|
June 2, 2010
What do Goldman Sachs and disgraced NBA referee Tim Donaghy have in common? As many sports fans know, Donaghy placed bets on the outcome of basketball games he would later referee. Similarly, Goldman Sachs trades its own capital in markets where it also plays the role of market-maker. Both Donaghy and Goldman have acted with blatant conflicts of interest. But while Donaghy was caught and sent to jail, Goldman's case is still up in the air. On April 27, Goldman Sachs executives testified to the U.S. Senate for almost eleven hours. While the likely goal of this testimony was for the Senate to set up a financial reform package for Congressional consideration, it should not have taken so long to get to the heart of the matter. Senator Carl Levin hit on the critical issue in his opening questions, asking if Goldman traders felt an obligation to act in the best interests of their clients. Stumbling answers by Goldman veterans Josh Birnbaum, Michael Swenson, and Fabrice Tourre spoke volumes, exposing the real issue: They did not want to admit that their firm does not always do what is in its clients' best interests. Or they were coached not to admit that reality. While complexity took over the Senate hearings as each side struggled to frame the dialogue, the problems posed by conflicts of interest remained at center stage throughout. Reforms to better align the interests of market participants would benefit the financial system as a whole. Three areas cry out for attention: (1) the role of market-maker and market participant, (2) the fiduciary standard and (3) the role of disclosure.
While Donaghy's conflict of interest was clearly illegal, Goldman and other investment banks are within their legal rights to bet their firm's money on markets they also facilitate. At any given time, investment banks serve as both market-makers and participants. As market-makers, they buy and sell securities from clients, earning a "markup" between the price at which they buy a security and the higher price at which they sell the same security to another client. At the same time, they can also engage in a business called proprietary trading, or "prop trading." Prop trading is a business where Goldman puts its own capital into specific investments, not to help facilitate markets for their clients, but instead, to earn profits from Goldman's independent view of a security's real value. In the ABACUS deal, for example, Goldman created a security ~ a so-called synthetic CDO ~ for a hedge fund client that wanted to bet against the housing market. Getting this exposure in place for its hedge fund client required finding other investors with an opposite view, willing to buy this synthetic security in hopes that it would benefit from further increases in house prices. One issue in this case is that when Goldman creates an investment product, it gains an information advantage from having been involved in the structuring of it. Another, more serious issue arises if Goldman's "prop desk" then uses this information to bet that the product's price will fall. With ABACUS, it looks like Goldman decided to invest alongside the hedge-fund client, expecting house prices to fall. If all the while, Goldman's sales force was working to find potential ABACUS buyers, it seems quite similar to Donaghy, betting on a game in which it is also serving as referee. At minimum, Goldman's position as an insider to complex markets allows it to better position "house" investments. It's potentially akin to insider trading. In Goldman Sachs' 2009 Annual Report, the firm breaks their various businesses into three segments. Investment Banking accounted for $4.8 billion in revenue, while Asset Management and Security Services contributed another $6.0 billion in revenue. Both businesses were dwarfed in 2009 by the $34.4 billion in revenue generated by Goldman's Trading and Principal Investments business. This final segment, which includes the questionable combination of market-making and prop trading, is a critical component to Goldman's overall revenue. In the end, how should institutional investors feel knowing that Goldman's sales force is pushed to get rid of positions, like the ABACUS deal, which Goldman no longer wants on its own books? How should Goldman's private clients feel knowing that a Goldman financial advisor's loyalty is to Goldman and its shareholders first, not to a wealthy but less sophisticated investor that pays Goldman's Private Client Group for advice? It's a broken model, which Congress needs to fix. Playing both market-maker and market participant introduces unnecessary conflicts of interest into our financial system. Congress should separate "prop trading" from "market-making." Firms should not appear in financial markets in both roles at the same time. Congress can force firms to choose one role or the other as a solution.
