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Goldman's Pieties Go Too Far

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics and Director of the Maurice R. Greenberg Center for Geoeconomic Studies
January 12, 2011
Financial Times

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For sheer, toe-curling embarrassment, it's hard to choose between last year's populist attack on Goldman Sachs by the US Securities and Exchange Commission and this week's cringe-worthy response from the investment bank.

Last April, when the SEC filed suit against Goldman, the bank could have fought back. The suit complained it had sold fancy mortgage securities without disclosing that a hedge-fund manager, John Paulson, was betting that those same securities would blow up. To which Goldman could have answered: so what? Any time an investment bank sells any derivative, it should be obvious to the buyer that somebody somewhere must be taking the other side. The SEC's assertion that Goldman had misled customers about the nature of Paulson's involvement was potentially more damaging, except that the SEC produced no evidence to make this charge stick.

It was surely not beyond the wit of Goldman's publicists to communicate these simple points. Banks cannot be held responsible for the profits or losses of their clients, since middle-men necessarily have customers who lose as others win. But after one vain attempt to explain market making at a belligerent Senate hearing, Goldman's boss, Lloyd Blankfein, gave up. He settled with the SEC, even though most lawyers think he could have beaten the charges. Then he ordered up an elaborate cleansing ritual to relaunch the firm of Goldman Sachs.

Several months later, the fruits of Goldman's sun salutations are out. A 67-page manifesto of self-purification proclaims that “our clients' interests always come first,” and that “if we serve our clients, our own success will follow.” But these pieties misrepresent the true nature of an investment bank just as surely as the SEC did.

A bank's first loyalty is to its profits, not those of its customers – it's us-against-them, not zen and om. Despite claims to the contrary, banks frequently play customers for patsies, keeping the best investments for themselves while selling leftovers to clients. They exploit knowledge of their customers' order books to make money on proprietary trading. They also advise corporate clients to merge, acquire rivals, and issue copious securities – activities that generate handsome fees but don't always benefit companies in the long run.

Consider, for example, Goldman's recent deal with Facebook. Goldman's private equity fund first considered providing Facebook with the capital it needed, but did not like the company's giddy valuation and decided to pass. Perhaps hoping to underwrite Facebook's eventual initial public offering, Goldman cemented its relationship by injecting $450m of its own capital. Then it invited its customers to put up a further $1.5bn – but on terms considerably less favourable than its private equity group had turned down. Of course, if Facebook's social network prospers those customers will be delighted. But it can hardly be argued that Goldman put their interests before its own.

Goldman used to say that its proprietary trading accounted for no more than a tenth of its profits, making the resulting conflicts a marginal distraction. Nobody believed that: the standard Goldman trading desk was designed to generate income from market-making and commissions, but also to garner intelligence about how major market players were positioned – intelligence that Goldman used to place its own bets.

To Goldman's credit, this week's purification has brought fresh honesty about how lucrative these bets are. In the first nine months of last year, proprietary investing and lending accounted for a fifth of the bank's pre-tax earnings: in one quarter they amounted to a remarkable 59 per cent. Since every investment or loan represents an opportunity that Goldman's clients might have wanted, why even pretend that customers come first?

The truth is that investment banks are rife with potential conflicts – first between their trading and that of their clients, and second between various classes of customer, whom banks may serve as advisers, market-makers, underwriters or as a fiduciary. No amount of yogic incantation can harmonise these split personae; the solution is to break banks into functional units, so that merger experts, marketmakers and proprietary traders no longer cohabit. A refashioned Wall Street of specialist boutiques would be healthier for customers. And since the boutiques would be smaller than today's megabanks, they might be small enough to fail.

Of course, this has long been evident to anyone who cared to look. An army of specialist advisory firms and hedge funds – ignorantly attacked as “shadowy” because they lack publicists and friends in Washington – has sprung up on the principle that focused private partnerships are preferable to conflicted behemoths. But for years policymakers have shrunk from challenging the big investment banks, comforting themselves with the thought that if the customers did not like them they would vote with their wallets. The customers, for their part, have been either awed or ignorant. Perhaps Goldman's pieties will encourage them to wake up.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here.

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