The mid-size broker-dealer MF Global filed for Chapter 11 bankruptcy this morning. In the big picture, this isn't huge news. MF Global had a $42.5 billion balance sheet-- not tiny, but about 1/15th the size of Lehman Brothers' when they filed three years ago. Clearly, the financial system isn't going over a cliff because of this one. But what's interesting about this is what it means for the Titans of Wall Street, whose biggest names are seeing their reputations continue to take a hit in the aftermath of the global economic meltdown.
MF Global is probably most famous for the guy in charge-- Jon Corzine. In his last life, he was governor of New Jersey. Before that, he was the senator from New Jersey. And before that, he was a senior partner at Goldman Sachs, succeeding Steve Friedman before Hank Paulson pushed him out in 1999. It's a bit of a stunning fall from grace for Corzine-- he goes from being run out of Goldman to losing a re-election campaign to Chris Christie to presiding over MF Global for 18 months before it collapsed. Corzine took over the sleepy broker-dealer and hoped to turn it into another Goldman Sachs-- a bold risk-taking firm that could make big returns on equity by placing bets with its own money. The perception was that he was succeeding-- in August, MF Global floated bonds whose yield would jump 1% (they'd have to pay more interest) if Corzine left the firm to serve in the Obama Administration before 2013. Instead, Corzine's strategy imploded. The firm found itself with about $185 million in losses last quarter (compared to just under $1.5 billion in equity) after taking an over $6 billion position in distressed European debt. As if that wasn't bad enough, it looks like almost $700 million in customer funds is unaccounted for after the bankruptcy filing. While it's unlikely that it was stolen, it does look like MF Global was mingling its customers' funds with its own capital, which is a big regulatory no-no.
But the big story, to me, is how Corzine's fall from grace continues a proud line of big names from Goldman who just haven't done particularly well in other places. First, it was Bob Rubin, who left with a glittering reputation to join the Clinton Administration, was hailed as a great Treasury secretary... and then left to become Chairman of the Executive Committee at Citigroup. There, he pushed Citi to take bigger risks, Goldman-style, saw his deregulatory policies as Treasury Secretary fall into heavy disfavor, then watched Citi drive itself to the brink of collapse after taking his advice. But Rubin and Corzine aren't the only ones who have fallen out of favor: Chris Flowers, who left Goldman to open his own private equity shop, lost almost $50 million betting on MF Global, and keeps appearing at the scene of financial disaster after financial disaster.
So it seems like Goldman execs don't exactly have a great track record of replicating Goldman's success after leaving the firm. But it's not just leaving Goldman that seems to be a recipe for disaster-- Goldman itself isn't exactly flying high right about now either. Last quarter, they posted their second quarterly loss since going public in 1999 (the first was in 2008). Their stock price is off by about 60% from its 2007 peak, and it had to cut 1000 more employees recently (in addition to the typical performance-related layoffs). What this looks like to me is that it's not Goldman's traders that turned it into the best-performing big investment bank of the last two decades-- it was their risk management people, who kept them afloat through rough market conditions even as other firms teetered on the brink. Take the risk takers like Corzine and Rubin away from the risk managers, and they're no better than anyone else in the industry.
Now, I might be wrong in my diagnosis, but, at least perception-wise, the old superstars of Goldman's past have pretty much all lost their luster over the last few years. Corzine wasn't the first, and I kind of doubt he'll be the last...
Showing posts with label Goldman Sachs. Show all posts
Showing posts with label Goldman Sachs. Show all posts
Monday, October 31, 2011
Wednesday, October 5, 2011
Why does the Left love George Soros but hate Goldman Sachs?
An inevitable response when anyone on the left mentions that Koch Industries is run more or less as a criminal enterprise is, "Well, George Soros is worse." Never mind that it's nowhere near true, but the left still goes to great lengths to defend Soros from accusations that he's the same kind of "immoral corporate goon" as all the others. On the other hand, the populists left's favorite target is Wall Street, and probably the biggest symbol they hold up of Wall Street's immorality during the financial crisis is Goldman realizing massive profits betting on the collapse of the housing market, while the economy crumbled around them. Now, the first thing to mention is that the argument puts Goldman in an absurd catch-22-- had they gone along with the herd and bet on housing, they would have been blamed for making dumb bets in the same way the rest of Wall Street was. By betting against housing, they were "betting against America" while ordinary people suffered. Either way, they couldn't win. Instead, let's focus on the parallels between Goldman's "big short" against housing and the defining act of Soros's career: his short of the British pound in 1992.