Some observers have asked about Goldman's fiduciary responsibility, suggesting that it could lead to a solution to conflicts of interest. But in reality, Goldman employees ~ like those of other investment banks ~ do not have a legal obligation to put client interests ahead of their own. In theory, Goldman employees actually have a legal obligation to put Goldman shareholders' interests first. In practice, employees of Goldman and similar firms seek to balance the interests of clients and shareholders with their own individual interests, which are based on how employees are compensated. For better or worse, employees respond to incentives, and compensation seems to take precedence in driving behavior. At the Goldman Sachs Annual Meeting on May 11, President and Chief Operating Officer Gary Cohn was asked about fiduciary responsibility. Cohn replied that just one of Goldman Sachs' units has a fiduciary duty to clients: the asset-management division. He said markets would not work if market-makers like Goldman Sachs' sales and trading division were required to serve as fiduciaries to clients (Bloomberg Businessweek, 5/11/10). When Congress considers extending the fiduciary standard, the idea of putting clients' interests legally in front of the interests of Wall Street firms will look attractive. But Goldman is right to argue that the fiduciary standard is unworkable for market-makers. In its role matching buyers with sellers, Goldman is not in a position to act in the best interests of both since they are entering into opposite positions in a transaction. This reality was the core of Goldman's defense. Still, many sophisticated Goldman institutional clients seem to mistakenly believe that their personal contact at Goldman has some responsibility to put their interest as a client first. Worse yet, Goldman's Private Client Group, where "advisors" work with wealthy but less sophisticated individual investors, has clients that are even less likely to understand the complex conflicts of interest in Goldman's business model. Addressing this natural "agency conflict" between a principal (the investor) who empowers an agent (a financial advisor) to serve them is best done through a standardized fiduciary standard. This legal requirement for advisors to put their clients' interests ahead of their own already exists for registered investment advisors. That high current standard should not be watered down by the lobbyists of broker dealer firms as part of new regulation. While extending the fiduciary standard to Wall Street firms as a whole is inappropriate, Congress should certainly extend it to all parties claiming to offer financial advice. If the difference between an advisor and a salesperson is clearly defined by a strong fiduciary requirement, investors will be much better served.
The U.S. Securities and Exchange Commission has accused Goldman of failing to disclose critical details and potential conflicts of interests in its ABACUS deal. The SEC may realize that Goldman's lack of disclosure and potential misrepresentations could have kept alive the mortgage machine at the heart of the financial crisis. And it sounds like Morgan Stanley might soon be in the SEC's crosshairs for similar behavior. Maybe the SEC is further ahead of the curve than many realize, focusing on one of the problems with this business model, and taking on Goldman in what will be a nasty and very public battle. If Congress stops short of simply killing off some of these conflicts of interest, improved disclosure and better enforcement is a minimum required step. For investors to make good decisions, they need to understand the role that their Wall Street contact person is playing in their relationship. In the current environment, the roles of advisors, salespeople, traders, and financial product distributors living together under one corporate roof is far too confusing. If sunlight is the best antiseptic, then disclosures that will clarify who is and isn't putting client interests first is a minimum first step to help market participants see the difference.
The 11-hour show trial of Goldman Sachs on April 27 exposed flaws in the business model of Goldman Sachs, as well as many other Wall Street firms that operate as broker dealers or banks. If Congress is serious about improving the health of the U.S. financial system while reducing the behaviors that led to the financial crisis of 2008-2009, it needs to address these conflicts of interest. Professionals in our system should have a legal, fiduciary responsibility to act in the best interest of their clients. Those who do not embrace this standard should disclose so. Today, disclosure rules allow Wall Street to blur the lines. The role of many salespeople sounds identical to that of an investment advisor, but they operate without accepting the legal responsibilities that should go with an advisory relationship. If a Wall Street business is not required to uphold the fiduciary standard, investors should not rely on it to provide objective advice, just as sports fans would not rely on Tim Donaghy to ignore his personal interests when officiating a basketball game.
|