Goldman’s public purpose and where I have problems with the Abacus deal

As I said yesterday,  investment banks are institutions which do fulfil a useful role in society. I would define their role as companies where large institutions and governments receive financial advice and raise capital. Goldman Sachs is an investment bank. As such, Goldman must offer financial advisory services, capital markets origination, and secondary market support to maintain an orderly market in the markets in which it originates deals. That is what a full-service investment bank does and has always done.

In my view, the advisory business and the sales and trading functions are black and white issues.

Advisory Business

When Goldman gives financial advice to a client and executes a transaction or deal on the back of this advice, it must do so only in the best interests of the client. There are no ifs ands or buts here.  The client comes first. I went into the moral and ethical obligations in my post "Inside the mind of an investment banker: Greece, Goldman and derivatives," so I will let you read that post to get a full picture there. I will just reiterate that this is a black and white issue.  You simply cannot execute transactions or do deals that you know are not in your client’s interests. Full stop.

Sales & Trading

On the sales and trading side, Goldman Sachs is a market maker. That means their traditional role is to buy and sell securities principally to facilitate liquidity in the market. They are not a principal actor in this regard. As such, caveat emptor applies to their counterparties. Goldman is under no obligation to reveal its positions to counterparties in the market it makes. In fact, doing so compromises a firm’s ability to make a market. If you want to do a trade, Goldman’s only obligation is to show you a price because that’s what broker/dealers do. Lloyd Blankfein said as much in his Senate testimony. I see this as a black and white issue. They have no obligation to reveal their positions. Full stop.

Capital Markets

Then there is origination, an area where I have worked. Origination is what many firms call their ‘Capital Markets’ group. Here is where the problems begin because the origination groups are at once advisors and market-makers in their function. Your role as Capital Markets professional is to originate equity, debt, or structured product (derivative) deals for institutional clients, sell those deals to ‘buy-side’ clients, and to make a market in those instruments in the after market.

So, the capital markets guys must do deals that are in the best interests of the institutions, originating those deals. But, do they have an obligation to inform ‘buy-side’ clients of the pitfalls of those deals?  Yes. 100%.  This is where the problems lie in the Abacus AC1 deal that is the subject of alleged fraud. This was not a deal without a client. Paulson was the client. The synthetic CDO never would have been created had Paulson & Co. not asked for its creation. Goldman originated this Abacus deal at the behest of its institutional client, Paulson & Co. Therefore, Goldman’s obligation in the deal was to structure a deal which was in Paulson’s best interest.

The problem, therefore, is that in originating this transaction, Goldman was obligated to disclose to its initial buy-side clients what Paulson’s role in the deal was. Goldman was not selling a structured product without a client nor was it making a market in a security already originated. It was originating a deal purposely put together for a specific institution, Paulson & Co.. If Goldman did not fully disclose Paulson’s exact role – and all indications are it did not – then, at a minimum, it was not fulfilling its public purpose. The SEC has indicated this goes further – to fraud i.e. making ‘material’ misrepresentations to its buy-side clients and the company structuring the deal.

Proprietary Positions

Moving to a different track, let’s talk about ‘proprietary trading’ and the Volcker Rule for a second. What is novel in financial services is what is known in the business as "risking one’s own capital as a principal." Every major bank now is not just in the business of servicing clients in the ways I described above but also in making money as a principal actor.

This began during the 1980s when firms would risk their own capital in making bridge financing to corporate raiders like Carl Icahn during the Predator’s Ball days. One reason investment banks became so leveraged is that commercial banks had a natural advantage in this business due to their enormous balance sheet.  So you saw firms like UBS, Deutsche Bank and JPMorgan muscling their way into mergers and acquisition and origination via this channel.

At some point, the banks realized that deregulation meant they didn’t have to risk their capital just for other people. They didn’t have to do deals where the profit accrued only to their clients. They could become principals, taking what they deemed to be prudent risks for their own benefit. In essence, the banks all became hedge funds and private equity groups, often competing with their clients for business.

Now, the capital markets business already presents an ethical dilemma because of the opportunity for duplicity i.e. flogging off garbage as AAA to sell-side clients just to make a buck. This goes as far as getting bad assets off the bank’s balance sheet and sticking it with buy-side clients.

But, proprietary activity raises the potential conflicts to a new level by pitting a potential client against the bank for the very same business. The bank goes from market-maker or advisor to rival who cannot be trusted.  This is why the Volcker Rule has been posited. The goal of the Volcker Rule is to fashion a way to separate these proprietary activities which are replete with conflicts of interest from the more public purpose role of banks.  I don’t think the legislation based on the rule drafted makes a lot of sense given how difficult it is to define what a proprietary trade is. But the concept is grounded in the knowledge that these conflicts of interest pose a risk to the financial system.

My own view is that none of this will be resolved because banks make too much money in proprietary activities. They will lobby Congress until they get legislation more palatable to their interests. Only when the financial system does collapse will Congress be forced to turn away from the banking special interests. And at that point, with populist fervour against banks much greater than it is today, much more draconian remedies will be in store.

Of course, between now and then, there will still be a lot of money to be made by individual bankers.

Update: one of the comments of this post at Naked Capitalism mentioned asset management. This is another area into which the legacy investment banks have expanded, but that isn’t a part of their traditional role.

  1. JKH says

    What would have been Goldman’s disclosure obligation in originating a cash CDO?

    i.e. Would it have had to disclose the names of the sellers of RMBS to the cash CDO?

    Was this routinely done with cash CDOs?

    If not, why does a synthetic CDO carry a higher burden of disclosure?

    i.e. the seller of cash RMBS to a cash CDO becomes net shorter just as the buyer of protection from a synthetic CDO. There’s no difference in terms of directional trading interface from that perspective.

    Is your view of the disclosure requirement a function of a single seller or a synthetic structure or both?

    If single seller is the problem, would it also be a problem in the cash CDO case? Did this ever occur in cash CDO cases?

    1. Edward Harrison says

      The ethics is pretty simple. This deal was originated for one specific
      client, which is a material piece of information. And if a Cash CDOs was
      issued for a specific client (who also picked some of the collateral) that
      should be disclosed too.

      1. JKH says

        I always end up back at ACA’s responsibility as CDO manager.

        They did control the final portfolio content – Paulson could not “pick” anything without ACA “not rejecting” it.

        They would have been obligated to exercise the same control with multi sellers/protection buyers.

        So I’m not sure the single seller aspect isn’t overriden by ACA’s portfolio control responsibilities.

        The Fab/ACA interface (noted by Marshall) is a separable issue. That is where the case will become difficult, I think – verbal versus written disclosure of Paulson’s transaction intent – but as important the whole question of ACA’s competence – including not getting written confirmation – if that was critical to their portfolio selection process – and I’m not even sure that it was indeed legally or functionally necessary to do so.

    2. Marshall Auerback says

      I think the bigger issue is whether GS via Fabulous Fab, actually misrepresented Paulson’s role in this deal. Because there might be grounds for misrepresentation here, if that’s the case. Whether the CDO was synthetic or pure cash should not be the issue. One can query whether these instruments have any public purpose and whether GS behaved ethically (personally I think the answer is NO in both cases). But that’s separate from the legal issues.

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