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.

What Else Is He Going To Say?

It’s inevitable that during an economic crisis, journalists will turn to financial leaders for "insight". And it’s just as inevitable those people will provide quotes such as this:

And in an interview broadcast on Sunday, the U.S. Treasury secretary, Timothy F. Geithner, signaled his confidence that Europe would resolve its debt crisis and that the American economy would withstand its impact. “Europe has the capacity to manage through this,” Mr. Geithner told Bloomberg Television. “And I think they will.”

Although some have pointed to this as an example of Geithner setting himself up to look silly, I’m not sure what else he’s going to say. Even if he believed Europe couldn’t make it through the crisis, he wouldn’t admit it. And, because of that, no one will ever believe it even if he did.

I realize both the journalists and the politicians are just doing their jobs, but I don’t really see this as a situation where either has much to gain. For the journalists, there is an infinitesimal chance Geithner actually says anything newsworthy. For the leader, at best, you have people question your motives, and, at worst, you leave yourself with public comments that will in the future looks as foolish as this.

Honesty is the Best Policy

Wanted to dust off the blog for a very quick thought on journalism. Ideally, more regular posting will resume once school concludes in a few weeks.

In today's New York Times, public editor Clark Hoyt had this to say about a reporter's use of Twitter to air some complaints about Toyota:

Hiroko Tabuchi, who said she knew the guidelines, nonetheless let frustration get the better of her on March 29, when she attended a news conference by Akio Toyoda, the president of Toyota. Her string of tweets about the event was first reported by The Nytpicker, an anonymous Web site that focuses on The Times.

With less than three hours of sleep, Tabuchi wrote, she had to get up at 6 a.m. “We love you Mr. Toyoda!” After the news conference, she wrote that Toyoda took few questions and “ignored reporters, incl me who tried to ask a follow-up. I’m sorry, but Toyota sucks.”

Lawrence Ingrassia, the business editor, said reporters have always complained to one another, about irritations at work, sometimes vividly, but when they do it “to the world, live, I think it’s unacceptable.” I would have pulled Tabuchi from the Toyota story, but Ingrassia said he decided not to because what she wrote indicated she was upset with the company’s press arrangements, not prejudiced against it or its products. He said he saw no bias in her reporting and had received no complaints about it.

Perhaps I'm alone in this, but Ingrassia's point about the newsroom banter actually suggests to me that we should encourage journalists to tweet about stuff like this. Unless they're emotionless human beings incapable of forming thoughts*, journalists are going to have opinions on a variety of issues related to the topics they cover -- even if it's just the press arrangements. Perhaps a journalist will block out experiences like this when writing her story**, but, if not, readers deserve to know about what could be shaping the reporter's opinion.

Further, what is the cost in making public thoughts journalists already parade around the newsroom? Certainly, it won't help with the persistent charges of bias levied against the press***--but those are going to continue anyway. For readers that understand and appreciate the media, this will serve as a welcome show of respect for their intelligence.

* I will not dispute this is within the range of possibility for some...
** And I'm not certain that the press accommodations aren't relevant in this situation. Given the problems Toyota is having, one would hope they would show some respect for those that want answers about safety from them.
*** A topic best saved for another time

Greece and Ethics***

Although I like Felix Salmon, I often suspect he's being contrarian for the sake of being contrarian. Recently, this has led him to defend Goldman Sachs on a number of fronts, including its role in the Greece debt crisis:

So while it’s entirely fair to blame Greece for trying to hide its debt, and to blame Eurostat for letting it do so, I think that blaming Goldman is harder. It was surely not the only bank involved in these transactions, and the swaps were simple enough to be shopped around a few different banks to see which one could provide the best deal. Structuring swaps transactions is one of those things which investment banks do. If countries like Greece buy swaps in order to hide their true fiscal status, then that’s the country’s fault, not the banks’. No self-respecting bank would decline such a transaction because they felt it was unfair to Eurostat.
Yes, I’m sure that Goldman put a team of people onto the Eurostat rules and made that team available to the Greeks. But let’s not blame the advisers here, for structuring something entirely legal and which the Greeks and Italians clearly wanted to be able to do all along. This is a failure of European transparency and coordination; Goldman is a scapegoat.

Sure, what Goldman did was technically legal, but does that make it right? Investment banking ethics is a bit of an oxymoron, so I'd expect to hear that reasoning from Goldman, but it's unfortunate that Salmon chooses to rationalize it this way, too. Would he also approve the work of people like Maurice Levy*?

* Obligatory watch-the-Wire-if-you-haven't-seen-it aside. Not going to waste much effort on it, though, because if you haven't seen it yet, I'm not sure how I'm going to persuade you.

