Shocked, Shocked!

“I am shocked, shocked to find that gambling is going on here!”

French inspector Louis Renault in Casablanca

It is one of the classic scenes in cinema, in my favorite movie Casablanca.  French Inspector Renault, played by Claude Rains, is instructed by the Nazis to close down Rick’s Café American.  When Rick Blaine (Humphrey Bogart) asks why, he is told that the inspector is shocked to have discovered gambling activity – just before pocketing his own winnings from the rigged roulette wheel.

Last week Greg Smith, one of Goldman Sach’s Executive Directors, resigned publicly from the firm and wrote a scathing Op-Ed in The New York Times about the decline of Goldman’s corporate culture.  Like Inspector Renault’s ‘discovery’ of gambling, Smith’s op-ed triggered a similar faux shock in the community of folks who run money.  Goldman Sachs has an amoral, money-worshipping culture that places its own profits before the interests of its clients?  Who knew?

The answer, of course, is everyone in the money business, and everyone who has followed the financial crisis and its aftermath.

A telling example of Goldman’s rapacious culture is the story of John Paulson’s enormously profitable bet against the mortgage market in 2007, as chronicled in Michael Lewis’ best-seller, The Big Short.  Paulson was convinced the mortgage market was beginning to tank, and Goldman helped him to construct a bespoke CDO, consisting of only the worst, most toxic underlying mortgage pools.  They let Paulson accept or reject individual securities:  Wells Fargo?  No, thanks, underwriting standards too high.  Washington Mutual?  Put that sucker in; those clowns will issue a mortgage on an outhouse, so the loans are sure to be garbage.

When the toxic, reeking mess was assembled, Paulson shorted it…and Goldman sold it to its clients.

Paulson’s hedge fund made $3 billion on the trade.  Goldman got fees for putting the security together and commissions for selling it.  And Goldman’s clients (the “muppets,” in Goldman-speak) lost the same billions that Paulson made on his Big Short.   After the fact, the SEC brought a criminal complaint against Goldman over the Abacus CDO, which Goldman eventually settled for $550 million, a fraction of the losses the firm’s clients suffered.

As someone said, not for attribution, “Everyone hates Goldman Sachs.  But when you need to find out the details of a new issue on the Hong Kong exchange, your Goldman contact always knows exactly who to call.”

Ruthless, self-interested and brilliant – that is Goldman Sachs in the 21st century.

It was not always thus.  Years ago, Goldman’s reputation was sterling.  Back then, it was the retail investment firms (the ‘wirehouses’ like Merrill Lynch and Dean Witter) whose reputations were questionable.  The wirehouse sales culture, which values revenue to the firm above results for the clients, was the reason my partner and I left large brokerage firms to form our own independent investment advisor back in 1990.

Today’s crisis of confidence in Wall Street has causes both cultural and structural.  There is a fundamental problem inherent in the profit model of the big firms.  At Goldman Sachs, just as at Merrill Lynch or Morgan Stanley Smith Barney, the bond trading desk is just as much a profit center as the brokerage branch office.  The bond the client buys may be the very toxic asset that the firm wants to get off its balance sheet, and the profits of the prop trading desk probably contribute more to the firm’s bottom line than the total of all client-facing activities.

The breakdown of trust in our financial system is based on an accurate perception of Wall Street’s culture and priorities.  This is a fundamental problem.  Like law and medicine, the profession of giving advice to other people about their money must be based on trust, or the system breaks down.   While I know people in the investment business who are as upright as Atticus Finch, the fictional attorney in To Kill a Mockingbird, too many are trapped working for big firms with different priorities.  Many of the most client-focused advisors are leaving to become independent advisors, as detailed here.

Congress and the regulators continue to wrestle with this problem.  The SEC is considering establishing a fiduciary standard for every individual or firm in the business of giving financial advice.  This standard, which already applies to investment advisors but not to stockbrokers, requires that every recommendation must be in the best interests of the client.  A uniform standard would be a good start towards restoring trust in our financial system.  Many Wall Street firms are coming around on the fiduciary standard, though insurance companies in particular remain bitterly opposed.

I wish Greg Smith well.  His was a gutsy move, one that will make it difficult for him to get another job in the investment business.  As to whether Goldman Sachs can reform, we’ll just have to wait and see.

One thought on “Shocked, Shocked!

  1. Some facts I found relevant in thinking about Goldman’s & Paulson’s deal:
    1) The CDO was synthetic, and this was not a secret to any party in the transaction
    2) The “muppets” in this case included Paulson, on one side of the deal, and IKB Deutsche Industriebank on the other side.

    IKB Deutsche Industriebank at the time of the transaction was an 80 year old German bank with about ~$80billion assets (from memory), Wikipedia lists it at about $60billion now.

    A “Synthetic” CDO is a bet, not an investment. A real CDO is a way of funding a bunch of mortgages. A “Synthetic” CDO means someone has defined a pretend CDO based on the performance of some real CDOs and is essentially brokering a bet on the performance of the real CDOs that underlie the synthetic.

    Now for the opinion part.

    If I were “investing” in a synthetic anything, I would know I was making a bet. I would KNOW that someone else was on the other side of the bet. I would KNOW that I was counting on some rich, creditworthy investor to pay me each month AS THOUGH he could borrow money at no better terms than were given to the subprime mortgagees listed clearly in the prospectus for this bet.

    I would have the inescapable knowledge that they thought I was the “muppet” and that I was counting on them being the “muppet.” That I was BETTING against someone else who is qualified to invest billions of dollars at Goldman.

    I would KNOW that someone else was betting that I am an idiot and that they were going to wind up with at least some of “my” money. And I am just a guy, not a $60billion 80 year old bank that survived a World War on the losing side.

    Goldman may not be Mother Theresa, but no one really thought they were, least of all their rich, experienced customers.

    More opinion: even the U.S. Government knew their case was sentimental garbage, but they knew they needed to go after somebody for PR reasons since there were (and still are) so few REAL prosecutions coming out of this crisis.



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