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By Ronald Fink
A couple of pieces published in the past few days come very close to accusing Goldman Sachs’ behavior in the credit markets before last year’s financial crisis of amounting to outright illegality.
The first, at the website Naked Capitalism, never quite comes out and says what laws Goldman may have violated by having its traders short the products its investment bankers sold.
The second, in the august pages of The New York Times, cites laws requiring “fair dealing” with customers.
I’m no lawyer, but my own experience with Goldman suggests there’s nothing new here and that this problem is inherent in the very structure of Wall Street.
Back when I was at CFO Magazine, one of the bank’s PR representatives invited me to its headquarters to discuss the virtues of a relatively new product called credit default swaps with one of its traders.
To demonstrate, the banker showed me how a swap on General Motors’ creditworthiness was trading following a $13 billion bond offering by the company that Goldman just happened to have helped underwrite. Indeed, the trader explained that there was tons of money to be made by using the swaps to bet on GM’s default following one of the largest debt offerings in history and one that Goldman had helped sell to investors.
When I naively asked about the conflict of interest this involved, the PR person quickly pointed out that Goldman, like all investment banks, had a “Chinese wall” separating its traders from its bankers, and on my way out, he showed me how it worked.
The traders were literally walled off by a glass partition from where the bankers worked, and the door between the two areas was electronically locked. The PR person explained that neither the traders nor the bankers had the pass code that would open it.
I didn’t ask the obvious question that came to mind, which was whether they could instead communicate by phone or computer on any given deal, though my understanding is that the firm had the means in place to prevent this from occurring as well, and that all this was standard industry practice.
The thing is, questions about the effectiveness of these measures are hardly new, and came up only a few years ago in the case of Enron and WorldCom. Remember this?
So all of this comes back to one question: How can investment banks make a market in the securities they underwrite if they can’t sell them short? Answer: They can’t, simply because there has to be a seller for every buyer. And if there aren’t enough sellers out there to support a given amount of buying, then the banks have to take the other side of any deal they underwrite.
Indeed, this is how the capital markets work. And as long as the economy requires them to function, the only significant question this raises is the degree to which taxpayers should subsidize the activity. That isn’t easy to answer. After all, the bottom line here is that taxpayers ultimately benefit from short selling, however indirectly. And that is why Congress separated investment and commercial banking under the Glass-Steagall Act that was chipped away at for decades and then abandoned outright in 1999.
Perhaps there are better ways to limit federal backing for banks’ own trading activities. But I haven’t heard one to date. And until this issue is resolved, taxpayers will remain on the hook for the behavior that has some reporters and bloggers up in arms.
Outrageous? Tell it to the Financial Crisis Inquiry Commission.
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