Excuses such as this further entrench the inappropriate business practices of  investment banks into the financial system. They encourage the development of a system where the way to make money isn't developing deals that benefit all stakeholders, but rather tricking regulators and investors by bending the technical definitions of the law**. With the prominence of this sort of behavior on Wall Street, I'm unsure how much increased regulation and new laws can help--banks and lawyers will only make more money figuring out new ways to evade them. And bloggers for major financial publications, apparently, will continue to support their right to do it.

** Again, I must turn to my familiar rallying cry and ask if we would allow this sort of behavior in any other industry. I'm pretty sure we hold even used-car salesman to a higher standard.

*** I'm sure someone with a background in philosophy (Shaun) could write an entire book on the actual "ethics" of this, but I think you understand the point I'm trying to get it and the definition of ethics I'm using.

Tactics vs. Strategy

In one call, [Larry] Summers said, “I have 13 bankers in my office and they say if you go forward with this you will cause the worst financial crisis since World War II.” -- Credit Crisis Cassandra

The quote above -- which occurred during a call in which Summers was fighting against regulating derivatives -- is one of the most illuminating of the financial crisis (so illuminating, in fact, it's the title of a new book by James Kwak and Simon Johnson). Viewed in the best light, it represents the extent to which regulators simply deferred to Wall Street for their cues on complex financial issues, while viewed more cynically...well...let's just say it looks a lot worse. At the very least, it's another example of why we should be wary about trusting the so-called "experts".

I highlight this quote today because the talk of naming a new Treasury Secretary had me thinking about one of the arguments made by those in support of retaining Tim Geithner*: who else would you get to replace him? I imagine many of his proponents believe that you need someone else with intimate knowledge of Wall Street in the position, but that anyone with the sort of ties to obtain that knowledge will not be confirmed**. 

* And also, in a broader sense, of why we defer to "experts"
**I seem to recall the argument for hiring Geithner and Summers in the first place--despite their involvement in supporting many of the practices that got us into this quagmire--was that they were the "only people" that knew had enough knowledge of these areas to fix it.

The fact that I'm skeptical about this argument will not surprise you. But my reason why might--it relates to the way I analyze sports.


As I allude to in the title of this post, I view the ability of fans to criticize coaches through a prism of tactics vs. strategy. When it comes to tactics--which I consider smaller-scale things, such as how a guard actually blocks or a how a quarterback actually throws--I will openly admit that every coach in the NFL (the "expert") knows way more than I do. But when it comes to strategy--bigger picture things such as play-calling and time management--I don't think that's the case (and I assume most of you would agree the same holds true for you). From awful time management to the refusal to question conventional wisdom, coaches make strategic decisions that are far from optimal all the time.

I think it's useful to consider this analogy when thinking about finance (or any other industry*, really). Certainly, all of the attendees at the Asset Securitization Forum know more than almost all the critics of the financial industry about how to structure a CDO^2 of ABS. But far fewer of these attendees have actually thought much about how the products they create and sell fit into the bigger picture.

*** If you're a television fan, think of it this way: Jeff Zucker knows way more than you do about how to actually produce a show. Still, most of you could have done a way better job than he did of running his network.


The implications of this for picking a new Treasury Secretary (and how he should perform the job once chosen) are clear. Contrary to the belief of those who believe Geithner/Summers/etc. are the "only people that could do their jobs," we don't need to someone that knows a great deal about the tactics of Wall Street. Instead, we should chose someone that has actually analyzed (and is, of course, willing to question) the big-picture strategy. I don't know enough about specific candidates to know who would be interested, by I can't imagine someone like this would be too difficult to find****.

And, on a broader note, it means that none of such feel bad about questioning what the "experts" tell us about finance. Just like our thoughts on a foolishly used time-out in a game last week, it's quite possible we know better.

**** Yes, I realize there a political constraints because this person needs to be confirmable. This suggestion, though, should, in theory, make that task much easier.*****

***** I feel like I owe a h/t to JoePos for once again stealing his technique. 

I Guess It Really Ain't Over 'Till It's Over

Anything I wanted was a phone call away. Free cars. The keys to a dozen hideout flats all over the city. I bet twenty, thirty grand over a weekend and then I'd either blow the winnings in a week or go to the sharks to pay back the bookies.
Didn't matter. It didn't mean anything. When I was broke, I'd go out and rob some more. We ran everything. We paid off cops. We paid off lawyers. We paid off judges. Everybody had their hands out. Everything was for the taking. And now it's all over.
And that's the hardest part. Today everything is different; there's no action... have to wait around like everyone else. Can't even get decent food - right after I got here, I ordered some spaghetti with marinara sauce, and I got egg noodles and ketchup. I'm an average nobody... get to live the rest of my life like a schnook.
-- Henry Hill, Goodfellas

Just a little more than 17 months ago, I convinced myself that Wall Street bankers had finally screwed up the racket they had going and were destined, like Ray Liotta's character in Goodfellas*, to live out the rest of their lives like "schnooks." Bank stocks plummeted. Credit markets froze. And Michael Lewis -- who wrote the seminal take on industry -- even declared that Wall Street had finally reached "The End."