Without getting into the economic details, the essence of Soros's trade was pretty simple: at the time, Britain was in the Exchange Rate Mechanism (the precursor to the Euro), which committed them to maintaining the pound at a certain level relative to other European currencies (not a specific price, but a band). To do that, the Bank of England had to maintain certain levels of foreign exchange reserves and commit to exchange them for foreign currencies on demand. Then, in 1992, Germany and England's economies diverged rapidly. Reunification produced a boom in Germany as the East was built up to restore parity with the West, and inflation started running higher than they wanted, leading the Bundesbank to raise interest rates (which has the side effect of strengthening the currency relative to others). At the same time, Britain was in a nasty recession, so it needed lower interest rates, and a relatively lower value for the pound relative to the deutschmark to make its exports competitive. But staying in the ERM would have required the Bank of England to raise rates, and it did so, exacerbating the Depression. Soros recognized this weakness, and started shorting the pound-- he borrowed pounds and started selling them to the Treasury at the par rate, draining the British Treasury of its foreign exchange reserves. Eventually, he (along with a bunch of other traders doing the same thing) forced Britain out of the ERM, and Soros realized a gain of over $1 billion. It was a brilliant opportunity for Soros-- an ordinary short position is extremely risky because it has unlimited downside-- by borrowing and then selling an asset, you run the risk of that asset rising to infinity in the meantime. This trade, however, was almost risk-free: the pound was never going to RISE relative to other currencies so, at worst, if the British Treasury had somehow managed to defend the pound from the speculative attack, Soros would have lost only the interest rate he paid for borrowing the pounds that he then sold short.
The ultimate loser, however, was the British taxpayer, as the Treasury sold its reserves of foreign currencies for far less than they were worth after it had to devalue the pound. So, in a simple sense, Soros made over $1 billion at the expense of British taxpayers. But the story doesn't end there, of course. Leaving the ERM was ultimately absolutely the right step for England-- it allowed the economy to escape the nasty recession it was in, and kept it out of the trap that was the Euro (today, Britain isn't necessarily doing much better in terms of its budget picture than Spain or Italy, but its borrowing costs are MUCH MUCH lower, the sole reason being that it has its own currency. If David Cameron hadn't stupidly decided to pursue austerity in the middle of a recession, they might actually be recovering nicely now.
Now compare that to Goldman's trade during the crisis. In essence, in 2006, while the rest of Wall Street was knee-deep in housing exposures, Goldman's mortgage desk realized the market was headed for a crash and made a big short bet. In essence, once the market tanked (as it was bound to do anyway), Goldman would profit. The losers, ultimately, were their counterparties (those on the other side of their short positions). The only differences between Goldman's short and Soros's are 1) the asset that was being shorted, and 2) the fact that the entire financial system didn't need to be bailed out after Soros's bet. Another difference is that, while Soros was a hedge fund manager (meaning that his sole business was finding and exploiting market inefficiencies), Goldman is also involved in raising capital for businesses and advising clients on mergers and acquisitions (each of which serves a much more straightforward social purpose, though the latter probably less than the former).
This isn't to say that Goldman necessarily didn't do anything wrong: they did pay a settlement to the SEC for fleecing clients on one of their Abacus deals in 2007. But the ones they might have fleeced on that deal weren't taxpayers; they were German banks who probably should have known better. So, while they did make plenty of money during the crisis, the right response isn't to pick up your pitchfork: it's to ask what you expected them to do.
But I suspect that what the difference might come down to is the fact that Soros has been bankrolling left-leaning causes for the better part of two decades. He funded the Center for American Progress, raised lots of money to defeat George Bush, and is one of the left's highest-profile donors. A dirty little secret, though, is that Goldman is a pretty liberal operation itself. Though ex-Goldman CEO and Treasur Secretary Hank Paulson is nominally a Republican, and former senior partner Steve Friedman also leans to the right, as a whole, Goldman is a pretty left-leaning organization. Their current CEO, Lloyd Blankfein, was a pretty prominent Hillary Clinton supporter in 2008. Clinton's Treasury Secretary (and former senior partner) Robert Rubin is a centrist, but certainly a Democrat. And the company as a whole has historically donated more to Democrats than to Republicans. While which political party an organization supports shouldn't necessarily matter, the fact of the matter is, I'm pretty sure liberals would be up in arms over George Soros if it were the Heritage Foundation that he was funding rather than CAP.
But my point isn't that liberals should hate George Soros, or that conservatives should hate Goldman. It's that there's no real reason to hate either Soros or Goldman-- both play by the rules of the system. The problem is the system has long had flawed rules. Fixing those rules is something Soros publicly welcomes, but it's something that is the responsibility of politicians rather than participants in that system. So instead of complaining about how terrible Goldman Sachs is, liberals should think about electing better politicians who will work to fix the rules of the system in which Goldman plays. Regardless of the environment, firms like Goldman will keep making money, and that is, at bottom, a good thing. But the environment should be one in which regulations prevent firms playing by those rules from endangering the global economy.
Without getting into the economic details, the essence of Soros's trade was pretty simple: at the time, Britain was in the Exchange Rate Mechanism (the precursor to the Euro), which committed them to maintaining the pound at a certain level relative to other European currencies (not a specific price, but a band). To do that, the Bank of England had to maintain certain levels of foreign exchange reserves and commit to exchange them for foreign currencies on demand. Then, in 1992, Germany and England's economies diverged rapidly. Reunification produced a boom in Germany as the East was built up to restore parity with the West, and inflation started running higher than they wanted, leading the Bundesbank to raise interest rates (which has the side effect of strengthening the currency relative to others). At the same time, Britain was in a nasty recession, so it needed lower interest rates, and a relatively lower value for the pound relative to the deutschmark to make its exports competitive. But staying in the ERM would have required the Bank of England to raise rates, and it did so, exacerbating the Depression. Soros recognized this weakness, and started shorting the pound-- he borrowed pounds and started selling them to the Treasury at the par rate, draining the British Treasury of its foreign exchange reserves. Eventually, he (along with a bunch of other traders doing the same thing) forced Britain out of the ERM, and Soros realized a gain of over $1 billion. It was a brilliant opportunity for Soros-- an ordinary short position is extremely risky because it has unlimited downside-- by borrowing and then selling an asset, you run the risk of that asset rising to infinity in the meantime. This trade, however, was almost risk-free: the pound was never going to RISE relative to other currencies so, at worst, if the British Treasury had somehow managed to defend the pound from the speculative attack, Soros would have lost only the interest rate he paid for borrowing the pounds that he then sold short.
