Surprise! The banks want to make money, Goldman Sachs

Goldman Sachs, one of the most prestigious banks in the world, has issued a detailed rebuttal of the SEC's accusation of fraud

 

Gordon Brown is "shocked". The notion that Goldman Sachs might have been playing off one set of clients against another to its own advantage, as alleged in a civil lawsuit filed by US regulators last week, had apparently never occurred to him, and he has called for a special investigation into the US investment bank's activities.

Give me a break. Until last week, I had never heard of the transaction in question – an unpleasant-sounding structure involving dodgy mortgages, a clever hedge fund manager and some less savvy investors – and I have no idea if the charges will stick.

I am, though, familiar with the concept that bankers in the middle of such transactions tread a fine line in order to remain on the right side of propriety. This issue is so widely understood that it has a special name: managing conflicts of interest.

It is also obvious that in the run-up to the financial crisis banks sold sub-prime mortgage products that were not, let us say, as safe as they were cracked up to be. Last year, the Securities and Exchange Commission subpoenaed Bank of America, Merrill Lynch, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Morgan Stanley and UBS, for information about the marketing of mortgage products.

This is par for the course: whenever there is a financial boom, bankers peddle hot products with enthusiasm that verges on the excessive, and after the inevitable crash, investors – rightly or wrongly – seek to pin the blame for their bad decisions on these middlemen. The difference this time is the scale of the crisis and the resulting economic downturn. As a result, a restructuring of the financial system, rather than some rule tweaks, is now on the cards.

Goldman in the line of fire

Given that Goldman has been at the centre of post-crisis controversy on several counts, it is not surprising that it is in the line of fire. Wall Street's most prestigious bank has always conceded that its business model involves managing complex conflicts of interest – not only between different sets of clients, but also between itself and its clients. This is true of all investment banks, since trading inevitably creates losers as well as winners.

Of course, banks which advise companies and execute big trades for clients have an edge: they are in possession of superior information. There are rules in place to prevent abuse, but let's not pretend that doing the right thing – or even defining what is the right thing to do – is always easy.

In recent years, grey areas have become even greyer, partly as a result of the proliferation of derivative instruments, which have many useful functions, including obfuscating what is really going on.

At Goldman, the web of conflicts became increasingly tangled as the bank built its own private equity business – allowing it to invest in companies directly – and developed strong relationships with hedge funds.

How effectively Goldman was "managing" these conflicts was an issue long before the crisis. Four years ago, Hank Paulson, its then boss, rebuked his London colleagues for a controversial attempt to bid for BAA, the British airports group it was supposed to be defending against a takeover approach.

Goldman's reputation, he feared, was at risk. That risk is now acute, particularly given Mr Paulson's subsequent role as US Treasury secretary during the financial crisis, when he allowed Lehman Brothers to fail but helped Goldman and Morgan Stanley to avert disaster.

Goldman has rebutted the SEC charges, and notes that the complaint involves "disclosure on a single transaction involving professional investors in a market in which they had extensive experience". The bank also points out that it subsequently lost money on the transaction.

I don't find this to be compelling evidence either way. Most banks lost money in the sub-prime market, but it doesn't mean that their actions were misguided, rather than ill-intentioned. The individuals who structured transactions may have been awarded big bonuses on the back of deals which, at least initially, allowed banks to book profits. This represents yet another potential conflict of interests.

The widely advocated separation of retail and investment banks would do nothing to solve this long-standing problem, since some of the worst conflicts are to be found within standalone investment banks. To strip down activities sufficiently to remove all conflicts would involve reducing the financial industry to uneconomic fragments.

Furthermore, the crackdown after the dotcom crash on analysts who privately denigrated stocks they publicly recommended showed that it is possible to end such abuse, if lines are clearly drawn then policed.

The big surprise, as far as I am concerned, is that anyone was naive enough to believe banks' "clients-first" rhetoric. Clever, financially motivated employees were given powerful incentives to prioritise short-term profits.

The email reflections of a Goldman banker, which form part of the SEC's case, describe "these complex, highly leveraged, exotic trades… created without necessarily understanding all of the implications of those monstruosities [sic]". Whatever the legal conclusion, that is a vivid indictment of how the industry operates.

 By Tracy Corrigan, Telegraph