Pearlstein: What Goldman tells us about the

Apr 28, 2010

Pearlstein discusses why Tuesday's hearing highlighted two big fallacies in much of the current thinking about financial markets.

Aside from whether or not the feds can win a prosecution, why would any clients stay with a company that bet against its own products? With or without a conviction, how can this company stay in business when its credibility is gone? Their clients must be so naive if they think that only THEY are the ones that Goldman treats fairly.

There's an ethic in the Wall Street culture among all the big banks and hedge funds, who do most of the trading, that they are each smarter than the others and they can handle themselves and that what Goldman does is what we all do, and the rest of the world doesn't understand that. So what a lot of them would say is that we never thought the guys at Goldman were out for anyone other than themselves.  We on the outside like to talk about investors, but on Wall Street, investors are irrelevant. The only thing that matters is traders (who often trade on behalf of investors, but really have no sense of duty of loyalty to those investor clients). Its come to that, and that is the reason why the shadow banking system has broken down and failed the larger economy.

Aren't they really just a form of gambling? Why else would someone buy insurance on a product they don't own? If they are just a form of gambling, then have the tax code treat the earnings and losses the same as any other gambling income.

My view, which I've expressed many times over the last year, is that we just shouldn't allow people to insure or hedge against instruments they don't own or control. No "naked" hedging, in other words. That keeps the system going for people who have a legitimate need to hedge, but doesn't allow the market to get distorted by additional speculation. [Note: anyone who takes the opposite position from someone who owns an instrument and is hedging it is, by definition, a speculator. So you need some speculation in the system if you are going to have any hedging.]

I thought fraud was already illegal. What in the Dodd bill would have changed the Goldman case? And why isn't the SEC IG report on the Stanford case getting more press? It's hard to take seriously any reform that leaves oversight of Wall Street with the same SEC that has failed and failed again.

If you are going to have a regulatory system at all, you have to have regulators and they have to have discretion -- in my opinion, quite a lot of discretion. So the system does rely on the competence and honesty of regulators. There's just no getting around that. That is why elections are important -- because the president and Congress get to decide who the regulators are. And in the past, they did a lousy job at it.

To me, this guy came off as extremely arrogant and dismissive of all the problems Goldman caused. Do you agree?

No, I think the Fab actually came off better than all the others on his panel. More than they did, he tried to understand and answer the senators questions.

Do you think the four Goldman execs were advised on demeanor yesterday in advance and yet, like the fable of the scorpion and the frog, it was just part "of their nature?" Having watched most of the hearing I can say I've never seen such a display arrogance, insolence, and evasiveness.

The way they spoke and sat and dressed was very carefully staged and practiced.

Do you think Carl Levin, etc. understand this stuff enough to really be questioning Blankfein? Why do we despise people who make money off of others misfortune? To some extent isn't that just the inherent destructive nature that is capitalism...

There were instances where senators clearly didn't understand what they were talking about or understand how market making and trading work. But Levin held his own pretty well, I thought. Like the others, he sometimes failed to understand that Goldman really has two different businesses -- one is underwriting, which means creating and selling securities, the other trading in the secondary market of those and other securities, and that the two are really separate. He also never really wrestled with the problem of whether he would have wanted Goldman NOT to have shorted the mortgage market when it saw how oversold it had become and thereby suffered huge losses. Does the senator really believe that would have been a better social and economic outcome? It is not clear that it would have.

Why would Goldman choose the tactic of innocence, in defense of their cowboy business practices, when it only reinforces the suspicion that they don't intend to change their ways? After all, their system has brought them immense success.

They don't intend to change their ways, absolutely, because they think they did nothing wrong, that this is the way a modern investment bank with various lines of business behaves, and that, overall, it creates the deepest, most liquid capital market in the world that generates the cheapest and most plentiful capital. That is their core belief. And people who complain about it, in their mind, just don't understand how these markets work, and apply silly notions to it -- notions like right or wrong or good and bad. So, for instance, when Goldman analysts say a security is "shitty," Wall Streeters don't infer from that that Goldman has a duty not to sell the security to anyone. It only means that Goldman thinks the price of that security should go down. There's no good or bad. In a market, everything simply has a price.

