THE US SENATE VOTED IN JULY TO APPROVE A DILUTED VERSION OF A MAJOR REFORM OF THE BANKING SECTOR, A POLITICAL SUCCESS FOR THE OBAMA ADMINISTRATION. HOWEVER, THE MORE SIGNIFICANT STORY MAY BE ABOUT THE LEGAL, YET SHARKISH, BUSINESS PRACTICES OF GOLDMAN SACHS
On the very day the Dodd-Frank Act (named after Democrats Christopher Dodd of the Senate and Barney Frank of the House of Representatives) was approved by the Senate, another development went barely noticed: a settlement between the Securities and Exchange Commission (SEC) and Goldman Sachs. This was over the Abacus case, in which the bank was accused of helping speculators "short" subprime securities while simultaneously selling the same securities to other clients. The bank did not acknowledge guilt, but agreed to pay a $550m fine. The SEC, long criticised for its inaction, could claim a victory. And Goldman Sachs displayed its political skills: while acknowledging "errors" in marketing the securities, it managed to keep its entire executive structure in place, allowing it simply to move on. The settlement may look significant, but it only amounts to two weeks' worth of its 2009 profits, and 3% of bonuses for that year.
The ability to play power games should not surprise. Since the early 1990s, every Goldman Sachs CEO has crowned his career with either a political appointment or elective office (see Friends in high places). This explains the involvement of Goldman Sachs in every major story in politics and finance: the onset of the subprime crisis and the rescue of the financial system; the Greek government debt and subsequent euro crisis (Goldman Sachs helped Greece hide its debt); and the rise in price of oil (due to speculation in commodities markets). Until the most recent scandal, Goldman Sachs managed to make consistently high profits, even profiting from the bursting of bubbles it had helped create. In prosperity, such success inspired admiration. But, when it was rescued by government intervention while the economy was in a terrible shape, record profits and bonuses provoked more shock than awe. Public opinion turned against the firm: were public misery and the stratospheric results of the company linked?
The company, created in 1869 by Marcus Goldman, a Jewish immigrant from Bavaria, later joined by his son-in-law Samuel Sachs, initially specialised in commercial paper (short-term debt issued by corporations). It was long shunned by a financial establishment dominated by Wasps. After being badly affected by the 1929 crisis, it rose in the years after the second world war, and played a key role in the 1956 public stock offering of Ford Corporation. It slowly acquired an enviable reputation for the professionalism of its hard-working, tightly knit teams and its strong corporate culture, dominated by old-style financiers such as Sidney Weinberg or Gus Levy. It gained the respect of the financial establishment – and finally came to embody the establishment.
Even so, Goldman Sachs, methodical and prudent, refused to get involved in hostile takeovers. One of its mottos, "make haste slowly", earned it the nickname "turtle". It avoided excess, and made a point of paying its employees less than its competitors, frugal by Wall Street standards. The firm believed in the virtue of being "long-term greedy" – of forsaking immediate gain in exchange for the abiding loyalty of its customers. Goldman Sachs's culture, an idealised vision of itself, was embodied in its 14 commandments, the eighth being: "We have no room for those who put their personal interests ahead of the interests of the firm and its clients." In those days, deontological codes and the "my word is my bond" principle still held some
Turtle to octopus
This started to change with deregulation in the 1980s. The supreme criterion became the achievement of ever-higher returns, which has meant more leverage, flouting the remaining rules and frenzied "innovation" (2). The new era was also marked by closer ties to governments (despite an official discourse stressing the free market) and internationalisation. Slowly but surely, the "turtle" turned into an "octopus" trying to rewrite the rules of global finance to its advantage. In every major foreign market, Goldman Sachs recruited top dollar people from the political and financial establishments to take full advantage of the opportunities of privatisation and deregulation.
Another major turning point occurred in 1999 when Goldman Sachs abandoned its partnership structure to become a publicly traded company (3). Where once every partner was personally liable for losses suffered by the company, and was expected to reinvest most of his profits in the partnership, the firm was now owned by shareholders with no special obligations towards the company. On going public, Goldman Sachs was "valued by the market" at $3.6bn, and the 221 former partners, owners of 48% of the shares, pocketed on average $63m each (4). This marked the end of financial discipline – and the long view. Success was to be measured exclusively in quarterly profits, and Goldman Sachs could boast of its exceptional profitability ($13.4bn in net profits in 2009) and bonuses.
In the financial casino, the bank is the house, which earns a cut from every transaction, and also a trusted adviser generously compensated to provide advice on strategy and investments to companies, governments, and institutional investors. The analysts and economists of Goldman Sachs are among the most influential in the world, and their utterances sometimes move markets. Most importantly, the bank trades on its own account, and on the gambling table it is a player who knows the cards of the other players. It invests its own funds in financial markets, in real estate and in the ownership of promising companies. And since it acquired J Aron & Co in 1981, Goldman Sachs has become a major player in the commodities market, and exerts some influence on the economic welfare of producers and consumers worldwide. It is a player in the energy market through its oil trading, and in the global warming debate through its role in carbon credits (5).
