Friday, April 30, 2010

Agency vs. principal, and Goldman 

Thanks are due again to Anon lawyer for linking to the article in Cardinalpark's thread below, providing the news that federal prosecutors are conducting a criminal investigation into Goldman Sachs, though no charges have been filed at this point; but, the story did move the market lower today. In the body of that article, reference is made to the prosecution against Bear Stearns executives, presumably referring to the Cioffi case. Having read House of Cards by William Cohan, I think that the facts were much worse in that case from the standpoint of the defendants, yet they were acquitted. So, nothing is a slam-dunk in front of a jury.

For about the last 30 years, since Salomon starting trading MBS for its own account (in addition to creating the MBS market and underwriting lots of bonds), there has been an erosion (to say the least) of the distinction between acting as a broker for a client and acting as a principal in a transaction. To the extent that it harms a client, it is a real problem, falling under the category of breach of fiduciary duty -- and that kind of problem is true in any market for any product or service, not just securities.

Yet, to the extent that clients are aware of the two functions, and accept it, I am not sure that government-initiated litigation is the best cure. I personally don't like it (I have much more of a "principal" or managerial mentality), and don't want to be on a trading desk somewhere, but if sophisticated participants want to play in that arena and go in eyes wide open, then so be it. If a party feels, after the fact, that fraud has been committed, then that party should sue in a special civil court, not the SEC (which, frankly, ought to be completely redone, given some teeth, and put under the FBI and Justice). The European banks and ACA, presumably the injured parties in the ABACUS case, are likely cooperating with the SEC, but that is not the same thing as being the plaintiff in a civil case. If there is criminal wrongdoing, again, an injured party ought to press charges and stand behind them and work with federal prosecutors.

I don't want to be an apologist for Goldman, but I think it is a mistake to count the firm out, as frequent commenter The Truth is Out There does in the thread below. While I would agree with him that Goldman should un-flip the switch that made it into a bank holding company at the height of the crisis in September 2008, I would counter that the investment banking side of the business has done a huge amount of good work over the past generation, including industrial companies. That's really the original business of the firm. If the Goldman parent company (The Goldman Sachs Group, Inc.) were somehow given a government edict death sentence tomorrow, the investment bankers at Goldman would re-form a new entity the next day, and open up shop under a new name with the same culture, and continue to do corporate finance and M&A work.

Here is the perspective of a long-time Goldman client, interviewed this week on Nightly Business Report (video at link):

TOM HUDSON: Since the Securities and Exchange Commission filed a civil fraud charge against Goldman Sachs almost two weeks ago, its stock is down about 15 percent. Tonight's "Street Critique" guest knows Goldman very well. Hilary Kramer is the editor of gamechangerstocks.com and chief investment officer at A&G Capital Research joining us this evening from the NASDAQ. Hilary, welcome back to NBR.

HILARY KRAMER, CHIEF INVESTMENT OFFICER, A&G CAPITAL RESEARCH: Thank you Tom. It's a pleasure to be here again.

HUDSON: You're in a very unique position. Not only are you a shareholder of Goldman. You've been a client for 16 years. In the past couple of weeks with what you've learned about Goldman allegedly and real, has your relationship changed at all? Have you reconsidered that relationship?

KRAMER: My relationship with Goldman Sachs is stronger than ever. The firm I'm very, very loyal to, all the firms on Wall Street and I've been a client in investment banking, mergers and acquisitions, restructuring, hedge fund, client and private wealth management as well as all aspects of even derivatives trading and I'm very, very dedicated to Goldman and still trust the company.

HUDSON: So really with all that experience with Goldman, the client, you, is at the center of this Senate deliberations and inquiries yesterday. Does it bother you that Goldman may be trading against your position?

KRAMER: It's not just Goldman, Tom. It's the entire Street. They're not saints. They're not angels. It's Wall Street. There's a reason why Goldman Sachs made $12.8 billion in net revenue in the first quarter. This is the game. This is the way it's played. When you make a trade there's someone on the other side. Buyer beware.

HUDSON: But what if Goldman is acting more than just a broker, matching you with that buyer seller, but Goldman itself is the buyer seller of that product that you're purchasing through Goldman?

KRAMER: But Tom, I understand that and I understand that across the street, because they're acting as a market maker or they're a principal investor, that's the way it is. Is it right, not always. But it's the way business works on the Street
As long as most Goldman clients maintain that perspective -- and I realize some will say that such a perspective comports with that of a battered wife -- then Goldman will stay in business and make money, both for itself and its clients.


By Anonymous Anonymous, at Fri Apr 30, 06:49:00 PM:

OMG -- the last thing you want is to put the SEC under the FBI, or DOJ....

