Thursday, May 20, 2010

Going Once, Going Twice, SOLD (Out Their Own Clients)

As expected, a number of bloggers have defended Goldman Sachs after the New York Times skewered the bank on the front-page the other day. Some critiques of the story had merit; others did not. I’m going to focus on part of one made by the Atlantic’s Daniel Indiviglio.

Next, the article faults Goldman for its involvement with auction rate securities. Yes, Goldman was wrong to think that these securities would be okay. But then, so was every other investment bank. Virtually all were advising clients to sell auction-rate securities, and all got out as quickly as possible when they realized how poorly the securities would perform as liquidity was drying up.

It’s true that many other banks also did this, but that should not excuse Goldman’s behavior. As my mother would say, "if everyone else was jumping off a bridge, would you do it, too?" But in any case,  Indiviglio misses some key points about this particular market.

The issue is not simply that the auctions began to fail in February 2008 — it’s that the banks had always stepped in and prevented them from failing in the past. The municipalities and nonprofit groups that issued the auction-rate securities believed they were getting a great deal — and no doubt the bankers assured them they were — because they essentially got to borrow long-term at short-term rates. Although, in theory, there was a chance the auction could fail and lead to penalty interest rates, this appeared impossible in practice, because the banks that ran the auctions had always supported them (until February 2008, at least). In fact, I’d be surprised if, when banks pitched the product to issuers, they didn’t mention their willingness to step in and prevent auction failures. With that in mind, it makes the banks' behavior a bit more egregious.

Further, Indiviglio fails to consider the perspective of an entirely different set of clients Goldman and the other banks screwed — the investors that bought what banks told them was a cash-like product. Investors purchased auction-rates securities because they provided better-than-average returns for a product that was supposed to be as liquid as cash—by always supporting the auctions, the banks had created the illusion of liquidity and sold their clients on it. But when banks stopped supporting the auctions, individuals and companies that needed the funds for day-to-day expenses discovered that the liquidity only existed as long as the banks decided it would. They no longer had instant access to the billions they had invested.*

* A number of state AGs filed lawsuits against the banks, eventually leading most of them to offer to buy back the securities from investors.

Sure, the issuers and investors probably deserve some of the blame—they should have realized that lower debt costs and better returns meant they were taking more risk, even if they weren’t sure where the risk came from. But I also would be willing to bet the banks didn’t emphasize those risks when selling the clients these products. Or make extraordinarily clear that they as investment banks had no fiduciary duties to the clients and thus wouldn’t necessarily have the clients’ best interests in mind.

But even if we assume banks behaved appropriately in their interactions with clients, it's not clear that this is what they should have done, despite this claim from Indiviglio:

But the article also blames Goldman for not breaking a contract so to treat one client more favorably regarding its auction rate securities. So the bank should have ignored a contract in order to voluntarily endure losses due to the risk a client agreed to take on? How do you think Goldman shareholders would feel about that decision? Goldman has a fiduciary duty to maximize their profit, which arguably outweighs any desire it has to protect clients form themselves.
Certainly Goldman should maximize shareholder value, but part of that is maintaining the brand name (something the old Goldman realized). An investment bank sucking every dollar out of clients today likely won’t be maximizing profits for shareholders in the future--only maximizing the current bankers’ bonuses. Most restaurants, for instance, realize it’s worth it to take a loss on a dinner someone might complain about today to convince them to try the restaurant again in the future (or at least not bad-mouth it quite as much). Pursuing a business model in which you hold every client to every contract—including those in which you provided bad advice—seems extraordinarily short-sighted. But, of course, bankers won't be worried about that when their bonus is only based on what they can extract from clients today, and not in the future.

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