The ultimate loser, however, was the British taxpayer, as the Treasury sold its reserves of foreign currencies for far less than they were worth after it had to devalue the pound. So, in a simple sense, Soros made over $1 billion at the expense of British taxpayers. But the story doesn't end there, of course. Leaving the ERM was ultimately absolutely the right step for England-- it allowed the economy to escape the nasty recession it was in, and kept it out of the trap that was the Euro (today, Britain isn't necessarily doing much better in terms of its budget picture than Spain or Italy, but its borrowing costs are MUCH MUCH lower, the sole reason being that it has its own currency. If David Cameron hadn't stupidly decided to pursue austerity in the middle of a recession, they might actually be recovering nicely now.
Now compare that to Goldman's trade during the crisis. In essence, in 2006, while the rest of Wall Street was knee-deep in housing exposures, Goldman's mortgage desk realized the market was headed for a crash and made a big short bet. In essence, once the market tanked (as it was bound to do anyway), Goldman would profit. The losers, ultimately, were their counterparties (those on the other side of their short positions). The only differences between Goldman's short and Soros's are 1) the asset that was being shorted, and 2) the fact that the entire financial system didn't need to be bailed out after Soros's bet. Another difference is that, while Soros was a hedge fund manager (meaning that his sole business was finding and exploiting market inefficiencies), Goldman is also involved in raising capital for businesses and advising clients on mergers and acquisitions (each of which serves a much more straightforward social purpose, though the latter probably less than the former).
This isn't to say that Goldman necessarily didn't do anything wrong: they did pay a settlement to the SEC for fleecing clients on one of their Abacus deals in 2007. But the ones they might have fleeced on that deal weren't taxpayers; they were German banks who probably should have known better. So, while they did make plenty of money during the crisis, the right response isn't to pick up your pitchfork: it's to ask what you expected them to do.
But I suspect that what the difference might come down to is the fact that Soros has been bankrolling left-leaning causes for the better part of two decades. He funded the Center for American Progress, raised lots of money to defeat George Bush, and is one of the left's highest-profile donors. A dirty little secret, though, is that Goldman is a pretty liberal operation itself. Though ex-Goldman CEO and Treasur Secretary Hank Paulson is nominally a Republican, and former senior partner Steve Friedman also leans to the right, as a whole, Goldman is a pretty left-leaning organization. Their current CEO, Lloyd Blankfein, was a pretty prominent Hillary Clinton supporter in 2008. Clinton's Treasury Secretary (and former senior partner) Robert Rubin is a centrist, but certainly a Democrat. And the company as a whole has historically donated more to Democrats than to Republicans. While which political party an organization supports shouldn't necessarily matter, the fact of the matter is, I'm pretty sure liberals would be up in arms over George Soros if it were the Heritage Foundation that he was funding rather than CAP.
But my point isn't that liberals should hate George Soros, or that conservatives should hate Goldman. It's that there's no real reason to hate either Soros or Goldman-- both play by the rules of the system. The problem is the system has long had flawed rules. Fixing those rules is something Soros publicly welcomes, but it's something that is the responsibility of politicians rather than participants in that system. So instead of complaining about how terrible Goldman Sachs is, liberals should think about electing better politicians who will work to fix the rules of the system in which Goldman plays. Regardless of the environment, firms like Goldman will keep making money, and that is, at bottom, a good thing. But the environment should be one in which regulations prevent firms playing by those rules from endangering the global economy.
Tuesday, August 2, 2011
My Explanation For Why Goldman Sachs Is Headed Downhill
Two years ago, Goldman Sachs was on top of the world, even as its rivals teetered. Lehman Brothers had disappeared. Bear Stearns and Merrill Lynch were acquired at fire-sale prices so they wouldn't disappear. Citigroup was insolvent, kept afloat by a massive $85 billion bailout, and Bank of America was hardly better. Morgan Stanley wasn't dead, but it was bleeding money, and had to reinvent its business model in the aftermath of the financial crisis. JPMorgan gained prestige and market share, but even they were a big, stodgy behemoth. Goldman, meanwhile, made a fortune. In 2009, when most of Wall Street was conducting a post-mortem and checking its pulse, Goldman reported record earnings of $13.4 billion. For that success, they had books written about them, and magazine articles and blog posts dissected their success, whether by calling them thieves who profited at clients' expense, or lauding them as visionaries who saw the crisis coming when few others did. At that point, it looked like Goldman was the undisputed King of Wall Street. Strangely, though, that hasn't been the case.
