The Bear’s Lair: Goldman needed a post-2008 clearout

Goldman Sachs announced this week that it was to offer consumer savings accounts over the Internet, with a minimum of $1. It’s not a bad marketing idea; no doubt a “Bank of Dr. Evil” branded savings account would also go well. It appears to indicate that Goldman’s confidence in its core investment banking business is not what it was, especially since its shareholders recently had to pay a $5.06 billion fine for Goldman’s past malfeasances. From a business and a regulatory perspective, the core problem is that the company has done no real cleanout since its 2006-07 misdeeds and errors were discovered. Thus its investment banking business remains a real danger to the global economy.

On its face, Goldman’s strategic move into consumer finance makes some sense. They see the credit card company Discover Financial Services (NYSE:DFS) with a current return on equity of 20.5% compared to Goldman Sachs’ 7.1% and think “How difficult can this be?” The answer will prove to be: “More difficult than you think.” Consumer finance is only an attractive business because the Fed has been grossly over-stimulative for eight years. At some point, the Fed will return to sanity, credit conditions will tighten, and Discover’s credit losses will spiral towards infinity. As a late entrant into the business Goldman will get more than their share of crooks and poor credits, because those of us with mortgages paid off and modest credit needs tend not to switch credit card suppliers even if a Goldman Sachs credit card would make us feel like a big shot.

Finance is full of gray areas, and getting fuller of them. Over-expansive monetary policy, pursued in the U.S. since 1995 and with fanaticism since 2008, makes those gray areas blacker, larger and more dangerous. This is not some new discovery; the Cantillon Effect, discovered by Irish-French economist Richard Cantillon (1680s-1734) after the failure of the 1716-20 Mississippi Scheme, postulated that expansionary monetary policy constitutes a transfer of money away from old money to new, encouraging financial wrong-doing and worsening wealth inequality. The evil effect of funny money is as clear now as it was in 1720, and Goldman Sachs in its funny-money incarnation is merely today’s equivalent of the get-rich-quick brokers jostling each other on the Rue Quincampoix.

One gray area in finance is insider trading, the one financial crime which the SEC prosecutes with fanaticism, throwing quite small malefactors into jail for lengthy terms. In many senses, insider trading, which was not illegal in Britain until 1980, is a victimless crime. Only very infrequently are the losers from insider trading activities aware of any losses; they have bought securities freely based on the knowledge available to them at the time.

In any case, there are more valuable forms of insider information than advance knowledge of the next quarter’s earnings or an upcoming takeover. The entire specialist system on the New York Stock Exchange relied for its profitability on knowledge of the order flow in the stocks concerned, which the specialist needed to do his job, but which also gave him a major informational advantage over those who came to him to execute trades. Being a specialist was a very profitable business, and it’s difficult to imagine a non-machine stock exchange without specialists or jobbers with inside information of the order flow, which of course they trade on.

Trading desks that have a substantial market share in foreign exchange, bonds and other financial instruments similarly have “inside” information superior to that of their clients, and make money therefrom. That was why the derivatives market grew so rapidly; it was only moderately beneficial to end users, and probably a net detriment to portfolio investors, but it provided a huge stream of income to the brokerage community, because it gave them more opportunities for trading on insider knowledge. Similarly, “fast trading” rests for its profitability on knowing the market order flow a millisecond or two before your competitors; again, this is insider information, and trading on it should on a strict reading of the regulations be illegal and, by SEC precedents, punished with jail sentences.

There are many other gray areas in finance, most of which are highly profitable to the brokerage community. The barrier between gray and white is basically represented by the phrase “caveat emptor,” requiring participants to be vigilant against scams and rip-offs; that between gray and black is formed by transactions that can reasonably be characterized as outright fraud.

