Most of the media is fascinated on the op-ed from an ex Goldman employee that said five managing directors of Goldman referred to their clients as muppets. Most of the attention has been on Goldman’s alleged condescending thoughts on its own clients and that Goldman is “bad” for this and several other things. Virtually no one is saying maybe the “muppets” are not really victims but not so innocent themselves. One exception is Henry Blodget who has called out many Wall Street participants as being muppets. You can see the muppet debate here: http://finance.yahoo.com/blogs/daily-ticker/goldman-clients-really-muppets-william-cohan-says-no-165557085.html
In general I am in agreement with Henry Blodget – but I would like to drill down more narrowly. Henry’s comments cast a wide net which would take in most retail investors who buy actively managed mutual funds. I consider those people innocent victims in many ways. But Goldman’s clients are principally not in this category at least not directly. Specifically in regard to derivatives, which is the area where Greg Smith worked and is the same area in which Goldman paid a $550 million record fine in the Abacus CDO deal, the clients were other institutions, not individual investors – though of course underneath all of this at the end of the day it all comes back to individuals.
Let’s first define muppets – it is British slang for idiot often used overseas in trading to describe unsophisticated trading partners. But even if we took the American interpretation of the word as being puppets like on Sesame Street – it is not much different. They are too many institutional clients of brokerage firms that fit either or both definitions.
Take the Abacus CDO deal – the “victims” were other financial institutions, ACA a bond insurer, IKB which is a German bank, and Royal Bank of Scotland. These are institutions the hold themselves to their own clients as being experts in high finance. If they can be so easily duped by Goldman Sachs how expert can they be and are they not committing a fraud representing themselves as competent in finance? In fact, IKB admittedly didn’t understand enough about the transaction to go in on their own, they were only in because ACA was in. The SEC allegation is the RBS would not have been in either without ACA’s participation. ACA says they would not have been in if they realised Paulson was shorting the structure rather investing in it.
Now we are getting close to what people really should be angry about. Most of the world of finance is populated by people far short of cutting edge brilliant – the brilliant ones works for the Goldmans or hedge funds like Paulson, but most of banks and insurance companies and mutual funds are littered with people who while not stupid in a Forrest Gump sense lack the mental ability to play at an even level with Goldman Sachs. In some cases they are even lazy buying anything with an “appropriate” rating from a credit agency – which is how we got the mortgage bond fiasco in the first place. In some cases, there are muppets who trust the “name” institutions like Goldman and Morgan Stanley who would not buy the same deal if it were put together by a regional brokerage firm. Nobody does their own work anymore – there are billions of dollars committed to deals based solely on credit ratings or because “other smart money” is in it. In some cases these individuals in these organisations are not dumb, but their clients are insisting on things that are dumb, so they follow suit – the number one culprit being a reliance on credit ratings. Why do your own homework on issuers, if the client will not trust your judgment over Moody’s and S&P anyway?
In the 1990’s I worked in the convertible securities department of Trust Company of the West (TCW) which at the time had the largest dedicated buyside business in convertibles and we were prized clients of Goldman, Morgan Stanley, Merrill etc. Convertibles themselves are a derivative, but sometimes we would buy structured derivatives to get exposure unavailable in the normal convertible market. As an example, we might buy a structured convertible from Goldman that converted into a basket of bank or pharmaceutical stocks. Sometimes it was the brokerage firm that pitched the product, others time we would request one and they would show one in. What was amazing to me about the Abacus deal was that one client (of Goldman) knew what another client was doing. My recollection is that I never had this type of information and it would have been considered unethical for Goldman say to tell us what other firms were doing or tell other firms what we were doing.
But even if I had known what other market participants were doing it would only make me somewhat more or less interested in a deal, it would never be the sole or even major basis to which to make a transaction decision. For starters, particularly when dealing with a hedge fund, you never know what other bets they have on, so looking at one position as being indicative of anything including a point of view can be misleading. They might be putting on a “negative” position to hedge a “positive” position or vice versa.
Looking at a mortgage deal like Abacus – the same attributes that Paulson found in the mortgage pools he wanted to short should have been red flags to ACA regardless of whether they thought Paulson was long or short. There are portfolio characteristics on FICO scores, downpayments, first or second mortgage position, geographical concentration, LTVs, loan documentation etc. These are things any potential buyer should have been focused on not what Paulson, ACA’s or anyone else’s opinion is. This is especially true when their buyer themselves in a financial firm.
When the buyers are not financial firms like the famous derivatives fraud case from 1994 involving Bankers Trust, and their clients Gibson Greetings and Proctor and Gamble, I have more sympathy with the clients as finance is not their core business – though their CFOs should be sophisticated enough to weed this out. But when the clients are other financial firms, I think we should not just be questioning the actions of Goldman, but the muppets as well. Notice the case I reference from 1994, that there were problems with derivatives and Wall Street firms tricking clients was not new to the 21st Century, something that has been forgotten and that I will write on in a follow up.