Goldman announced its second quarter earnings about two weeks ago, and the results were pretty disappointing. Their earnings per share were more than 20% lower than analysts had expected, at around $1.85. Breaking down that result further, the biggest reason they struggled was that they had weak earnings in their fixed-income, currencies and commodities division (FICC). This is the same division that drove their success during the crisis. The question, then, is why. A lot of the people who were responsible for Goldman's best trades during the crisis are gone, but Goldman's had constant attrition and still managed to continue to do well-- Wall Street and Washington are littered with Goldman alumni: they become Treasury Secretaries (Bob Rubin and Hank Paulson), governors, senators and White House staffers (Jon Corzine and Josh Bolten), open hugely successful private equity shops (Chris Flowers and Guy Hands), manage hedge funds (Ed Lampert) and run central banks (William Dudley and Mario Draghi). All have left, but the profit machine has managed to chug along. And the leadership hasn't changed at all-- the CEO, COO, and CFO have all stayed on deck. But FICC's revenue has been down for six quarters in a row now, which is starting to look less like a blip on the radar and more like a pattern of decline. But why?
Well, I've got a hypothesis, and I think it has to do with Goldman's success sowing the seeds of its downfall (sounds cliche, I know, but I think it works in this case). Rewind to the days when Goldman was making its most profitable bets. At that point, the conventional wisdom was still that real estate-related assets were still a great investment. You could get AAA-rated CDOs that yielded more than similarly AAA-rated Treasuries, and most investors assumed that this was a conservative buy. Now, I think it's worth pausing for a minute to consider what a fixed-income group actually does. Generally speaking, they make markets-- they find a long side (a party that wants to make a bet that the price of a certain asset class, security, or other instrument will rise) and a short side (betting that this price will fall), and taking a fee to bring them together. Until Dodd-Frank passed, they could also put their own money on the line to make these bets (this was called proprietary trading, and Dodd-Frank limits banks form putting more than 3% of their capital into these trades). The two aren't always easy to distinguish from one another-- sometimes, to facilitate a deal, a market-maker will leave some of the unsold securities from the deal (either on the long or the short side) on its own balance sheet; other times, it will buy up securities as inventory if it anticipates clients placing large orders for them in the near future.
This setup created obvious conflicts of interest. What if, for instance, Goldman had a client who wanted to take a long position in housing, but Goldman itself was taking a short position in that market? What if Goldman was aggressively limiting its exposure in a certain asset class by dumping its inventory on an unsuspecting client? There's a compelling point to be made that Goldman shouldn't necessarily care-- its clients are big boys who can take care of themselves, and by and large have access to the same information. If "the Germans" (there were a lot of German banks that were losing money on Goldman's deals while Goldman was minting it in 2008 and 2009) thought housing was a good bet, they were entitled to make that decision. The purpose of this post isn't to address that line of argument, but, even if it is valid, it creates serious perception problems for banks that do it. For example, if a firm makes markets in real estate, but is massively short real estate on net, clients don't look too kindly at a bank that is, essentially, making money at their expense. In the future, they're likely to be hesitant to do business with that bank, out of fear that they'll be stabbed in the back.
And that, in a word, is what I think is happening to Goldman. Plenty of financial firms were making markets in housing in the run-up to the crisis. But when the bubble burst, those firms lost as much money as their clients did, if not more. Merrill, Lehman and Bear didn't survive, but Morgan Stanley bled money alongside its clients after the crisis. Citigroup would have gone the way of Lehman if it hadn't been for the government. But, when Goldman's clients took fat losses, Goldman recorded record profits, largely on the back of their trading operation being massively short housing. Their executives ended up so embarrassed about this that they went and lied to Congress about it; CEO Lloyd Blankfein called it a "hedge". Now, that may fly as an explanation for some people, but it's complete baloney. Yes, there were deals in which Goldman ended up stuck with mortgage-related residuals and lost money (even after taking fees). But where a hedge is intended to protect your risk, Goldman's short position was a MASSIVE directional bet. Had Goldman wanted to hedge its mortgage-related exposure, it could have unloaded significant parts of its mortgage-related assets into the market to dial down their risk. Instead, they took every conceivable step to go short housing. They dumped their mortgage holdings. They bought credit default swaps (CDS's; essentially insurance on a bond default, whether a mortgage bond or a sovereign bond or a corporate bond) on mortgage-backed securities and companies that were heavily involved in the mortgage market. They shorted the stock of those same companies. In sum, they made a huge bet that mortgage-related assets and the companies that trafficked in them were headed for a fall. And they were right.
But now the acute phase of the crisis is over. The economy is still struggling, but, unless the Tea Party decides to shoot the country in the nuts, we're past what Krugman calls the "We're-all-gonna-die" phase. And now Goldman is in a pickle. Dodd-Frank limits the amount that they can commit to prop trading, so FICC's lifeblood is now making markets. But making markets still requires being able to step in and take a portion of the position to facilitate getting a deal done. And I get the sense that clients don't trust Goldman to do what's in their best interests anymore. And, until now, FICC was Goldman's biggest profit driver, sometimes bringing in over 40% of revenue and over 70% of profits. But I get a feeling that what might be happening is that clients are afraid of getting burned in dealing with Goldman and taking their business elsewhere. Making them, in essence, the victims of their own success.
