May 11, 2010
In HCM’s experience, prosecutors of securities violations have consistently proven themselves to be among the least ethical and most politically motivated participants in our system of government. In this respect, the SEC has shown itself over the years to be particularly deficient. Reports that the SEC heard testimony from Paulson officials that contradicts the gravamen of its case against Goldman would not surprise HCM; there are many things about the civil complaint that don’t add up.4 The SEC is already trying to use the Goldman case to boost its funding, which is one of the rare cases in which the agency is putting the cart ahead of the horse rather than scrambling after the horse after it has already fled the barn. On April 28, SEC Chairwoman Mary Schapiro touted the Goldman case in asking for more funding from the Senate. She is going to look awfully silly if the agency can’t make its case against the Wall Street giant.
There have been too many examples in recent years of prosecutors violating the rules by concealing exculpatory evidence from defendants, trying to deny defendants access to counsel, and otherwise using pressure tactics better suited to the Gulag than the United States. Powerful white collar defendants deserve no special breaks, but they are certainly entitled to the same assumption of innocence as violent criminals. HCM has no doubt that what occurred with respect to ABACUS was morally deficient, not simply on Goldman Sachs’ part but also on Paulson’s part. But moral deficiency is a far cry from legal culpability. The SEC’s allegations concerning insufficient disclosures may or may not prove to be correct particularly with respect to IKB, the German bank that lost $150 million in the deal. But the SEC might as well close its doors if it suffers a defeat in this case. In fact, the stakes are so high that history suggests that the agency will be sorely tempted to do whatever is necessary to win this case, a frightening proposition for Goldman Sachs and the rest of Wall Street. The ghost of Rudy Guiliani, a serial abuser of defendants’ rights as well as a political grandstander of the worst sort during his tenure in the Justice Department (and thereafter frankly), has not yet been extinguished, and populist anger at Wall Street has never been stronger. As is unfortunately all too often the case, the safeguards against mob justice are weakest just when they need to be strongest. As a result, the rule of law may end up to be the biggest casualty in this case. Certainly the demagoguery that filled the Senate hearings held on April 27 was a harbinger of ugly things to come in this respect.
The Senate carnival
Goldman’s Chairman Lloyd Blankfein and other executives spent almost eleven hours defending their firm before a hostile committee of lawmakers on April 27 in Washington D.C. Two key things became apparent during that hearing. First, lawmakers do not understand (or do not want to understand) that the modern Wall Street business model involves firms acting primarily as principals trading for their own account and acting as market makers whereby they make two-sided markets for other market participants. Yet this business model is largely attributable to rules and regulations and other policies promulgated by these suddenly outraged politicians who are shocked, simply shocked that gambling is occurring in the very casinos that they were responsible for licensing.
The clients that Goldman is serving as a market maker, however, are not “clients” in the fiduciary sense of the term. Senator Carl Levin consistently misapplied the standard of disclosure that relates to Goldman as an underwriter to Goldman in its role as market maker as he quite effectively played to the crowd to feed public outrage at the Wall Street firm. In fairness, these two roles blur when Goldman Sachs acts as an underwriter and then makes a market in the securities it underwrites. But underwriters and market makers are not subject to the same disclosure obligations because they fulfill different functions. A market maker does not owe a fiduciary duty or a duty of full disclosure to those with whom it trades; it does, however, owe a duty of fair dealing. While a fiduciary is required to place its client’s interests ahead of his own, a firm acting as a market maker is not subject to any such requirement. What a market maker cannot do is cheat those with whom it is trading. The market making function requires a firm like Goldman Sachs to take both long and short positions in order to manage its risk while using its capital to facilitate market transactions; the other parties trading with the firm understand that even if United States Senators do not. If a market maker does not prudently manage its capital, it will go out of business. Look no farther than Bear Stearns, Lehman Brothers and Merrill Lynch for object lessons in how not to perform that function effectively while harming the system in the process.
The system would cease to function if market makers were required to disclose their trading positions, not as an ethical matter but as a practical matter since these positions are constantly changing and may be entirely unrelated to the firm’s view of the underlying investments. It would be entirely impracticable for a market maker to be required to explain its changing positions and the rationale for them. Clients don’t expect such disclosure (in fact the most astute ones assume market makers are betting against them) and are not being cheated when the firm does not share this information with them. Goldman’s executives could have done a better job explaining this reality, but that doesn’t change the fact that their conduct is not only legal but appropriate in modern markets.
