"A speculator is a man who observes the future and acts before it occurs."

Bernard Baruch
The Public Years
Holt Reinhart and Winston (1960)

Last week, as the media feeding frenzy surrounding the disclosures about Goldman Sachs (GS) and Paulson & Co reached a fever pitch, we started to reflect on how the confluence of politics and finance often produces some very strange results. In particular, we saw once again how the efforts in the 1980s and 1990s to deregulate Wall Street created extraordinary risks for all concerned, bankers, traders and investors.

We all seem to suffer from a common, self-inflicted wound that can be summed up simply as a lack of trust. The lack of trust, in our view, stems from the breakdown in the rules which once governed and also limited the actors in the world of finance, particularly the rules regarding the creation and sale of securities. Banks, funds and the rating agencies all share the blame, but none more than the politicians in Washington and in the Congress who enabled this mess. Remember that as you watch the hearings before the Senate Permanent Subcommittee on Investigations this week.

One senior media maven asked us if we thought that the disclosure about GS selling securities to one client while enabling another, namely Paulson & Co, to sell the same securities short would damage the ability of Buy Side clients to trust GS. Our initial response was no.

In our experience, Buy Side investors today don't do business with GS or the other major Sell Side firms because they trust them. They do business with firms like GS because they believe that the firm has better access to information than do the other dealers in the marketplace. The sad fact is that the trust that once made firms like GS and the old JP Morgan & Co special has long since been lost, leaving the marketplace that remains a hideous, barbaric place that is bereft of honor -- and a source of infinite risk to the participants.

The reputation of GS as a firm for being smarter and better informed that the larger firms on Wall Street goes back many decades, to the turn of the last century when Wall Street was run by the white shoe securities firms in Boston, Philadelphia and New York. In those days, firms like GS and others which occupied the lower rungs of the Wall Street food chain had to be smarter than everyone else as a basic matter of survival. And in those days, GS protected and nurtured each client relationship because the trust that these clients put in the firm were considered to be a precious asset.

Through the 20th Century, GS grew and it gained a reputation not as a trading firm first and foremost, but as trusted investment advisers and bankers. The best example of this was Sidney J. Weinberg, the great GS partner who earned the label of "Mr. Wall Street" and was the successor to the mantle of Bernard Baruch, the self described speculator who helped the US manage the logistics of fighting two world wars. Weinberg served on dozens of corporate boards and was a confidant of political and business leaders all over the world. Known for his diligence and attention to detail, Weinberg made his clients' interests his own, and on that basis won their trust and their enduring friendship.

Weinberg knew how to give clients good advice and how to keep secrets. If you were a banking client of Sidney Weinberg, there was no question about whether the entire firm was working in your best interests -- including the trading desk. The esteem and trust that Weinberg held on and off Wall Street was such that he could operate in any venue, any office or corporate suite, and never be seen as a source of risk or potential scandal. GS CEO Lloyd Blankfein should ponder that example on the way to Washington this week.

Such was the level of trust earned by Sidney Weinberg that he could trade confidences with some of the leading journalists of his era without fear of hurting their reputations. The senior partner of GS, for example, spent many happy hours sitting in the office of Henry Luce, the publisher of Time Inc., trading information and gossip, and talking with the writers who bustled in an out of Luce's office to report on their research.

One of the young writers who worked for Fortune in those days was Richard J. Whalen, the father of IRA co-founder Christopher Whalen. He remembers Weinberg as a kind man who was generous with information and with sharing relationships, but who on no account ever violated a confidence. There was never any question or concern that the information that Mr. Weinberg might obtain regarding a story that might appear in the next issue of Time or Fortune would be used by the GS traders. Protecting confidences given and received was a matter of honor in those days. Weinberg was also close confidant of Carol Loomis, the legendary editor of Fortune, and likewise kept those confidences over decades of friendship.

Wind the clock forward a few decades, beyond the Big Bang and the financial deregulation of the 1980s, and sadly a different ethic applies on Wall Street. In 1999, President Clinton signed the Financial Services Modernization Act, which tore down the Depression era Glass-Steagall reforms and removed the walls between banks, securities firms and insurers. The bankers who once dominated the major Wall Street firms were pushed aside by the traders, who pay big money to obtain information of all types and by any means. We discussed this evolution in an earlier issue of The Institutional Risk Analyst ("Financial Economics, Deregulation and OTC Derivatives: Interview with Yves Smith of Naked Capitalism," February 22, 2010).