Of course, memories are short on Wall Street: two years after a lack of regulation almost drove the economy off a cliff, they were pulling out their pitchforks and screaming about Dodd-Frank overreaching. So I don't think I'm writing Goldman's obituary by any means. But being branded as a firm that's willing to stab its clients in the back for profit (whether that label/perception is fair or unfair) is something that could be a drag on the firm in the next few years.
Goldman announced its second quarter earnings about two weeks ago, and the results were pretty disappointing. Their earnings per share were more than 20% lower than analysts had expected, at around $1.85. Breaking down that result further, the biggest reason they struggled was that they had weak earnings in their fixed-income, currencies and commodities division (FICC). This is the same division that drove their success during the crisis. The question, then, is why. A lot of the people who were responsible for Goldman's best trades during the crisis are gone, but Goldman's had constant attrition and still managed to continue to do well-- Wall Street and Washington are littered with Goldman alumni: they become Treasury Secretaries (Bob Rubin and Hank Paulson), governors, senators and White House staffers (Jon Corzine and Josh Bolten), open hugely successful private equity shops (Chris Flowers and Guy Hands), manage hedge funds (Ed Lampert) and run central banks (William Dudley and Mario Draghi). All have left, but the profit machine has managed to chug along. And the leadership hasn't changed at all-- the CEO, COO, and CFO have all stayed on deck. But FICC's revenue has been down for six quarters in a row now, which is starting to look less like a blip on the radar and more like a pattern of decline. But why?
Well, I've got a hypothesis, and I think it has to do with Goldman's success sowing the seeds of its downfall (sounds cliche, I know, but I think it works in this case). Rewind to the days when Goldman was making its most profitable bets. At that point, the conventional wisdom was still that real estate-related assets were still a great investment. You could get AAA-rated CDOs that yielded more than similarly AAA-rated Treasuries, and most investors assumed that this was a conservative buy. Now, I think it's worth pausing for a minute to consider what a fixed-income group actually does. Generally speaking, they make markets-- they find a long side (a party that wants to make a bet that the price of a certain asset class, security, or other instrument will rise) and a short side (betting that this price will fall), and taking a fee to bring them together. Until Dodd-Frank passed, they could also put their own money on the line to make these bets (this was called proprietary trading, and Dodd-Frank limits banks form putting more than 3% of their capital into these trades). The two aren't always easy to distinguish from one another-- sometimes, to facilitate a deal, a market-maker will leave some of the unsold securities from the deal (either on the long or the short side) on its own balance sheet; other times, it will buy up securities as inventory if it anticipates clients placing large orders for them in the near future.
This setup created obvious conflicts of interest. What if, for instance, Goldman had a client who wanted to take a long position in housing, but Goldman itself was taking a short position in that market? What if Goldman was aggressively limiting its exposure in a certain asset class by dumping its inventory on an unsuspecting client? There's a compelling point to be made that Goldman shouldn't necessarily care-- its clients are big boys who can take care of themselves, and by and large have access to the same information. If "the Germans" (there were a lot of German banks that were losing money on Goldman's deals while Goldman was minting it in 2008 and 2009) thought housing was a good bet, they were entitled to make that decision. The purpose of this post isn't to address that line of argument, but, even if it is valid, it creates serious perception problems for banks that do it. For example, if a firm makes markets in real estate, but is massively short real estate on net, clients don't look too kindly at a bank that is, essentially, making money at their expense. In the future, they're likely to be hesitant to do business with that bank, out of fear that they'll be stabbed in the back.
And that, in a word, is what I think is happening to Goldman. Plenty of financial firms were making markets in housing in the run-up to the crisis. But when the bubble burst, those firms lost as much money as their clients did, if not more. Merrill, Lehman and Bear didn't survive, but Morgan Stanley bled money alongside its clients after the crisis. Citigroup would have gone the way of Lehman if it hadn't been for the government. But, when Goldman's clients took fat losses, Goldman recorded record profits, largely on the back of their trading operation being massively short housing. Their executives ended up so embarrassed about this that they went and lied to Congress about it; CEO Lloyd Blankfein called it a "hedge". Now, that may fly as an explanation for some people, but it's complete baloney. Yes, there were deals in which Goldman ended up stuck with mortgage-related residuals and lost money (even after taking fees). But where a hedge is intended to protect your risk, Goldman's short position was a MASSIVE directional bet. Had Goldman wanted to hedge its mortgage-related exposure, it could have unloaded significant parts of its mortgage-related assets into the market to dial down their risk. Instead, they took every conceivable step to go short housing. They dumped their mortgage holdings. They bought credit default swaps (CDS's; essentially insurance on a bond default, whether a mortgage bond or a sovereign bond or a corporate bond) on mortgage-backed securities and companies that were heavily involved in the mortgage market. They shorted the stock of those same companies. In sum, they made a huge bet that mortgage-related assets and the companies that trafficked in them were headed for a fall. And they were right.