The $5 billion Goldman settlement in January related to Goldman Sachs sales of subprime mortgage packages to investors in 2006, on which it appears that Goldman’s own investigations had determined that some of the mortgages were very likely fraudulent, a fact not disclosed in the offering documents. That appears to me to cross the line from gray to black in the world of investment banking. If Goldman knew the statements they were making to investors about the mortgages were untrue, they had a duty to amend those statements, otherwise the offering document would have been fraudulent.

I write here as a journalist with only the sketchiest knowledge of the various transactions involved; it’s possible there were extenuating circumstances. However, if in fact the offering documents relating to the securities offered were inaccurate, and Goldman, the issuing bank, knew them to be so, then the transaction was fraudulent. At that point it crosses the line from grey to black. A $5 billion fine, the cost of which falls on the Goldman Sachs shareholders of 2016, not on those of 2006, and not on the executives who carried out the transactions and only to a limited extent on Goldman Sachs top management, is not the appropriate punishment. For fraud, involving large financial sums, prison sentences are the appropriate punishment, as are doled out for the much less economically heinous crimes involving insider trading.

Similarly, the “Abacus” transaction, in which the junior Goldman trader “Fabulous Fab” Tourre arranged to defraud German banks on a set of mortgage collateralized debt obligations in the interest of another Goldman client, involved only civil penalties, again paid primarily by Goldman Sachs shareholders. Fraud is a serious criminal offense, allowing which makes the capitalist system impossible to operate. Criminal penalties, probably including imprisonment, should have been imposed both on Tourre and on those up his chain of command who authorized and encouraged him to carry out the offense. Regulatory bureaucrats who get jollies and bonuses for extracting large amounts of money from Wall Street banks are imposing penalties that, being paid by shareholders, are no deterrent at all to the senior management of the institutions involved.

There are several other substantial examples of Goldman Sachs malfeasance, where proper ethical controls should have blown a whistle and where legal penalties should have been imposed on the executives involved and their superiors. The 2.8 billion euros loan to Greece in 2001 disguised as a cross-currency swap, thereby allowing Greece to evade the Maastricht Criteria for euro membership, has cost both the Greek people and the whole world hundreds of billions of dollars. Imprisonment should have followed, both for the Greek officials responsible for the transaction and for the Goldman Sachs executives who enabled it. Also the $300 million fee on a $3 billion bond issue for 1MDB, a public sector entity of an A-rated sovereign credit, was direct robbery of the Malaysian people and should again have resulted in jail for all concerned.

It is very clear that Wall Street investment banking is a business where the regulators need to force some prison sentences from time to time, with job losses right up the chain of command, in order to shove the business back towards the white side of gray. In the case of Goldman Sachs, this deterrent effect has been altogether missed – CEO and Chairman Lloyd Blankfein is still, extraordinarily, in the job he assumed in May 2006. There were not even any huge losses inflicted on Goldman Sachs during the crisis, because the $13 billion of credit losses which Goldman incurred on its AIG credit default swaps (most of which represented profits from betting against the market in which they were simultaneously issuing securities to investors) when the AIG CDS business failed were bailed out by the $185 billion provided to AIG by taxpayers.

The real difficulty is that investment banking needs to clean up its act, returning its ethical standards to those of 40 years ago and reducing the remuneration of investment bankers, especially on the trading desk, to more manageable levels, thereby raising the profitability of the business to a level that more properly reflects the risks involved. Probably there also needs to be some substantial downsizing of the investment banking business, and exit of overcapitalized firms like Barclays and Deutsche Bank that are no good at it. At the same time, as in Britain, the regulators need to “ring fence” deposits that are acquired using the FDIC $100,000 guarantee to which Goldman Sachs as a bank is now entitled. If Goldman wants to use that guarantee to attract deposits and go into the credit card business, they are welcome to try, but should do so in an entity entirely separate from the gambling casino that is their trading desk.

Investment banking used to be an economically useful business with high ethical standards and modest but comfortable returns. It needs to get back to that, losing most of the casino, losing the excessive remuneration and above all losing the tendency to defraud clients, which is not an economically useful occupation.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)