Last month, the world’s major financial institutions reported quarterly earnings. Several new records were established. The most impressive results were generated by Goldman Sachs. The firm earned $3.46 billion for the first quarter, nearly double last year’s results. However, the bigger news was the securities fraud claims filed by the SEC against Wall Street’s most profitable and prestigious organization.
The allegations were that Goldman Sachs preferred one client, John Paulson, to the disadvantage of other clients. Paulson asked the firm to create a synthetic collateralized debt obligation of vulnerable mortgage loans. His goal was to bet against certain tranches within the complex structure and profit from declining values. As in any gamble of this sort, Goldman needed an investor to take the opposite position. Given its expansive set of clients, Goldman identified candidates for the other side of the trade. Those clients were not informed that Paulson had heavily influenced which assets were included and, eventually, they collectively lost over $1 billion.
Goldman is defending itself vigorously. Its impeccable brand is at risk, and it knows that a Wall Street’s firm most valuable asset is its reputation. Before the alleged activities took place, Goldman was considered by many as Wall Street's marquis firm. Why would it take proprietary positions against clients and favor some clients over others? Cynics suggest that the firm’s next fixed income offering will be called Barry Bonds.
Barry Bonds broke dozens of baseball records, including for most single-season and all-time home runs. He is the only member of the 500-500 club (for home runs and stolen bases). His exploits were all the more remarkable - and, ultimately, more suspicious - as his prowess increased in his late 30s and early 40s, a time when most players have long-since retired. Barry Bonds was blessed from birth. His father Bobby was also an All-Star and his godfather was Willie Mays. His own career was already stellar before he began enhancing performance artificially.
When Roger Maris broke Babe Ruth’s single-season home run record in 1961, loyal Ruth fans insisted that an asterisk be added as the baseball season had 8 more games by the time Maris played. In 1998 Mark McGwire broke Maris’ record with 70 homers in a race with Sammy Sosa who hit 66. No one talked about adding asterisks or qualifying the recognition of these achievements in any way. Admittedly, there was some speculation about their potential anabolic steroid use, but the sluggers were generally applauded.
When Bonds hit 73 home runs in 2001, at age 37, most fans assumed he was using steroids. By the time he broke Hank Aaron’s all-time home run record in 2007, they knew. They also knew that this trio of home run kings was destined for the Hall of Shame rather than Cooperstown. Instead of joining the ranks of Ruth, Maris and Aaron, they would be lumped together with Shoeless Joe Jackson, Pete Rose and others whose cheating eclipsed their on-field accomplishments.
Throwing spitballs at investors
The allegations against Goldman are murky and have not yet been proven. However, even if Goldman didn’t violate a specific securities law, the perception that they favored certain clients over others, or profited by taking positions adverse to their clients’ interests, sullies the market's image and impairs the confidence required its orderly running. It’s hard to claim you’re doing “G-d’s work,” as Goldman CEO Lloyd Blankfein asserted last November, when the world thinks you and your colleagues are creating devilishly complex products, sliced and diced beyond recognition, and then stuffing the worst of them down certain clients’ hungry, greedy mouths with a pitchfork.
I’m reminded of the fellow who watched hours of Texas Hold ‘Em poker on television until he was finally convinced he could beat all of the players he observed. He went to Las Vegas and, to his shock and dismay, lost all his money. Our poor friend didn’t realize that, in real life, you’re not allowed to see everyone else’s cards. However, according to the SEC, Goldman set up a game where it could indeed see everyone else’s positions. Moreover, it was also the dealer and, at least in John Paulson’s case, allowed him to choose which select cards he wanted to play. Needless to say, the favored player won a lot of hands.
To be fair, Goldman is not the only Wall Street firm that engaged in these transactions and was not even among the largest issuers of these products. But it made astounding amounts of money while most other firms were licking their wounds amidst mounting losses. Likewise, many baseball players, particularly the growing numbers who admit taking steroids, contend that over half the league was using as well. But, as might be expected, on the field and in the markets, the spotlight shines most brightly on the winners.
In my securities class, I compare government supervision of the capital markets to conventional law enforcement. Though nearly all the colloquial nicknames for police are pejorative, and many of us are apprehensive when seeing squad cars on roads, we are certainly grateful that they are there. A world without police would be anarchic. We feel safer on our highways, in our neighborhoods and in our homes knowing that criminal impulses are checked by police presence and criminal law is enforced by the justice system.
Investors also want to feel secure in their marketplace. Wall Street designed derivatives that were purposely opaque. Only those able to invest millions in technology had any chance of understanding what was being bought and sold. The playing field was not level and, as a result, system abuses should be scrutinized with even greater care. Any reputational rehabilitation of the industry will require more responsible self-policing by all major market participants and, inevitably, more aggressive regulation.
Lloyd Blankfein has spent much of the past month on the phone, in the press and in Washington DC. He is keen to explain Goldman’s position to its clients, the United States Senate and the general public. Blankfein knows that the SEC’s civil complaint against the firm was strike one. If the stock continues to decline, a likely plaintiff shareholder suit would be strike two. A criminal indictment (a preliminary investigation by prosecutors has already been launched) would be strike three. In that regard, it is worth noting that the likes of Shoeless Joe and Pete Rose were not only denied entry to the Hall of Fame. They were banished from baseball.
Lyon Roth is an adjunct professor of Business Law and Ethics and a member of Ben Gurion University’s Board of Governors.
Published by Globes [online], Israel business news - www.globes-online.com - on May 9, 2010
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