But now the acute phase of the crisis is over. The economy is still struggling, but, unless the Tea Party decides to shoot the country in the nuts, we're past what Krugman calls the "We're-all-gonna-die" phase. And now Goldman is in a pickle. Dodd-Frank limits the amount that they can commit to prop trading, so FICC's lifeblood is now making markets. But making markets still requires being able to step in and take a portion of the position to facilitate getting a deal done. And I get the sense that clients don't trust Goldman to do what's in their best interests anymore. And, until now, FICC was Goldman's biggest profit driver, sometimes bringing in over 40% of revenue and over 70% of profits. But I get a feeling that what might be happening is that clients are afraid of getting burned in dealing with Goldman and taking their business elsewhere. Making them, in essence, the victims of their own success.
Of course, memories are short on Wall Street: two years after a lack of regulation almost drove the economy off a cliff, they were pulling out their pitchforks and screaming about Dodd-Frank overreaching. So I don't think I'm writing Goldman's obituary by any means. But being branded as a firm that's willing to stab its clients in the back for profit (whether that label/perception is fair or unfair) is something that could be a drag on the firm in the next few years.
Friday, July 8, 2011
"Money and Power" and Goldman Sachs
So a few days ago, I finished reading William Cohan's new book about Goldman Sachs. It's called "Money and Power: How Goldman Sachs Came to Rule the World", and I think it's definitely worth a read. I guess for background's sake, I read Cohan's book about Bear Stearns ("House of Cards") a couple of years ago, and I didn't like it at all. This one is much, much better. More balanced, less muddled, and more informative. Cohan is an editor at Fortune magazine and used to work for Lazard and JPMorgan, so he understands finance and is capable of discussing it in an informed way. On the other hand, I think the further away he's gotten from working within the industry, the more capable he's become of looking at it objectively. In "House of Cards", he essentially ignores astonishing risk taking by the Bear brass and pins the mortgage bubble on the Community Reinvestment Act of 1977 and policies promoting housing... from the beginning of the Clinton Administration. That view is typical of Wall Street insiders who refuse to acknowledge faults of their own, but has little basis in reality. In this book, Cohan takes a more holistic view, and it makes for much more credible reading.
I think, when it comes to Goldman, most people take one of two positions. The two are someone at odds with one another, and each has a small kernel of truth to it, but on the whole, both are wildly misleading. One is the position Goldman itself takes: that it is the best, the smartest, and the most ethical firm on Wall Street. Alone among the big banks, Goldman has a set of fourteen "Business Principles" that make it clear that they think they're special (#1: "Our clients' interests always come first"). Like all the big banks, they do a pretty miserable job of following those principles. At heart, Goldman does a lot of the same things every other bank does; it's true that they're the best on Wall Street at a lot of those things (managing risk in particular), and that they probably have, on balance, the smartest people. But I don't think there's anything, positive or negative, that Goldman does or doesn't do, that sets it apart from the rest of Wall Street, aside from carefully crafting its image.
The other position is the one thrown out by Matt Taibbi at Rolling Stone, that Goldman Sachs is essentially Satan, Inc. Taibbi has written at least two articles arguing that Goldman, in essence, collapsed the global economy, profited from it, and then took a fat bailout from the government on top of that. That view is even more bunk. The short story is that, in essence, while the economy was collapsing around Goldman, they made big bets and profited off that collapse. But think through that position, and you realize how absurd it is. Along among the big banks (there were some hedge funds and the like that were also short housing, but all of the big deposit-taking banks and the four other stand-alone investment banks were net long), they saw the housing bubble coming and hedged their exposure. Taibbi wants you to believe that, because the rest of Wall Street was absurdly long housing, and Goldman saw the bubble coming, it was somehow unethical for them to make a bet the other way. People like Taibbi liken that to realizing your car is a lemon and then selling it on. Which is an absurd analogy. All the information that Goldman had about housing was widely available to every other firm. They just weren't as good at interpreting the information as Goldman was. So, essentially, Taibbi and those who agree with him want you to think that, back in 2006, when the market as a whole was convinced that housing was a great investment, Goldman somehow shouldn't have taken an opposing position because... we found out a couple of years later that the market was massively overvalued. I'm unpersuaded.
Now that doesn't mean that Goldman is the world's most ethical firm. Some of their most famous declarations are straight-up untrue. One is their famous declaration that they don't represent clients in hostile takeover bids. There are enough cases Cohan points out of Goldman doing just that that it's clear that their claim is baloney. Not to say that there's anything illegal about it, but hostile bids for public companies are a fairly controversial practice, so if Goldman was going to claim that it's "better" than other Wall Street firms, it better actually live up to its claim. Another is putting their clients first. This one is a bit tricky. Goldman's clients, for the most part, are sophisticated investors, hedge funds, and other banks. If a deal goes bad because Goldman has a different opinion from a client's, and the client knows Goldman is short the deal, then there's no reason to punish them. Similarly, if two clients come to them, and one wants to be short housing while the other wants to be long, there's no reason Goldman shouldn't be able to structure the deal for the clients. By definition, one party's going to make money, and the other is going to lose money. But where Goldman crossed the line was that it probably misrepresented what was going on to some clients. Take the infamous ABACUS deal. John Paulson (the now-famous) hedge fund manager came to Goldman and said he wanted to go short housing. Goldman found a company to choose the portfolio, and found another client willing to take the long end of the deal. Of course, famously, Paulson made billions on his bet, while the party on the other end (a German bank) lost just as much. Where Goldman probably crossed the line was in failing to tell the German bank that Paulson was going to be both short the deal and had indicated which CDOs he wanted to short. And, whereas Goldman wrote that the securities were "sourced from the Street" (Wall Street), in reality they all came from Goldman's balance sheet. Their explanation was 1) that the German bank was sophisticated enough to do its own analysis of the securities it was buying (certainly true) and 2) that Goldman itself was part of the Street (disingenuous as all hell). But, even if their clients on the long end were sophisticated, Goldman still has a duty to disclose all material information about the deal to them, and they almost certainly failed to do that. Would doing so have led the German bank to exit the deal? Who knows. But it certainly would have made Goldman look better in hindsight. And would have lent some credence to their claim that their clients come first.