The problem with the SEC, in a nutshell, is that just about anyone with enough financial sophisitication to go toe-to-toe with Wall Street is not a lawyer with an English or History degree; and those with that sophisitication can usually earn more money in some finance field.

There are exceptions, but in a long time as a lawyer I know exactly one lawyer (other than myself) who I trust to understand economics and finance. Wait. I'm sorry. It's two. But two out of thousands of lawyers isn't many. (That is lawyers who haven't switched to being businessmen already.)

Finally, it's premature to say anything about the Goldman matters, I think, except that were I at Goldman, I would want to exit this maelstorm stage right as quickly as possible.  

By Blogger JPMcT, at Fri Apr 30, 09:19:00 PM:

The vote to proceed at the SEC was 3 to 2...strictly along party-affiliation lines.

If the investigators could not convince the entire commission that woeful wrongdoing had occurred (which, by the way, it didn't), then it is of interest that the Obama admisistration would risk further market disruption and loss of investment by standing firm with the SEC that was not unaninimous.

So...tell me again why these guys are political "geniuses"?  

By Anonymous The Truth is Out There, at Fri Apr 30, 09:39:00 PM:

"but I think it is a mistake to count the firm out, as frequent commenter The Truth is Out There does"

I've never counted Goldman out.

If you see all my comments over multiple threads, I've pointedly said that Goldman wasn't the worst offender. They have the "good fortune - bad luck" of being the Last Man Standing. Morgan Stanley hardly counts -- they're so boring by comparison.

Many points to make, so here's just a couple to start..

Lloyd is a mensch. He proved it this week. Compare him to just the next two:

ex-Bear Stearns CEO Jimmy Cayne
I never understood what Jimmy did at Bear, other than to be Ace's bridge partner. When is started to get tough, Jimmy sacrificed Warren Spector to save his own ass. As smart as Alan Schwartz is, that meant there was no one senior left at Bear who actually knew anything about the mortgage business. We'll never know, but if Warren had still been around it all may have played differently -- at least not as bad.

ex-Merrill CEO Stan O'Neal
My Public Enemy #1. Stan drove Merrill to be the worst offender at driving shit mortgages through the system. It was all very purposeful. When Stan's group heads resisted this, he fired them. I don't know where Stan is hiding out these days, but he needs to be dredged up and publicly pilloried, ... and worse.
I guess that makes me a racist.


It's a wonder to me how Lloyd became Goldman's CEO. They wouldn't have interviewed him in the 1980s. But he's truly impressed me lately as a stand-up guy. He's not just hanging in there for a pay-day. He could have easily quit a year or two ago, if it was only about the money. Obviously, Goldman saw gravitas in Lloyd that dumb me only started to credit ....

More to come ....  

By Anonymous Billy Bob Corncob, at Fri Apr 30, 10:50:00 PM:

@JPMcT: You read too much into a vote that is made behind closed doors, without the benefit of an opinion.

Moreover, I learned long ago as a lawyer that sometimes I had a compelling, slam dunk case, fairly judged, and I could lose not just 2 but all 3 judges on the Court of Appeals.

To paraphrase Justice Jackson, sometimes a decision-maker is infallible because they have the last word, but they do not have the last word because they are infallible.

(Both the Republican commissioners, btw, are something of lightweights....)  

By Anonymous Anonymous, at Fri Apr 30, 11:47:00 PM:

I'm the anon lawyer who posted the link, but not the anon lawyer who posted above. I should probably get a handle, but I can't be bothered to sign up with any of those services. Plus, I'm a bit paranoid.

I have the following comments and observations on a Friday night after Chinese take away, one beer and one vodka tonic:
1. These threads are the most interesting, erudite, and civil discussions I've ever seen on the internet. Kudos to all, and let us all thank God Al Gore invented these interweb thingies.
2. Agree with Escort81 (What's with that name, anyway? My assumption is that the 81 refers to a year and the Escort refers either to a car or to your first time, or perhaps both?) that at one point in time Goldman did a lot of societal good. That was your father's Goldman. Those days are long gone.
3. In reviewing these Goldman posts and the accompanying comments the general breakdown seems to be that the practicing attorneys are in agreement that Goldman violated the law, while those in finance appear to be aghast that the SEC brought an action.
4. I very much enjoy reading the writing of The Truth is Out There. I'm cracking up, and it's funny 'cause it's true. Bring on some more of the pirate flag stuff. I can't stop laughing at that.
5. Financials have been the primary drivers behind market gains. It is easy to make money when you can borrow money at zero percent from the Fed's discount window and loan it back to the Treasury at 2-3%. It's a game of chicken between Goldman and the administration. IMHO I believe the administration holds the cards. Goldman can crash the market, but a market crash is not necessarily a bad thing for Obama because it drives a flight to safety in T-bills, which the administration desperately needs.
6. I see Republican gains in November 2010 slipping away day-by-day, and this issue is the biggest reason why. Democrats will successfully paint Republicans as the party of the insurance industry and bankers.
7. If Democrats keep control of Congress they will tackle pension reform in 2011 or 2012. Kiss your 401k goodbye, or at least be prepared to invest a bureaucratically determined portion in t-bills.