* Speaking of the mafia, a Jimmy Breslin quote --with a slight modification by me--seems particularly apt for this occasion. It appears to me that Wall Street bankers, just like gangsters, have  "yet to find anything that's too small to steal."

Ah, how naive we were...

As if you needed any further proof that wasn't going to happen, here it is: Lloyd Blankfein--The $100 million Man.

It's tough to decide what angers me most about this middle-finger to taxpayers, the millions of Americans still out of work and those being forced out of their homes. Perhaps it's that Goldman--despite its protests otherwise--has benefited from government assistance in many ways other than the TARP money it claims it didn't need, from the government guarantees of its debt to its conversion to a bank-holding company to when it got billions of dollars through a back-door bailout of AIG. Or, it could be that Wall Street cares extraordinarily little about fixing the pay practices encouraging behavior that hurts shareholders, clients, and taxpayers. But maybe it's just that these assholes actually think they deserve it.

Whatever the case, it's pretty clear we're a far cry from where we were just a little while ago. I remain unconvinced that even the current plan to regulate the financial industry will do much to eliminate the worst practices on Wall Street or make the economy safer. And if it looks that way now, just imagine what it will look like in 17 months...

Who is To Blame?

Although it’s fun to vilify bankers, the truth is that there are many people whose interactions helped contribute to the financial crisis. People want to treat finance like physics, but it’s much more like biology. As Richard Bookstaber points out in his excellent A Demon of Our Own Design, the financial system is similar to a complex ecosystem—a minor event in one part of the world can eventually move through the system and lead to a major blow-up in another.

Unfortunately, many of the people within the system have incentives that are not aligned with the economy’s greater good. In a vacuum, many of these actors may believe there is nothing wrong with acting in their own self-interest. But when these actions are combined, the result can be disastrous.

These actors include:

Investment Banks: Salesmen have an incentive to sell products to clients (even if inappropriate for that client), traders have incentives to take risks, investment bankers have incentives to create bigger and bigger deals, etc. Not spending too much time on it because you’ve heard this all before.

Institutional Investors: Often, they are judged by relative, rather than absolute, performance. Even if a fund manager believes buying a CDO, for instance, is a bad idea in the long-term, he might need to buy them now or risk being outperformed by competitors (which would lead to funds flowing out of his funds and into the better performing ones). And even if the CDOs eventually do blow up, he can simply point to these other funds to show he shouldn’t be blamed—“no one else saw it coming, either”. As long as he does no worse than his competitors, he’s not in bad shape. This “Keeping Up With The Joneses” mentality can increase demand for products (whether CDOs or tech IPOs) from investment banks, whether or not the investments are sound.

Monoline Insurers and AIG: They were paid for taking on risk—not surprisingly, they took on a lot of it. They’re willingness to insure many of the structured finance products allowed many of the deals to be workable (on paper, at least) for the banks. No doubt this helped drive the issuance of these products.

Rating Agencies: They are paid by the issuers of the securities, so they have an incentive to give better ratings (even if they claim they aren’t influenced by it). You’ve heard of the we’d- rate-these-if-they-were-structured-by-cows fiasco. But they also have an incentive not to look too foolish. Once they began actually downgrading the structured finance instruments and the insurers, it led to a downward spiral across the financial system.

Mortgage Originators: They were paid for making mortgages and, thanks to securitization, did not need to worry about the risks. Not surprisingly, they sold as many mortgages as they could, some resorting to boiler-room tactics including misrepresentation and fraud. They clearly did not have the best interests of the client in mind.

Regulatory Agencies: Some of them are funded by the people they regulate, so they have incentives to race-to-the-bottom when it comes to regulations. They also might have incentives to govern by rules rather than standards—easier to administrate, but also creating a demand regulatory arbitrage (triple-A requirements led to demand for the insurers). A cynic might also suggest that the regulators themselves have incentives not to question the people the regulate too much for fear of losing future employment opportunities when they move to the private sector.

Politicians: Obviously, “increasing homeownership” is a pretty good platform for both parties. Unfortunately, it leads to the creation of policies that allow many of these other actors to do bad things.


Homeowners: If they weren’t willing to trust financial professionals and take out mortgages, the investment banks couldn’t have created quite as many products (although, of course, many of the more complicated products were synthetic and, therefore, did not require actual mortgages).

A simple list that can go on and on.

The bigger point of this is that reforming the financial system requires more than just taking on banks on a few issues--it will require an extraordinary overhaul.