God Is Dead: The Implications of the Goldman Sachs Case

The SEC

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.

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Two decades ago, Drexel Burnham played the difficult hand it was dealt very poorly, partly because of the limitations of its management but also because few financial firms in the modern age had any experience dealing with such a challenge from the government.⁶  Goldman should study the Drexel matter carefully to determine the appropriate course of action in order to assure the best outcome for itself as well as for the financial system.  Goldman would be far better served by settling this matter, and the government would be far better served by agreeing to settle rather than acting like it is dealing with organized crime and inflicting unnecessary systemic damage in a situation where it licensed and opened the casino and has now decided to come in after the fact and change the rules. 

Goldman’s management will be distracted by its fight with the government, and embarrassing emails and other unsavory disclosures will continue to leak out into the press for the duration of the case.  The optimal outcome would be one in which Goldman survives as a firm that is a beacon of ethics, transparency and fair dealing, a standard that its involvement in transactions like ABACUS strongly suggest the firm has allowed to lapse in recent years.  Goldman would also be served by making a corporate decision to shift its business toward more productive activities in the future.  Profits may suffer, but profits without principle are proving an empty accomplishment.  If Goldman is fighting for the ideal that it was providing the marketplace with a useful product in ABACUS, it is tilting at windmills.

Private equity

One of the more unfortunate byproducts of improving corporate credit markets is the ability of private equity firms to cover up their mistakes.  It is unfortunate because it allows the private equity industry to continue to squander the nation’s institutional capital in unproductive investments while delivering poor risk-adjusted returns.  The so-called “maturity mountain” rising up in 2012-14 is being rapidly chipped away by massive refinancings that allow buyout firms to extend the debt maturities on the portfolio companies for which they grossly overpaid during the height of the credit bubble. 

The latest manifestation of private equity’s lack of value creation is a flurry of sales of portfolio companies among buyout firms.  Deals in which both buyer and seller were private equity firms have risen to their highest level since 2006, according to Bloomberg News.⁷  Thus far in 2010, there have been 40 such deals; in 2006, there were 149 such deals.  Recent deals have included TPG Capital’s $1.3 billion acquisition of American Tire Distributors Holdings Inc., the second time since 1999 that the tire company has been purchased by a buyout firm; Cerberus Capital Management LP’s $1.5 billion purchase of DynCorp International Inc.; and the $1.1 billion buyout of Sedgwick Claims Management Services by Stone Point Capital LLC and Hellman & Friedman LLC.

The process whereby one private equity firm sells a company to another private equity firm is one of the more noxious phenomena in today’s financial markets.  Such transactions keep these companies enslaved by debt while the lion’s share of their cash flow is devoted to paying undeserved fees to their private equity sponsors and interest payments to their bankers and bondholders (principal is rarely repaid because these companies are generally incapable of growing after being starved of growth capital for so many years).  These companies often end up in bankruptcy, like the manufacturer of Simmons mattresses, which has changed hands more than half a dozen times in recent years as it has been swapped among private equity firms like a bunch of baseball cards.  Private equity firms are obviously desperate to generate “realization events” that allow them to return capital to unhappy investors and generate fees for their otherwise moribund businesses, which is one reason why these pointless transactions persist.  Institutions are properly starting to question these types of transactions, a promising sign that investors are beginning to wake up to the disappointing reality of private equity.

Public pension funds

HCM read with great interest CALPERS’ announcement that it had reached an agreement with private equity firm Apollo Management⁸ that will lower that firm’s extortionate fees by $125 million over five years.  We would have been more impressed, however, had CALPERS shown greater recognition of the fact that Apollo and other buyout firms with whom it is seeking similar accommodations are responsible for job losses, lower R&D expenses and other drains on economic productivity that ultimately harm the beneficiaries whose capital the giant pension fund invests.  This was particularly disappointing in view of CALPERS adoption of a new policy to prohibit excessive rent increases and the involuntary displacement of low-income households in real estate in which it invests.  This change in policy demonstrates that the pension giant is starting to awaken to the broader implications of its investment decisions. Investors need to understand that private equity is asking them to load a gun that is aimed at the heads of their own constituents.

Public pension funds also need to come to terms with the realities of the post-crash investment environment.  Despite the impressive stock market and credit market recovery since the March 2009 lows, future returns are likely to be both volatile and modest.  The large California pension funds are currently engaged in a debate with Stanford University’s Institute for Economic Policy Research, which published a study suggesting a more than $500 billion unfunded liability for California’s three largest pension funds – CALPERS, Calstrs and the University of California Retirement System.⁹  The three funds criticized the report in part due to the use of an expected return rate tied to 10-year Treasuries of 4.14 percent.  This is far more conservative than the assumed rates of return used by the three large California funds, which range from 7.5 percent to 8.0 percent.  Reasonable minds can disagree about the appropriate return target, but 7.5 to 8.0 percent is too high, particularly if these funds are going to continue to invest significant amounts of money in private equity and other strategies that have proven themselves to be highly overrated (see Chapter 5 of The Death of Capital for a detailed discussion of the fallacy of private equity returns).  Public funds need to be realistic about the markets, and such realism should acknowledge that markets are going to have to contend with the fallout of the massive government stimulus that was required to prevent a replay of the Great Depression.  Accordingly, expecting returns in the 7.5 to 8.0 percent range in a zero interest rate environment, or an environment in which zero interest rate policy is certain to be abandoned, is the opposite of realistic.  Instead, it is likely to lead to investments in strategies that will be unduly risky.  As such, they will involve illiquidity, leverage, concentration risk and other characteristics that led to catastrophic losses in the periodic market collapses that have scarred the investment landscape over the past two decades and most recently in 2007-2008. 