There's a lot at stake in 2010. Like I said before, I can't for the life of me understand why Republicans are rushing in to defend Goldman, especially after Goldman backed Obama in 2008. Screw Goldman. Let 'em twist in the wind while Obama sticks it to them.  

By Anonymous Billy Bob Corncob, at Sat May 01, 03:51:00 PM:

1. Republicans on the Hill are the problem. Rank-and-file Republicans are mad as hell at the lack of action to return the financial system to where it was before the 1990s. Every Republican I talk to from the heartland echoes this view.

2. A note: Goldman insists it was dealing with sophisticated investors, so sophisticated that they knew that they were buying crap and bought it anyway.

That's how sophisiticated they were.  

By Blogger Escort81, at Sat May 01, 07:20:00 PM:

Anon lawyer - My aim here, and that of my fellow and more senior bloggers, I believe, is to encourage civil discourse. Hopefully we succeed some of the time.

My nom de plume reflects my class numerals (1981) and the combination of the fact that 1) my recently deceased father served aboard a Destroyer Escort for much of his active duty service in the Atlantic during WWII; and 2) as a bachelor who is a bit up there in age, wives of friends of mine would kiddingly ask, "OK, who are you escorting around now?"

I kind of liked the old Ford Escorts, but never owned one and didn't think of it when I created the name. Probably TMI, but when I was in high school, my family owned a Checker Marathon, and, well, the back seats were really spacious.

I agree that Democrats appear to be halting Republican electoral momentum for November, but my sense is that the immigration issue may more responsible for pulling independents back into the Blue column as compared to the debate over financial regulation.  

By Blogger JPMcT, at Sun May 02, 08:57:00 AM:

"Goldman insists it was dealing with sophisticated investors"

IKB and ACA Capital were extraordinarily sophisticated...and so was Paulson. Goldman supplied an investment vehicle so that the investors could, basically, BET on whether the housing market was going to bubble or tank. The offering documents explicitly describe the "BBB" ratings of the securites.

If you thought housing sucurities were going to improve, you bought and held. If you thought they were going to decline, you sold short.

Simple as that.

Paulson sold short and made a ton of money. The others held (including Goldman)and lost.

Everybody shrugged and went about their business. No lawsuits. No complaints.

Until 3 years later when the Obama administration decides to expand it's control over financial markets and needed a straw man.

It is a very transparent admisistration, Billy Bob...at least in the sense that you can see right through them.

Their only hope of pulling this off...and it is a very likely prospect, is to rely on UNsophistcated voters who don't understand what really happened,  

By Blogger Bomber Girl, at Sun May 02, 11:52:00 AM:

I don't think the suit brings forth the issue of "sophistication" of the investors, rather it was the nature of the disclosure which is alleged to have been misleading and omitting material information.  

By Blogger Escort81, at Sun May 02, 02:30:00 PM:

Right, Bomber girl is correct, I believe -- the "sophistication" line might have an impact on the atmospherics of the case, but isn't on point in terms of legal question of material disclosure.

There's no suit at all, I think, if the offering documents had included statements about Paulson's role in the construction of the synthetic CDO, and Paulson's ecomomic interest. A judge has to decide (if it gets that far) whether the failure to disclose this information was "material." My understanding is (and hopefully the lawyers around here will pipe in) that the concept or practical application of the definition of materiality can vary from judge to judge. There are tests that judges apply, I believe, to arrive at a conclusion about whether a disclosure was material or not in a securities case.

Perhaps not an apt comparison, but certainly the accounting concept of materiality in a specific matter can differ depending upon which partner at a CPA firm you talk to.  

By Blogger JPMcT, at Sun May 02, 04:14:00 PM:

GS formed a fund with a hypothetical selection of extremely low-rated real estate securities and Paulson participated in proposing a list of hypotheticals, some of which were finally selected by ACA Management, a company with extensive experience in these markets and instruments, who knew Paulson, and knew that he was very involved in the deal, and knew that Paulson was extremely negative on the residential real estate situation in most of the U.S.

ACA Management knew specifically of Paulson’s interest is selling real estate investments generally, and low-rated mortgage-backed securities such as these hypotheticals specifically.

If an investor thought that the residential mortgage-backed markets were going to improve, the investor could purchase interests in the portfolio. If an investor thought that these markets would decline, the investor could sell the portfolio short. The portfolio was simply a vehicle set up to enable an investor going long or short on these markets.