This leads to a second thing that became very apparent during the hearings and that does not redound to the benefit of Goldman Sachs. Mr. Blankfein and other Goldman executives consistently expressed the view that the firm’s only job is to provide market participants with different types of risk exposures to the financial markets, including the housing market in the form of mortgages. Mr. Blankfein in particular still seems to believe that synthetic CDOs serve a useful economic or social purpose. Even if there were a glimmer of truth hidden somewhere in the bowels of this argument (we do not think there is), Mr. Blankfein should give it up. Nothing says that Goldman Sachs must engage in every form of trading known to man just because the firm’s clients demand it or because its competitors are doing so. HCM will repeat what it wrote concerning Goldman’s role in the Greek debt debacle: “There is a plethora of ways to earn a profit in the financial world, as Goldman knows better than any other firm in existence; that doesn’t mean the firm has to take advantage of every one of them.” 5
Many of the firm’s clients who were active investors in the mortgage markets ended up failing, including two that were involved in the ABACUS transaction (ACA Management, LLC and IKB). Three of the firm’s primary competitors, Bear Stearns, Lehman Brothers and Merrill Lynch, also failed in large part due to their mortgage investments. The fact that Goldman is the last man standing not only suggests that the firm was more adept at managing its risk but raises politically damaging but ultimately unsupportable post hoc suspicions that it knew something that these other firms didn’t know and took advantage of that knowledge. Goldman may be smart, but it wasn’t that smart – the firm was already long significant mortgage risk through its underwriting and market making operations and worked hard to offset this risk with short positions. Had it not done so, it could have suffered massive losses like its failed competitors. There is a vicious irony in the fact that Goldman is now being attacked for surviving, particularly when the allegations that it did so by breaking the rules are so tenuous. If the disgraced former chairmen of firms that engaged in similar practices but failed to protect either their clients or themselves (i.e. Richard Fuld, James Cayne and Stanley O’Neal) were held to the same standard as Mr. Blankfein by a Senate panel, they would be delighted if the worst adjective used to describe their conduct was “shitty.”
What Goldman should do now
Perhaps we need to expand our definition of intelligence to encompass moral as well as purely technical intelligence. For managers of systemically important financial institutions like Goldman Sachs or JPMorgan Chase or Paulson, being the smartest guy in the room should mean more than just making money in any way possible – it should mean being able to look ahead to judge the potential political and social impact of a business strategy, trading program or new product. People are still raving about how brilliant John Paulson and his lieutenants were in figuring out how to make billions of dollars by shorting the mortgage market. There were others of us who believed what Paulson did about the housing market but who decided not to act on it for a variety of reasons. Paulson may have been correct in a purely intellectual sense, but in a moral and ethical sense his actions should more properly be considered as bankrupt as the flawed fodder from which he made his fortune. While in most cases there is nothing wrong with shorting stocks or financial instruments, it is hard to avoid the judgment that what Paulson did was unseemly.
Goldman needs to stand behind the young employee, Fabrice Tourre, who has been singled out by the SEC for punishment. HCM has always found one of the most despicable aspects of Wall Street’s culture to be the willingness of management to sell out its employees. HCM experienced this personally at Drexel Burnham Lambert, Inc., where management even went so far as to retroactively waive its employees’ attorney-client privilege. At Merrill Lynch, management abandoned the investment bankers who foolishly (but with the firm’s full knowledge and backing) did business with Enron Corp. (and were later exonerated if memory serves correctly with the able representation of attorney Ike Sorkin). Countless other examples of such disloyalty abound. Thus far, Goldman appears to be grudgingly standing by the actions of Mr. Tourre, who was all of 27 years old at the time in question and whose deal was approved by a committee consisting of the firm’s most senior managers. But there are clearly signs of strains in the relationship as Goldman tries to figure out its best course of action. Certainly the release of Mr. Tourre’s personal emails was unnecessary and reflected far more poorly on the firm than on Mr. Tourre, and Mr. Blankfein’s avoidance of responsibility for such a decision at the Senate hearings cannot breed confidence among the troops in his leadership or his loyalty to them. Knowing what I know about Goldman’s operations and culture (HCM has worked on several structured finance transactions with the firm), it is simply not credible to contend that the firm permitted a 27-year old employee to cowboy a $1 billion transaction. Goldman’s strong risk management culture is based on the intimate involvement of senior managers in the business. Accordingly, Goldman should not try to have it both ways by defending its own actions while trying to separate itself from Mr. Tourre. There is no suggestion that Mr. Tourre was a rogue trader sticking tickets in a drawer or otherwise hiding what he was doing from his bosses. Mr. Tourre acquitted himself well in his opening statement before the Senate Committee (although his testimony went downhill from there), and he deserves the strong backing of Goldman Sachs and its top executives.
4 See footnote 3.
5 The HCM Market Letter, March 1, 2010, “Greeks Bearing Gifts,” p. 2.
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