The most troubling part about their practices, though, is their seeming willingness to let business lines with inherent tension mix, and it's something Cohan harps on. Any securities firm has three major practice areas-- the size of those varies by firm, but more or less all of them do some form of merger/acquisition advisory, securities underwriting (underwriting debt offerings and IPOs), and broker/dealer activities (creating structured securities for clients, or trading for their own accounts; the last part is theoretically being scaled back by the Volcker Rule from the Dodd-Frank Act, but, given how hard it is to determine whether the firm is buying up securities to have them in inventory for clients, or to express an opinion about their future value). There are plenty of more specific business lines, but they all fall into one of these general categories. The problem is, trading relies on information, and the advisory and underwriting businesses have plenty of information that is material and not public. If a big company comes to Goldman and tells them that they want to purchase another company, Goldman's trading desk can make a killing if they find out about it and buy up the target company's stock (acquirers pay a premium to acquire a publicly traded company). The conflicts on the underwriting side are similar (the underwriter needs material non-public information to prepare the equity/bond issue). So what's Goldman's response? In essence, it's "Trust us, we're honest". They claim that the "Chinese walls" between their departments keep information from the investment banking floors from trickling down to the trading floor. This story might be believable if, in reality, Wall Street didn't have such a history of their "Chinese walls" working more like sieves. At the height of the tech bubble, much of Wall Street (Goldman included, though they were far from the biggest perpetrator) had to pay hefty fines because their research departments (people writing public outlooks on companies they were supposed to be researching) came under pressure from the investment banking department to issue positive outlooks for their clients, since doing so would allow those companies to be acquired or to go public, which in turn would mean the banks' advisory/underwriting departments would pocket a fee. Once Eliot Spitzer (then New York's attorney general) got word of this, the banks ended up having to pay fines, but the story nevertheless doesn't exactly inspire confidence in the Chinese walls put up in places like Goldman. Now, I suppose the last question on this count is what sets Goldman's conflict there apart from any other firm's. The honest answer is twofold. First, Goldman, up to the crisis, had the biggest portion of revenues coming out of their trading division of all the major banks (including trading houses like Bear Stearns). So they stood to benefit more than banks with smaller trading departments from placing directional bets on that kind of material information. Second, I don't honestly know enough about the other banks to know the full extent of what they do, but if I had to guess, they probably do the same thing.
In sum, though, I think Cohan's book did a good job laying out the history and the facts, and provided a balanced view of Goldman. It's certainly not Taibbi's terrible "Vampire Squid". Nor is it the client-focused beacon of Wall Street it claims to be. It's a Wall Street firm like any other-- filled with conflicts, occasionally toeing the line between the acceptable and the inappropriate, and notable mostly for its unparalleled success at making money.
I think, when it comes to Goldman, most people take one of two positions. The two are someone at odds with one another, and each has a small kernel of truth to it, but on the whole, both are wildly misleading. One is the position Goldman itself takes: that it is the best, the smartest, and the most ethical firm on Wall Street. Alone among the big banks, Goldman has a set of fourteen "Business Principles" that make it clear that they think they're special (#1: "Our clients' interests always come first"). Like all the big banks, they do a pretty miserable job of following those principles. At heart, Goldman does a lot of the same things every other bank does; it's true that they're the best on Wall Street at a lot of those things (managing risk in particular), and that they probably have, on balance, the smartest people. But I don't think there's anything, positive or negative, that Goldman does or doesn't do, that sets it apart from the rest of Wall Street, aside from carefully crafting its image.
The other position is the one thrown out by Matt Taibbi at Rolling Stone, that Goldman Sachs is essentially Satan, Inc. Taibbi has written at least two articles arguing that Goldman, in essence, collapsed the global economy, profited from it, and then took a fat bailout from the government on top of that. That view is even more bunk. The short story is that, in essence, while the economy was collapsing around Goldman, they made big bets and profited off that collapse. But think through that position, and you realize how absurd it is. Along among the big banks (there were some hedge funds and the like that were also short housing, but all of the big deposit-taking banks and the four other stand-alone investment banks were net long), they saw the housing bubble coming and hedged their exposure. Taibbi wants you to believe that, because the rest of Wall Street was absurdly long housing, and Goldman saw the bubble coming, it was somehow unethical for them to make a bet the other way. People like Taibbi liken that to realizing your car is a lemon and then selling it on. Which is an absurd analogy. All the information that Goldman had about housing was widely available to every other firm. They just weren't as good at interpreting the information as Goldman was. So, essentially, Taibbi and those who agree with him want you to think that, back in 2006, when the market as a whole was convinced that housing was a great investment, Goldman somehow shouldn't have taken an opposing position because... we found out a couple of years later that the market was massively overvalued. I'm unpersuaded.