So IKB and ACA Capital bought the new fund, as they intended, because they thought real estate was going up, and Paulson sold it short, as he intended, because he thought real estate was going down. Goldman Sachs also was “long” the portfolio, and lost $90 million on their investment, made with full knowledge that Paulson was intending to go short. If IKB and ACA Capital thought the RMB markets would decline, they could have shorted the portfolio.

In other words...WHERE's THE BEEF????

...and also...if the SEC is so troubled by lack of investor "information", why are they not troubled about the "information" that Paulson had...and turned out to make him a fortune on the deal???

The whole thing stinks to high heaven!  

By Anonymous The Truth is Out There, at Sun May 02, 04:18:00 PM:

As Captain Lloyd sails Goldman through uncharted waters, SEC v Goldman isn't his only worry.

The Levin hearing turned out not so bad. None of the Goldman witnesses blew up. It could have gotten into AIG and worse things but didn't. The Republicans weren't totally compromised by the hearing, but it has made the passage of some version of Financial Service Reform that much more likely. I expected Goldman to have run aground here, but it didn't. Credit Captain Lloyd.
Re: SEC v Goldman. For the last time, Goldman's conflicts weren't disclosed and should have been -- and they were material -- and it was a billion dollar deal. It goes to a jury, if the SEC lets it. Unlike the good Senators, a good lawyer -- even an SEC lawyer -- will carve up Goldman's witnesses -- they'd salivate at the thought of it. Guys in French cuffs in front of Brooklyn doormen and Bronx bus drivers. Sheeeeeeeet.

Don't cite the Bear Stearns Cioffi case. That was a criminal case over nothing more than a business failure -- the jury saw right threw it. The DA in the EDNY has Enron on the brain, literally. He should be ashamed for bringing the case.

You can't criticize the SEC for bringing the case against Goldman, but maybe only over its timing and the SEC's unwillingness to settle. Goldman fucked up. Clients will decide whether it was a one-off; but Congress too may respond by hurting Goldman's business with Financial Services Reform.

I don't see SEC v Goldman settling soon, because it's now a sideshow in a bigger production -- the bid / ask on settlement is too wide -- and the timing isn't ripe yet. Stories about a possible settlement were smoke blown by sources like The New York Post. A few of Goldman's PR people owe a few editors a steak and a blowjob.

Greek CDSs would worry me more. There's a strong parallel to the Enron barge deal that got Merrill bankers jail time. I'm not saying that what happened to the Merrill bankers was just -- only that it's a similar kind of exposure but with even potentially worse fallout for Goldman. Both situations involved facilitating client "window dressing." When things get really bad, prosecutor-types ignore that there was no intent to facilitate a bigger fraud.

There's a lot of civil securities litigation still out there. I see this from my day job. Before it's over, expect the big banks to write settlement checks well into the billions. One affect of SEC v Goldman is to make it that much less likely that these suits will be dismissed early. Judges read newspapers.

There are suits over bad securitizations. There are suits over related bad financial guaranties. There are suits over all the equity raised by banks just before the crisis. Some of the issuers -- notably Lehman -- are no longer around to indemnify. Third parties -- like the Lehman bankruptcy examiner and NYAG Andy Cuomo -- keep breaking the facts to make the plaintiffs lawyers case easier.

Meanwhile we have Financial Service Reform hanging ....  

By Blogger Bomber Girl, at Sun May 02, 05:24:00 PM:

Well done commentary on the evolution of the I-banks:

By Anonymous The Truth is Out There, at Sun May 02, 05:36:00 PM:

Another thing on SEC v Goldman: The dog that didn't bark

Presumably some lawyer wrote the ABACUS Offering Circular and at least vetted the pitchbook. If said lawyer knew of the specifics of John Paulson's involvement, they'd have taken the blame for the non-disclosure. Ergo, said lawyer wasn't told about Paulson including that he was paying Goldman a $15 million advisory fee to put the deal together. Which means that said lawyer must never have seen the Paulson-Goldman engagement letter. This suggests affirmative lawyer "containment."

Just speculating. But there may be something to this. The SEC doesn't have to put everything in its initial complaint.  

By Anonymous The Truth is Out There, at Sun May 02, 05:49:00 PM:

Bomber Girl's article is worth reading. I've been making this point over several posts here: traders took over. ABACUS is an example of Fabrice manufacturing a product -- not just trading it. A different legal standard applies.
Further still, Fabrice didn't even need an issuer to create this product.
Further still, ABACUS had no economic effect on the real world. It didn't create a long/short position in mortgages. It was an undisclosed private deal. It was just a bet. Why these aren't regulated as insurance or such like is beyond me. Were they so regulated -- with real capital requirements -- the market for this stuff would largely disappear.
This is not your daddy's I-banking. But nice work if you can get it.  

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