Isn't Goldman basically saying it is a book store? You can have them help you find the product you want, but whether it is valuable to you is up to you - not the book store. Why should Goldman be different from the book store?

Because it also underwrites some of those securities, and underwriting used to mean putting your name and reputation behind a security. That didn't mean you promise the value of the security will always go up. But at the same time, if you think the bond is made up of lots of bad mortgages that are likely to blow up, then you shouldn't underwrite it. That's where the fraud or unethical behavior comes in.

I watched some of the hearings. They were hysterical as our elected members of Congress tried to pretend like they had a clue and fully understood exactly what Goldman is and was doing. What a bunch of grandstanding, just like the SEC suit. Why haven't the investors sued Goldman? I'll tell you why: because they don't have a case and neither does the SEC. The investors knew the deal and were just as greedy if not more greedy than Goldman. Sorry, any new regulations for Wall Street will just be window dressing for the ignorant American voter and the MSM. The Dems in Congress and the WH are not going to cut off or upset some of their biggest contributors and the taxpayer will get the shaft again. Wall Street is now leaning towards the Dems and the left. It's sad. There should never be 'too big to fail.' There is no risk if the government bails you out! Break up Goldman and the others who are too big to fail. We would have been better off with no bailouts and the government not coming to the rescue. The economy will get worse.

I somehow doubt the world would be better off it no government had intervened to save the banking and shadow banking system. Sorry. You're just wrong on that. You sound like the central bankers in 1929.

     Your other point is one that can be argued, about how the critics just don't understand trading and market making. They don't -- they bring a kind of judgmentalism to it that people in the markets find naive and irrelevant. As to why the investors haven't sued, we don't know that they won't piggyback the SEC suit. I'm sure there are lots of plaintiffs lawyers out there right now laying the groundwork for that. But there is also, as I said earlier, an ethic among the big trading houses and banks that all support the idea of caveat emptor, because they themselves don't want to be sued. The Street doesn't believe in government regulation, but it doesn't believe in private regulation either, which is what law suits are about. They believe in caveat emptor, which is fine, because as I wrote last week, they have the big information advantage, so they always win.

I read recently that Goldman, because it is now a bank holding company, is able to borrow from the Fed at less than 1 percent, and it is turning around and buying Treasuries with about a 3 percent yield. Is this true, and if so, what is you take on this?

We don't actually know that is the case, although it is possible. The data on who borrows from the Fed is now available. But in a way that is beside the point. The low Fed interest rate means that banks (which have lots of extra cash these days) can lend to each other, overnight, at roughly the same rate, and then invest in longer term government paper or bonds and earn a very nice spread. This is the dirty little secret of what the Fed has been doing for the last year, which is reflating the balance sheet of banks by allowing them to earn big profits on what is essentially a no-risk carry trade. THIS is the big bailout, not TARP. And the banks are thrilled that the Fed is so ridiculously fixed on inflation rate that it has decided to keep this carry trade going for the indefinite future. They should be sending the Fed policy makers a huge Christmas present, because they have generated literally tens of billions of dollars in profits for the banks by their zero interest rate policy.

If this bill passes how will it impact the Fed's role as lender of last resort? Goolsbee has said in several interviews that any firm that needs to come to the federal government for help will have their shareholders wiped out and new management. Given the expansive popular definition of "bailout" are we about to curtail the Fed's policy levers?

As I just mentioned, there are lots of ways to bail out the industry. The part of the bill having to do with "resolving" a failing bank isn't really a bailout. It's just the opposite -- its a wind down of the institution, selling it off in pieces. Shareholders get wiped out, management is booted, depositors will be insured under the FDIC. The only question is how much the unsecured creditors will get and when they will get it.

"The more benign way to look at this dramatic rebound is that it speaks to Goldman's knack for anticipating the market and its willingness to break from the Wall Street herd." Perhaps we should enter into a contract with Goldman and have them take over the SEC functions. They seem to have a better grasp on future market issues than the regulators.