The end of fixed commissions for the brokerage function on Wall Street forced the dealers to depend more and more on risk taking and exploiting "informational asymmetries," a fancy way of saying that they traded on non-public or even insider information. One example of that culture shift on Wall Street was the creation of the market for unregulated, unregistered over-the-counter securities and derivatives, particularly the CDO. These very same opaque and deceptive instruments led to the failure of Lehman Brothers, Bear, Stearns and fire sale of Merrill Lynch, and have now landed GS and the remaining Wall Street firms in a growing political mess.

As you watch the media circus in Washington this week, keep in mind that politicians like Senator Carl Levin (D-MI) are the ultimate source of the problem. You can blame Lloyd Blankfein and the other managers of GS for being short-sighted and unwise when it comes to trafficking in risky OTC assets such as CDOs. You can also fault GS for not exercising greater care in dealing with their clients, but ultimately the Congress makes the rules by which firms like GS and Paulson play the money game. And the fact that the rules allow GS to create toxic waste such as CDOs is the root of the problem.

IRA co-founder Chris Whalen has been quoted in the media as saying that Paulson & Co faces the risk of litigation as a result of the GS fiasco, but the sensationalist media misses the point. The professionals at Paulson & Co did nothing wrong, in our view, other than to notice that other people in the marketplace were doing really stupid things. They followed the advice of Bernard Baruch to the letter. The real point is that the structure of our financial markets is so flawed and so opaque that such opportunities can be created by firms such as GS with impunity and little or no disclosure.

In fact, Paulson & Co seems to be the only player in this chain of woe that actually understood the risk of the OTC derivative securities created by GS. And GS was only able to create and sell these securities because of the negligence and stupidity of the rating agencies, the monoline insurers and banks such as IKB and ABN Amro. All of the other parties failed to do any real diligence on these derivative securities. But the larger question is why we even allow firms like GS to create toxic OTC securities such as CDOs in the first instance.

Paulson & Co actually did its homework, but now that firm faces significant reputational risk for exploiting the flaws in the system created by the Congress, the SEC and, lest we forget, the happy squirrels at the Federal Reserve Board, who continue to act as advocates for the OTC markets. The fact that Paulson & Co reportedly told clients last week that it will defray any legal expenses from the scandal shows that the fund already is under significant pressure because of the frenzied media treatment of this mess.

David Kotok of Cumberland Advisers writing in his latest comment, "The Paulson, Goldman, Tourre Affair," reports: "We are personally aware of three investors who have withdrawn or plan to withdraw funds from Paulson & Co. They are concerned about how Paulson achieved his investment returns now that there is a question about the construction of the investments he used." As we noted last week, the mere existence of OTC securities and derivatives can threaten the existence of all manner of financial institutions -- and the regulators led by the SEC and Fed have known this for years, but still they refuse to act.

The comment by David Kotok describes precisely the type of reputational risk to funds and financial institutions that should make members of Congress and the SEC insist on shutting down the OTC ghetto permanently. But the larger banks, led by JPMorgan Chase (JPM), continue to block such change. When you look at the horrible losses being generated by CDOs, many of which are being liquidated, it seems reasonable to ask why the Congress is unable to respond. So long as we allow firms such as GS, JPM and the other OTC dealers to create unregistered securities such as CDOs, the world of finance is going to continue to produce scandals and systemic events.

To us, the solution to the crisis of trust that grips Wall Street is not merely more regulation. We need to restore basic rules of behavior and compensation in the financial markets so that it is once again in the best interest of firms like GS to exercise a duty of care to all clients. So long as the Congress refuses to accept its primary role in creating the financial crisis via misguided actions such as deregulation, we are not likely to make any progress toward a solution. Were Bernard Baruch or Sidney Weinberg alive today, we can only imagine what they would say.

Questions? Comments? info@institutionalriskanalytics.com

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