“Goldman chief Lloyd Blankfein was understandably wide-eyed with wonder at last week's hearing of the Financial Crisis Inquiry Commission. He pointed out that the people on the other side of every Goldman housing-related trade were, for Jiminy Cricket's sake, professional investors.”Many of the investment banks' defenders have used the “professional investors” argument, but it stands up neither to general nor specific critiques.
Generally speaking and contrary to popular belief, caveat emptor is not a well-established legal principle (thanks contracts class!). Professionals in other fields have many avenues of recourse when they are sold a defective product—just because you’re an expert doesn’t mean you’ve disclaimed all warranties (if this wasn’t true, we wouldn’t need lawyers). Certainly, if a supplier sold GM a faulty $1 part used in a Chevrolet, we wouldn’t want to shield the supplier from liability simply because there are automotive “professionals” that also work at GM. It eludes me as to why you’re liable if a $15 toaster blows up, but not if a $1 billion collateralized debt obligations of asset-back securities does. (These arguments also fail to take into account that Goldman is certainly much more sophisticated than many of the clients it sells to. Clients such as public pension funds in the middle of Wisconsin relied on these financial professionals to give them sound advice—not send them to the poorhouse.)
More specifically, the behavior as it relates to these complex financial products goes beyond investors making a bad deal — there is evidence of fraud and misrepresentation when it comes to creation of these products. Many of the bond insurers (who similar to AIG insured these CDOs) have gone back to find documentation for mortgages stuffed in CDOs is missing or falsified. It’s one thing to fault an investor for buying a product based on the assumption that housing prices will always go up. It’s quite another to assume that they should have been aware the purchaser of a home made only $50,000 per year instead of $100,000, despite an investment bank and its lawyers telling them the mortgage application said otherwise. It seems to me that the shady mortgage origination practices, rating agency bribery, and corrupt sales techniques practiced by investment banks has gone overlooked (or has been forgotten) in this discussion.
Jenkins’ second argument is no better:
“He might have added that Goldman bets against its clients every time it buys something they want to sell or sells something they want to buy. He might have suggested that any client who doesn't understand Goldman is looking after its own interests (just as Goldman expects the same of its client) is an idiot and has no business being in business.”This line of defenses misses two key points about the issue at hand.
First, it doesn’t fairly represent what investment banks do when they make markets for their customers. When they buy a security from a client, they’re not making a bet on the future price path—they’re simply selling liquidity to the customer. In return for the service of buying at almost any time the client wants out of a product, the investment bank “charges” the customer by buying the security for slightly less than it’s really worth. It makes it money not by holding onto the bond and praying its price will go up, but rather by quickly flipping it to another client willing to pay full price.* This has nothing to do with taking a position opposite either client.
*The idea of a bid-ask spread is familiar to anyone that collected baseball cards as a kid and read Beckett's.
But even if we take the market-makers argument at face value, it really has nothing to do with the practice FCIC chairman Phil Angelides was referencing when he compared the investment banks to salesman who sold cars with faulty brakes while taking out insurance on the driver — the origination of complex structured finance product. In this case, the banks are not taking a position against the clients — they’re just selling them a product they created. Issuing a CDO of ABS is no different than taking a company public—except with more complex models and a lot more profit for the bank. Using investment bank’s market-making business is an attempt to excuse bank's behavior by shifting the argument to a completely different service the banks provide.
It’s unfortunate the much of the furor over investment banks have focused on their outrageous bonuses. Although most investment bankers are certainly overpaid and overconfident, it distracts the public, the media and even me (at times) from digging into the real questions about their business practices. I remain unconvinced that anything will be done to taking real steps to clean up this corrupt industry.
UPDATE: Principle not principal. Thanks to commentor Nemo on the Baseline Scenario for pointing that out.