Unfortunately, that would create a huge conflict of interest. And if we have learned anything from yesterday's hearing, it is that Goldman is really lousy at managing its conflicts, no matter how many committees it claims to have that are focused on that issue.

Does Goldman have to fight the government's allegations, because they made lots of similar deals to the one with Paulson and if they are found to have done something wrong there it would open the floodgates. They would be facing many similar lawsuits from the government and their "customers."  Is there a chance that these suits could cause Goldman much more serious trouble than is yet recognized?

That's what I was trying to get at with the idea of people from two planets that talked past each other because they have very different value systems and vocabulary. The senators want to talk about whether something is socially useful or whether conduct is right or wrong. The Wall Streeters never ask those questions -- if there are willing buyers and sellers, then it is, according to their logic, useful and proper and right. The market determines all those things, and they are simply participants in a market. There is no morality -- they are amoral.

Do you agree with his characterization of the White House mood as "giddy" following Republican refusal to bring the reg reform bill up for debate?


Steve, you are always both well-informed and sensible. I read Sorkin yesterday in your competition and the gist of his piece was that most of the investment crowd he talked to were both arrogant and defensive, and saw very little wrong with what they and their Goldman brethren were (maybe still are) doing when the system collapsed. So, are Sens. Levin and McCaskill merely showboating and venting public rage, or were there serious moral and legal offenses committed by the various investment houses? And what sort of regulation, if any, would you put in place if you had the power? Thanks.

Thanks. The point of today's piece was that these people come from different planets, with different forms of intelligence and different languages and differrent set of moral codes and values. The senators talk about good and bad, right and wrong, social utility or lack of social utility. The Wall Street folks basically don't know what they are talking about. In their view there are willing buyers and willing sellers who come together in markets -- and if there is a market, the market determines what value things have. There is no morality. Markets are good, markets are right, and they are just participants in those markets.

I don't think there is anything necessarily wrong with Goldman Sachs hedging their bets, in fact, it would be irresponsible of them NOT to. But if they actively encouraged clients to buy products they knew were bad deals...that seems to border on fraud. Am I missing something?

You understand perfectly, Mr. Buffett.  (Just kidding about the last part, but I see you are from Omaha.)

I am not technically knowledgeable on the markets, but don't these parties profit off of both sides of the deal? They win if the deal goes up or the deal goes down.  If so, that kind of validates my suspicion and fear of the market itself. I'm hoping my value grows over time, but other folks are using my money to get rich immediately either way.

The same people don't benefit from the movement in different directions, at least at the same time. Goldman was long, but then it spent a lot of time and even money to get short on the mortgage market.

What did you think of his frequent references to Goldman's "s---y deals"? Some may claim it was over-the-top; I thought it was much-needed.

It was amazing how easily the senators slipped into the vernacular, shall we say. The Goldman witnesses were careful not to use the language, because of course it is very embarrassing that the Goldman employees talk that way in private and have such views about their own products.

Wouldn't your goal of requiring people buying derivatives to have an interest in the underlying security or commodity be met by prohibiting cash settlement? That is, the security or commodity would need to change hands at settlement. Also, I'm curious if anyone is investigating whether the people who bet against mortgage bonds in which they had no interest had any involvement in the terms and conditions on the mortgages. I think the mortgages were deliberately designed to go into default. You can't qualify a borrower at a teaser rate and keep raising the rate without eventual default. Buy a derivative on bonds based on such mortgages and you have guaranteed profit with almost no fingerprints.

Wll, that would be something, wouldn't it. You set up a mortgage bank, make lousy loans that you, uniquely, know are going to blow up, you sell them to a Wall Street house to package and distribute them, and then you short the packages. That is the definition of fraud in my mind, but it would be very difficult to detect and prove and, if I understand Goldman's defense, they would say that the investment bank that does the packaging and distribution, and makes markets in the securities, has NO culpability or responsibility not to traffic in such paper. Caveat emptor -- those are the words that should be etched over 85 Broad Street.

