It wasn’t very Goldman Sachs-like for Greg Smith to use the Op-Ed page of the New York Times last week to tender his resignation as an executive director, accusing the image-battered investment bank of having shamelessly put its interests ahead of its customers. But then again, Smith’s point is that even Goldman Sachs is no longer like Goldman Sachs now that it has given up the “long term greed” in favor of the short-term variety necessary to produce industry-beating profits and bonuses.
The predictable response from Wall Street was to dismiss Smith as hopelessly hypocritical and naïve — hypocritical because he didn’t resign from Goldman until after he had been passed over for promotion and after he received his 2011 bonus check, naïve for thinking that trading financial instruments with customers has ever been anything but a zero-sum game.
Such a dismissal would be more convincing, however, if it wasn’t merely the latest piece of evidence of the ethical deterioration at Goldman in particular, and on Wall Street more generally.
In fact, Smith was not a trader of derivatives, but someone who helped to design and sell the complex instruments to corporate treasurers and hedge-fund managers. The boiler-room atmosphere and “rip-out-their-eyeballs” culture that Smith describes jibes perfectly with what we learned just a year ago about Fabrice Tourre, the self-described “Fabulous Fab.” It was Tourre and his colleagues, you may recall, who deliberately set out to create credit-default swaps that they knew would blow up so they could peddle one side of the bet to a client who was in on the joke and another set of unsuspecting clients who foolishly assumed Goldman had their best interests at heart. It cost Goldman $550 million to settle that one with the Securities and Exchange Commission and its former clients.
There’s also recent evidence that this “toxic” culture that Smith describes has infected the investment banking floors at Goldman, where longtime corporate clients get supposedly impartial advice on mergers and acquisitions.
In a scathing opinion issued last month by Delaware’s Chancery Court, Chancellor Leo Strine concluded that Goldman had seriously breeched its duty to the board and shareholders of El Paso Corp. in advising them to accept a takeover bid from Kinder Morgan, in which Goldman itself held a 19 percent stake and two seats on the board of directors. Goldman argued that it took care to deal with this “potential” conflict-of-interest by having its two Kinder Morgan directors recuse themselves from merger discussions and by bringing in another investment bank, Morgan Stanley, to advise El Paso on the terms of the proposed takeover. But Strine ruled that Morgan Stanley’s independence was badly compromised by the fact that its $35 million fee was entirely contingent on the merger going through. In the end, the judge concluded, Goldman benefited in two ways from its unresolved conflict of interest: from the $20 million investment banking fee from El Paso for a transaction in which it claimed to have no active role, and from the lowball (“suboptimal”) price that El Paso shareholders were persuaded to accept from Kinder Morgan, in which Goldman continues to hold a 19 percent interest.
Isolated examples involving low-level Goldman employees? Well then, how to explain that it was a former Goldman chief executive, Jon Corzine, who headed MF Global, the commodities brokerage firm accused of stealing more than $1 billion from its customers’ accounts?
As it happens, just as Greg Smith was reminding us of how Wall Street rips off its customers, Washington was moving to roll back regulations designed to protect investors from that kind of predation.
The Senate this week scheduled to take up the House-passed “JOBS” bill, a politically clever double entrendre meant as an acronym for “Jumpstart Our Business Startups Act.” The premise behind the legislation is that fewer companies are issuing public stock than in the past because of the onerous regulatory burden placed on public companies and the process of going public.
The alleged proof of this tight causal relationship, it turns out, comes from surveys of the executives of growing companies. Imagine that — executives not liking regulation! Have you ever met an executive who said he liked regulation? Or one who wouldn’t swear on a stack of Bibles that he could never, ever take advantage of customers or shareholders because he would be punished in the competitive marketplace?
What we also know from painful experience — from the mortgage and credit bubble, from Enron, Worldcom and the tech and telecom bubble, from the savings-and-loan crisis and the junk bond scandal and generations of penny-stock scandals — is that financial markets are incapable of self-regulation. In fact, they are prone to just about every type of market failure listed in the economics textbooks.
Financial markets are hotbeds of asymmetric information, when one party in a transaction knows much more about the thing being traded than the other.
They are, as Greg Smith reminded us, rife with agent-principal problems, in which the self-interest of bankers and brokers and ratings agencies are not well-aligned with those of their clients.
Financial markets are magnets for moral hazard, where people can take risks knowing that they won’t have to suffer the full consequences of those decisions because of government bailouts or insurance.
And financial markets are highly conducive to herd behavior because bankers and money managers know that, no matter how disastrous their decisions turn out to be, they won’t lose their jobs or their standing in the industry if they were making the same bad decisions as everyone else.
Yet despite this well-accepted theory, and in spite of recent experience, Wall Street and its political spear-carriers are always quick to blame “excessive regulation” for whatever ails the markets or the economy.
Their latest idea is to exempt any firm with less than $1 billion in sales from many of the reforms enacted after Enron or the latest financial scandals. That’s a pretty loose definition of a “small” company, and one that would have exempted from these regulations about 80 percent of companies that have recently gone public.
Under the House-passed bill, these “small” companies would be exempted from rules requiring that they disclose the compensation of executives and other insiders or that they give shareholders the right to approve such compensation. They also would be exempted from having to hire outside auditors to assure that they have internal controls sufficient to prevent and uncover investor fraud.
In addition, the legislation would repeal reforms put in place after the dot.com bust to protect the integrity and independence of research analysts at investment banks that win underwriting business by promising favorable reports from analysts. And for the first time, it would allow investment bankers to issue glowing reports about an upcoming stock offering they are underwriting that would not be covered by the rules for accuracy and truthfulness that now apply to the official prospectus.
There’s also a provision to allow companies to use Internet “crowdfunding” to raise up to $1 million in equity from small investors without even having to provide so much as an audited financial statement, a description of the business or a description of the voting rights of shareholders. If that isn’t an open invitation to penny-stock fraud, I can’t imagine what would be.
The House bill also would remove or loosen regulations for “private” stock that now can be offered and sold to a small number of “sophisticated” investors. If the industry has its way, you will soon be seeing advertisements for private offerings on late-night cable television and billboards outside of nursing homes.
It tells you how desperate the White House is to show its pro-business bona fides that it has thrown its support to this crappy piece of legislation. To her credit, the controversy-shy chairman of the SEC, Mary Shapiro, last week penned a letter to the Senate with a warning that the JOBS bill will undermine important investor protections. And on Thursday, a more reasonable alternative was offered in the Senate by Carl Levin, the Michigan Democrat whose investigations subcommittee was the first to shine light on the financial antics of “Fabulous Fab” and his Goldman colleagues.
As Greg Smith so eloquently reminded us, if small companies are having trouble going public, it’s not because of excessive regulation but because too many investors have been burned too many times by markets that are rigged against them.