Goldman: Gambling Prosperity at Client Expense?
What a scene that 11-hour Senate subcommittee interrogation of Goldman Sachs (GS) executives was on C-Span – I’m still wondering whether a forklift was utilized to hoist in the multi-thousand page binders stuffed with reams of exhibits. With caffeine beverage firmly in hand, I watched as much of the marathon as possible until fatigue set in. Not all was lost though, because I managed to simultaneously conduct new stock research as I was glued to the hearings. After I saw the Goldman executives repeatedly wrestle open the gargantuan-sized binders of smoking-gun emails, I checked the paper futures markets and am now contemplating a purchase of International Paper’s (IP) stock.
Lead trader of the controversial Abacus/John Paulson deal, “Fabulous Fab” Fabrice Tourre, did not disappoint his supporters either, firmly addressing his responses in his French Pepe Le Pew accent. His Goldman trading counterparts (Daniel Sparks, ex-mortgage department head, Joshua Birnbaum, ex-managing director of the department, and Michael Swenson, current managing director of the department), like all Goldman witnesses, did their best at bobbing and weaving the intrusive, pointed questions. On the cozier side of the questioning fence, the Senators did a superb job of raking the Goldman execs over the coals with endless exhibits of emails. Judging by the shiny, sweating mugs of the traders, the Senators were successful in making the testifiers uncomfortable – either that, or the Senators had the thermostat in the room raised to 82 degrees.
Betting Away to Profits
At the heart of the questioning was the key issue of whether Goldman Sachs executives and employees were acting in the best interest of their clients (fiduciary duty), or were they making bets against clients with the benefit of privileged information. Senator Claire McCaskill compared Goldman to a bookie manipulating bets in their own favor without sharing their edge with bettors (investors). In the case of the Abacus deal, Goldman admits to not freely disclosing the involvement of now-famous, mortgage market short seller John Paulson (see the Gutsiest Trade) to the so-called sophisticated institutional investors, ACA Capital Holdings Inc. Was this lack of disclosure illegal? Perhaps unethical, but pundits have already established the high hurdle the SEC (Securities and Exchange Commission) will need to clear in order to prove Goldman’s guilt.
Based on the testimony and facts introduced in the hearings, and as I write in my previous Goldman article (Goldman Cheat?), Goldman’s behavior throughout the housing collapse and participation in the ACA deal reflects more about intelligent opportunism within a loose regulatory framework than it does about criminal behavior. Having managed a $20 billion fund (see my book) I dealt with the conflicts of interest and self dealings of the investment banks first hand. As I entered trade orders reaching into the millions of shares, do I naively believe Goldman and other banks altruistically kept that information in their trading vaults? Or is it possible that information leaked out to other clients or was used for the banks benefit? Suffice it to say, the regulatory structure and conflict of interest frameworks, as they stand today, are not stacked in favor of investors.
Although we wish our regulators and government officials could have been more forward looking, rather than reactive, nonetheless, some reforms need to be instituted to resolve the substantial risks built into our financial system today. Here are a few ideas from the 10,000 foot level:
Volcker Rule: Former Federal Reserve Chairman’s so-called “Volcker Rule” is looking better by the minute. Not a new concept, but as regulators shine the light on the opaque industry of derivatives trading and proprietary trading desks, the need for new reforms becomes even more evident. Derivatives are not evil (see Financial Engineering), but like a gun or knife, if misused these instruments can become extremely dangerous…as we have found out. The Glass-Steagall Act, which separated investment bank functions from commercial bank functions, was repealed almost 70 years after its introduction in 1932. The Volcker Rule would be a “lite” version of Glass-Steagall Act because the thrust of the proposal is aimed at splitting the risk-taking proprietary trading desk activities from the client based activities.
Heightened Capital: If you rented out an exotic car or motorcycle from a store, you would likely be required to commit a deposit or collateral to protect against adverse conditions. The same principle applies to derivatives, which generally raises volatility due to inherent leverage. The riskier the product, the larger the capital requirement should be. The collapse of Bear Stearns, Lehman Brothers, and AIG are painful lessons learned from situations of excessive leverage.
Central Clearing/Transparency: Derivative products such as options, futures, and swaps have existed for decades. The transparency gained by trading these securities on exchanges increases market confidence, thereby increasing liquidity and lowering costs for end-users. Standardization around complex derivatives like CDOs (Collateralized Debt Obligations), CDSs (Credit Default Swaps), and CLOs (Collateralized Loan Obligations) is a must to ensure the fact regulators can actually understand the products they are regulating.
Credit Rating Agency: It’s not entirely clear to me that the rating agencies play a critical role in the market place. In effect, the agencies serve as an outsourced research resource primarily for fixed income investors. If the agencies disappeared today, investors would be forced to do their own homework on each deal – not necessarily a bad idea. If the existing oligopoly structure of agencies ultimately survives, I suggest penalties should be incurred by firms with inaccurate ratings. Conversely, ratings could be structured such that compensation could be tiered (or escrowed) over time with payment incentives tied to the underlying deal performance relative to ratings accuracy.
Too Big To Fail: The massive bailouts and TARP (Troubled Asset Relief Program) money handed out to the financial and auto companies have left a sour taste in taxpayers’ mouths. A systemic risk regulator with the authority to unwind unhealthy institutions makes common sense. An insurance pool financed by self-inflicted industry taxes would assist regulators in achieving the reduction of troubled financial institutions.
Fiduciary Duty: Sidoxia Capital Management is a Registered Investment Advisor (RIA) and must act in the best interests of the client. Unfortunately, much of the industry is structured with a much lower “suitability” threshold, which provides a veil for firms to engage in less than ethical behavior.
Overall, regulatory reform urgency is in the Washington D.C. air and there is no question in my mind that a certain degree of witch hunting and scapegoating is occurring. Nonetheless, Lloyd Blankfein and team Goldman Sachs made it out alive from the Congressional hearing, but not without suffering some negative reputational damage. Former Goldman CEO alum and Treasury Secretary Henry Paulson probably sent roses to Mr. Blankfein thanking him for taking Paulson’s job before the 2008 market collapse. When regulatory reform eventually kicks in, perhaps Lloyd Blankfein and Henry Paulson will take a trip to Las Vegas to celebrate (or commiserate).
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and in a security derived from an AIG subsidiary, but at the time of publishing SCM had no direct positions in GS, IP, AIG, JPM/Bear Stearns, LEH/Barclays or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.