Now that doesn't mean that Goldman is the world's most ethical firm. Some of their most famous declarations are straight-up untrue. One is their famous declaration that they don't represent clients in hostile takeover bids. There are enough cases Cohan points out of Goldman doing just that that it's clear that their claim is baloney. Not to say that there's anything illegal about it, but hostile bids for public companies are a fairly controversial practice, so if Goldman was going to claim that it's "better" than other Wall Street firms, it better actually live up to its claim. Another is putting their clients first. This one is a bit tricky. Goldman's clients, for the most part, are sophisticated investors, hedge funds, and other banks. If a deal goes bad because Goldman has a different opinion from a client's, and the client knows Goldman is short the deal, then there's no reason to punish them. Similarly, if two clients come to them, and one wants to be short housing while the other wants to be long, there's no reason Goldman shouldn't be able to structure the deal for the clients. By definition, one party's going to make money, and the other is going to lose money. But where Goldman crossed the line was that it probably misrepresented what was going on to some clients. Take the infamous ABACUS deal. John Paulson (the now-famous) hedge fund manager came to Goldman and said he wanted to go short housing. Goldman found a company to choose the portfolio, and found another client willing to take the long end of the deal. Of course, famously, Paulson made billions on his bet, while the party on the other end (a German bank) lost just as much. Where Goldman probably crossed the line was in failing to tell the German bank that Paulson was going to be both short the deal and had indicated which CDOs he wanted to short. And, whereas Goldman wrote that the securities were "sourced from the Street" (Wall Street), in reality they all came from Goldman's balance sheet. Their explanation was 1) that the German bank was sophisticated enough to do its own analysis of the securities it was buying (certainly true) and 2) that Goldman itself was part of the Street (disingenuous as all hell). But, even if their clients on the long end were sophisticated, Goldman still has a duty to disclose all material information about the deal to them, and they almost certainly failed to do that. Would doing so have led the German bank to exit the deal? Who knows. But it certainly would have made Goldman look better in hindsight. And would have lent some credence to their claim that their clients come first.
The most troubling part about their practices, though, is their seeming willingness to let business lines with inherent tension mix, and it's something Cohan harps on. Any securities firm has three major practice areas-- the size of those varies by firm, but more or less all of them do some form of merger/acquisition advisory, securities underwriting (underwriting debt offerings and IPOs), and broker/dealer activities (creating structured securities for clients, or trading for their own accounts; the last part is theoretically being scaled back by the Volcker Rule from the Dodd-Frank Act, but, given how hard it is to determine whether the firm is buying up securities to have them in inventory for clients, or to express an opinion about their future value). There are plenty of more specific business lines, but they all fall into one of these general categories. The problem is, trading relies on information, and the advisory and underwriting businesses have plenty of information that is material and not public. If a big company comes to Goldman and tells them that they want to purchase another company, Goldman's trading desk can make a killing if they find out about it and buy up the target company's stock (acquirers pay a premium to acquire a publicly traded company). The conflicts on the underwriting side are similar (the underwriter needs material non-public information to prepare the equity/bond issue). So what's Goldman's response? In essence, it's "Trust us, we're honest". They claim that the "Chinese walls" between their departments keep information from the investment banking floors from trickling down to the trading floor. This story might be believable if, in reality, Wall Street didn't have such a history of their "Chinese walls" working more like sieves. At the height of the tech bubble, much of Wall Street (Goldman included, though they were far from the biggest perpetrator) had to pay hefty fines because their research departments (people writing public outlooks on companies they were supposed to be researching) came under pressure from the investment banking department to issue positive outlooks for their clients, since doing so would allow those companies to be acquired or to go public, which in turn would mean the banks' advisory/underwriting departments would pocket a fee. Once Eliot Spitzer (then New York's attorney general) got word of this, the banks ended up having to pay fines, but the story nevertheless doesn't exactly inspire confidence in the Chinese walls put up in places like Goldman. Now, I suppose the last question on this count is what sets Goldman's conflict there apart from any other firm's. The honest answer is twofold. First, Goldman, up to the crisis, had the biggest portion of revenues coming out of their trading division of all the major banks (including trading houses like Bear Stearns). So they stood to benefit more than banks with smaller trading departments from placing directional bets on that kind of material information. Second, I don't honestly know enough about the other banks to know the full extent of what they do, but if I had to guess, they probably do the same thing.
In sum, though, I think Cohan's book did a good job laying out the history and the facts, and provided a balanced view of Goldman. It's certainly not Taibbi's terrible "Vampire Squid". Nor is it the client-focused beacon of Wall Street it claims to be. It's a Wall Street firm like any other-- filled with conflicts, occasionally toeing the line between the acceptable and the inappropriate, and notable mostly for its unparalleled success at making money.
Subscribe to:
Posts (Atom)