After the hearing yesterday and getting a glimpse of how Goldman operates, why would anyone want to to do business with them?

Actually, if you were someone who was intent on snookering investors, Goldman would be your investment bank of choice. As it was, for example, with the government of Greece, that wanted to hide how much sovereign debt there was. Or as many corporations do when they want to use derivatives to play accounting games in an effort to reduce the amount of debt on their balance sheet or even avoid taxes, as George Soros has suggested.

If the Goldman hearings told us anything, didn't they tell us that Wall Street still just doesn't get it?

They don't get us and we don't get them. We're from different planets.

Steve, I'm no fan of Wall Street, but I think I understand Goldman's point: that everything they sell is worth *something* on the market. Not all subprime loans go bad, for example. Is that right?

That's right. Everything is worth something and the market makes that determination.

Is it clear Goldman did anything unethical (forget, for a moment about illegal) if the long side of the Abacus trade knew what was in the CDO? If you and I are betting against each other on the outcome of a baseball game, and I get to pick the line-up of a team, what does it matter to you so long as you can see the line-up (and do your own due diligence) before you place your bet?

What if you are betting against the manager of the other team who not only knows a whole lot more about how all the players are feeling and doing at any particular moment but also has some impact on the strategy taken by the team?

Hi Steve: I've got a comment and a question. It's a royal shame on all of us and especially our elected officials that even after the recent meltdown we need to debate the need for financial reform. This shows how polluted our political system is in that our elected officials have been so swayed (or bought off) by special interests. Separately, can you please explain to me why Goldman was allowed to convert to a bank holding company? And why then, is Goldman is essence allowed to borrow at 0% from the Treasury, and Goldman could conceivable use that money to buy Treasury bills and earn a risk-free spread?

I think I've already answered the second part of that question, although the borrowing is done from the Fed. As to how any politician can be opposed to reform, I think we can give some of the Republicans the benefit of the doubt that they are not opposed to the idea of re-regulation, but opposed to the particular way in which Democrats propose to go about it. In fact, the reason most Republicans are opposing it has nothing to do with the substance, which most of them don't understand. It has to do simply with denying the president and the Democrats a victory and an accomplishment. It's all political and partisan.

We see this sort of cultural balkanization in many areas, but really this is the ultimate danger, isn't it? If the people that essentially control our money have, as you put it, no morals, aren't we condemning ourselves to further game playing? Given the level of influence they have, is there any realistic hope that sensible and yes, ethically-based regulation can be put into place? When Warren Buffett, whom I generally respect, has the ability to influence a senator's vote, then we are really losing our ability do well by anyone other than the moneyed elite.

Well, on that last point, Mr. Buffett seems to have been turned back, so the system didn't actually work in the way you suggest.

We may be from different planets but we share money and an economy. So someone better find a way to translate before their planet destroys ours.

Hey, that's what I do every day.

Thanks for another great column today. You touched briefly on the issue that maybe we are jealous of Goldman Sach's success. What I'm wondering is how you think the Wall Street types look at regulators like Bernanke and Geithner or the Senators who were quizzing them yesterday or the man (in my case, woman) in the street? Do they think we are saps who are jealous that we can't /aren't making the kind of money they do? Do they think that if Bernanke and Geithner were really any good that they'd have gone over to the Wall Street side? In other words, does anyone on Wall Street have any respect for (or even fear of) those who are calling them on the carpet now?

Short answer to your last question: No. They think we're just dumb and they're happy to take our money. Their disrespect is palpable if you read the e-mails.

Could the average person invest in these long or short deals? are these only big investor instruments?

Its hard to do it, if not impossible, and they would charge you so much that it wouldn't be worth it. Its a volume thing.