Bank capital

In The Death of Capital, one of the regulatory changes I recommend is an absolute minimum level of bank capital of 10 percent.  This level might even be too low, but it is far better than what current exists.   This minimum level should be maintained at all times, not just at quarter ends or at certain measuring periods.  The reason for such an approach was highlighted recently by a report from the Federal Reserve Bank of New York showing that major banks have been temporarily lowering their debt levels at the end of reporting periods and then significantly increasing them immediately thereafter.  According to this report, 18 banks – including such corporate leaders as Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America and Citigroup Inc. – understated the debt levels used to fund securities trades by lowering them by an average of 42 percent at the end of each of the last five quarters.  They then increased them sharply by the middle of the following quarter before lowering them again.  The banks’ outstanding net repo borrowings (repos are overnight borrowings that these institutions use to finance their trading activities) at the end of each of the last five quarters turned out to be 42 percent lower than their peak borrowings during those quarters.  HCM need not remind its readers that all of these institutions are now bank holding companies and that the three largest of them enjoy government guarantees of one sort or another on their deposits.  HCM should point out that this type of activity is an age-old practice on Wall Street.  Financial firms of all types – banks, hedge funds, whatever – have always dressed up their books for reporting dates.  The question is whether such a practice should be allowed to continue in the wake of the financial crisis, or whether greater transparency and discipline should be enforced through regulatory reform.  HCM believes the answer is a resounding yes, particularly if naked credit default swaps are not going to be banned.

Europe and the rating agencies

The rating agencies are ripping through Europe, downgrading first Greece, then Portugal and then Spain.  The question remains why these intellectually and morally discredited businesses still exist, but HCM is tired of beating that dead horse.  Once again, these self-appointed doyens of credit, who know less than nothing about credit, are showing up at the party too late and adding fuel to a fire that is already raging, making it that much more difficult for governments and central banks to make sound decisions about how to stabilize the situation.  Greece was downgraded by Standard & Poor’s to BB+ from BBB+, Portugal was downgraded to A-, and Spain was lowered to AA.  If the markets continue to allow the imprimatur of credit agencies to determine investment suitability, there is a genuine risk that these downgrades will inflict systemic damage.  This would be, in the words of Karl Marx, both a tragedy and a farce.  The world’s governments and central banks need to get their acts together immediately with respect to these organizations and develop a plan whereby they can no longer inflict damage without consequence.

HCM expects the European Union to end up doing what is necessary to insure that Greece and the other peripheral countries in the union do not drive off a cliff (or further highlight the impossibility of economic union without political union).  As noted in these pages recently, there is no true periphery in an interconnected world, so Greece’s collapse should not be taken lightly.  But it should be kept in perspective.  Greece accounts for only 2.5 percent of the Eurozone’s GDP, and Portugal is even smaller.  Spain is larger, but it is taking strong steps to address its budget woes.  Greece’s €300 billion of debt is hardly insignificant, but it is manageable and is unlikely to reverse the strong recovery in U.S. credit markets unless a default is permitted to spread beyond the Aegean (and Iberian Peninsula).  Policy makers have presumably learned something from the 2008 crisis and will be able to manage the current one.  Investors should remain vigilant, however, just in case something unexpected happens.

Greece is no longer financeable on its own.  After being downgraded by Standard & Poor’s on April 27, Greece’s credit default swap spreads traded at spreads of more than 800 basis points, and its two-year bonds traded at yields in the high teens.  These are unsustainable levels, meaning that the country is effectively closed off from raising additional financing.  Only a bailout will prevent an outright default, and a bailout will occur.  The issue will come down to how much austerity will be inflicted on the Greek state, and whether other countries in similar straits will get the message. 

Michael E. Lewitt

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Disclosure Appendix

This publication does not provide individually tailored investment advice.  It has been prepared without regard to the circumstances and objectives of those who receive it.  This report contains general information only, does not take account of the specific circumstances of any recipient and should not be relied upon as authoritative or taken in substitution for the exercise of judgment by any recipient.  Each recipient should consider the appropriateness of any investment decision having regard to his or her own circumstances, the full range of information available and appropriate professional advice.  Harch Capital Management, LLC recommends that recipients independently evaluate particular investments and strategies, and encourage them to seek a financial adviser’s advice.  Under no circumstances should this publication be construed as a solicitation to buy or sell any security or to participate in any trading or investment strategy, nor should this publication or any part of it form the basis of, or be relied on in connection with, any contract or commitment whatsoever.  The value of and income from investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies, geopolitical or other factors.  Past performance is not necessarily a guide to future performance.  Estimates of future performance are based on assumptions that may not be realized.  The information and opinions in this report constitute judgment as of the date of this report, have been compiled and arrived at from sources believed to be reliable and in good faith (but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness) and are subject to change without notice.  Harch Capital Management, LLC and/or its employees, including the author, may have an interest in the companies or securities mentioned herein.  Neither Harch Capital Management, LLC nor its employees, including the author, accepts any liability whatsoever for any loss or damage arising from any use of this report or its contents.  All data and information and opinions expressed herein are subject to change without notice.

 

The HCM Market Letter
Michael E. Lewitt, Editor

 

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