course they will reverse engineer rating company models to establish artificially high ratings. That’s all just life out there with the tigers.
I think a big global financial market needs these kinds of companies. I see them as heat-seeking missiles targeted at over-priced, over-hyped stocks and bonds, at flaws in governance and regulation, and at bad corporate management. They also go long — hunting opportunities others won’t risk, and seeing innovations long before others do. Overall — “net, net” as they say in the game — they make markets more efficient at lower cost than any other way. (Although the cost and the compensation is way out of line, but I will focus on that in a couple of days.) It’s good to have wild tigers out there. You just don’t want to be tilling your field real close to their habitat.
Which is my point. It is insane to have a public policy allowing the mixing of these kinds of businesses with more agriculture-like banking businesses, with clients who need to trust their bankers with savers and genuine borrowers. (This is not sarcasm. People in real business can’t spend all their time figuring out how to outrun tigers.) These cultures don’t mix. And they haven’t in the big mergers. In every real case I know of, this cultural gap remains unbridgeable. Back when the tiger businesses were relationship businesses focused on mergers and acquisitions and strategic advice to CEO’s, allowing these combinations maybe made some sense or did little harm. But no one noticed as these businesses became deal/trading businesses. And in these circumstances the combination is dangerous.
It is insane to encourage inordinate leverage in these businesses, or allow anyone to think in any way that the risks of these businesses are back-stopped by the taxpayer. All leverage does here is allow the amplification of trades and risks; and combining high leverage with a taxpayer guarantee is lethal. Let the tigers be tigers but don’t give them a nice comfy home at night.
And, it is probably wrong to have these businesses structured as limited liability public equity companies. But, then, if a normal common shareholder wants to bet that she has well aligned interests with one of the tigers — or partners — who the shareholders have granted unlimited upside and not much downside, good luck. I’m not making that bet.
So I’m completely with my friend Paul Volker. The big divide that has emerged in the last 25 years in finance is between business businesses and trading/deal businesses — farmers and tigers. We would take a big step away from the next financial crisis if we made this divide one of the principles of financial reform.
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