Steve, I have been very frustrated by the recent praise for Goldman from some very prominent commentators like David Brooks and Fareed Zakaria. Generally, I find them to be very reasonable and thoughtful, but their arguments in favor of Goldman seem ridiculous. Essentially they are saying that because Goldman shorted the housing market and turned out to be right, they should not be criticized. How is that relevant? The case that the SEC made and that the thoughtful critics of Goldman have been making is that Goldman was committing fraud. They were lying about material facts when selling deals to their customers. I guess this is not really a question you can answer, but what is wrong with David Brooks? It seems like he is just reacting against the stupid criticisms of Goldman and ignoring the valid and important criticism. Thanks for your clear, thoughtful analysis of this whole mess.

Their secondary argument, which is Goldman's defense, is that the buyers of the security at issue knew that the securities were being created so somebody could short it, what they didn't know was immaterial, and that as it turned out, the market turned down so much that it didn't really matter what mortgages were included in the package because any mortgages from this period would have yielded the same financial result.  All buyers had access to the information about the mortgages themselves and therefore had the ability to make their own determination of how risky they were. That's the defense, and it may win out, I have to warn you.

     Brooks and Zakaria are just good columnists, and they know its a good tactic for them to zig when everyone else is zagging, particularly when everyone else doesn't really understand what Goldman does. What is unfortunate is that Brooks and Zakaria also don't understand enough about the system to see how fundamentally corrupt it is, and by this error of omission wind up on the wrong side of the issue.

I would describe the Goldman reps testimony as "confident" and perhaps also a little arrogant. Of course, they have a lot of past earnings which make them confident. Do you think a "clawback" provision to confiscate past earnings might make them a little nervous and more cooperative??

Why should there be a clawback when Goldman made money?

I'm not a lawyer so I can't comment about the strength of the SEC's lawsuit. However, it seems at the very least, that Goldman has a major public relations problem. Do you have any thoughts regarding whether big instituitional investors such as Fidelity or T Rowe Price, or big pension funds will tell Goldman cut out the nonsense or we're taking our business elsewhere?

I doubt it. They probably fool themselves into believing that they want to be on Goldman's side in the daily market brawl. Goldman may manipulate markets and snooker investors but if they do so on my behalf, they will reason, its fine with me.

These Senate Hearings are a complete waste of time. Do you think anything useful came from yesterday?

Yes, particularly the first panel with the mortgage traders. Their amorality came through perfectly.

Steve, Do you think Fab will be sacrificed (and if he were me, I'd be squealing like a pig by now) and do you think ultimately GS will get away with this?

No, if you ask that you don't understand Goldman. Goldman is like the Marines -- they will do anything to save a wounded comrade. And they won't settle, I can assure you of that. They will litigate this one to the Supreme Court if necessary.

One reader wrote this: "Do you think Carl Levin, etc. understand this stuff enough to really be questioning Blankfein? Why do we despise people who make money off of others misfortune? To some extent isn't that just the inherent destructive nature that is capitalism... " One answer is no, Wall Street is not what capitalism is about. Capitalism is about creating new values. Those guys are not; they are trading existing values. We are resting in the wake of the computer's communication revolution: that generated destruction caused by creation.

Interesting point. Good point.

Steven, From the beginning of this crisis you've cautioned against reacting emotionally and punishing Wall Street. You've argued we can fix the problem or take revenge. Well, now I think it's time for revenge. You state that Wall St. and the rest of us live on different planets. No, we don't, and it's time for us to teach them that they DO live in the same world we do. And also that they are not Masters of it. I'm a strong Democrat but if a credible politician of either party ran on a platform of kneecapping Wall Street, I'd support her in a flash. That entire industry needs to be cut down dramatically. Let them go to London or Beijing if they don't like it here.

I'm with you, man. Now is the time to have a ritual public hanging, because it is the only message these guys are going to understand. Otherwise, they'll be back to business as usual in no time. In fact, they already are.

Yes, and we appreciate it. Are you able to influence the system to the degree necessary to fix things?

I have very little, if any, influence on the system, is the honest truth.

That's all for today folks. Good discussion. I've got to be away next Wednesday so we'll pick up in two weeks.

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Steven Pearlstein
Steven Pearlstein is a business columnist for The Washington Post. He won a Pulitzer Prize in 2008 and is co-moderator of the On Leadership discussion site.
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