Conflicts of interest are inherent in a financial supermarket offering many financial products and constantly seeking to maximise profits. The Abacus scandal, triggered by indiscreet emails sent by trader Fabrice Tourre (see Quants who turned lead into gold) is an illustration. Goldman Sachs was accused by the SEC of having cheated its customers in 2007 by selling them CDOs (collateralised debt obligations), complex derivatives based on subprime mortgages without informing them that it was betting on the collapse of the CDOs. The bank liquidated its own portfolio, which it had every right to do. But it also hid from its clients that it had received from the Paulson hedge fund $15m to structure the transaction, and that John Paulson, the speculator, had participated alongside bank executives in selecting the mortgages most likely to fail.
Although convinced of the imminent collapse of the real estate market, it was still encouraging its clients to purchase securities premised on its continuous rise. Worse, its actions in tandem with bearish hedge funds accelerated the decline of these securities. Investors, unaware of such double-dealing, may have lost more than $1bn. Before conceding "errors" and paying a fine, the bank denied any wrongdoing, considering the SEC complaint "without foundation".
Goldman Sachs was also speculating on the debt of Greece – while being paid, rather handsomely, as an adviser to the government in its debt-renegotiation efforts.
Let the buyer beware
Legally, Goldman Sachs may have a point: what is unethical is not necessarily illegal. Twenty years ago, at the time of the savings and loans scandal, more than 1,500 bankers went to jail under anti-racketeering laws meant to fight organised crime. Financial institutions can now take advantage of a new ideological and legal framework. Many new products, such as credit default swaps (CDS) are not regulated at all. The caveat emptor (let the buyer beware) principle prevails. As Goldman Sachs has ceaselessly repeated, it sold controversial products in response to demand from "sophisticated institutions" which should have exerted due diligence. Furthermore, these investors had signed documents that were replete with warnings and disclaimers.
In high finance, opacity can be the result of excessive transparency. Products often come with hundreds of pages of (unreadable) documentation that investors are supposed to have understood – which explains why investors often prefer to rely on the shortcut provided by ratings agencies, although these have generally failed to understand what is going on. In the words of Rama Cont, director of the centre of financial engineering at Columbia University, in order to understand the true risks of subprime securities (which had earned AAA ratings), "the information was available, but every subprime security was explained in 50 to 60 pages, often with different legal methodologies. An appropriate staff would have been necessary to decipher the 5,700 pages of the debt derivative Abacus" (6).
Goldman Sachs, long a widely admired corporation, has a serious image problem. In a recession that it helped create, along with other Wall Street giants, it awarded its employees obscene bonuses. A proliferation of scandals suggested that its good fortune amid misery was not unrelated to the ubiquity of its alumni in politics. It is now common for politicians to rail against it. Gordon Brown, Angela Merkel and Barack Obama had harsh words about a bank that may still some day offer them a job.
The Goldman Sachs affair made it politically possible to enact financial reform. But although the Dodd-Frank legislation is clear on broad principles (preventing the collapse of large financial institutions and their bail-out by taxpayers; limiting trading by banks on their own account; imposing greater transparency on the over-the-counter derivatives market; protecting consumers from predatory and usurious practices), it will all depend on how the 2,300-page legislation is implemented. According to the US Chamber of Commerce analysis, the Dodd-Frank legislation will require that 10 government agencies write 533 new regulations, 60 inquiries and 94 reports within a period of between 3 months and 4 years. The banking lobby has many battles to fight and is counting on the gradual disappearance of public resentment against Goldman Sachs and banks in general.
SEE ALSO: Quants who turned lead into gold
(1) Charles D Ellis, The Partnership: The Making of Goldman Sachs, Penguin Books, New York, 2009.
(2) See Suzanne McGee, Chasing Goldman Sachs: How the Masters of the Universe Melted Wall Street Down...And Why They'll Take Us To the Brink Again, Crown Business, New York, 2010.
(3) Lisa Endlich, Goldman Sachs: The Culture of Success, Simon and Schuster-Touchstone, New York, 2000.
(4) Nomi Prins, It Takes a Pillage: Behind the Bailouts, Bonuses and Backroom Deals from Washington to Wall Street, Wiley, Hoboken, 2009.
(5) Matt Taibbi, "The Great American Bubble Machine", Rollingstone.com, New York, 5 April 2010.
(6) Sylvain Cypel, "Les conflits d'intérêt d'Abacus", Le Monde, 4 May 2010.
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