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After watching hours of the US House Government Affairs committee on Investigations’ hearing on Goldman Sachs,  I concluded--totally contrary to the disavowals by the Goldman managers who testified--that there was indeed a conflict of interest between Goldman’s proprietary and market-making functions.  By proprietary, I mean a bank trading on its own books beyond simply being the counter-party in its market-making transactions. In their testimony, Goldman managers presumed that all of the bank’s proprietary transactions are part of its market-making role. However, I contend that the bank has been both a market-maker and a player in those markets, and furthermore that the latter function has affected the former in ways that are intended to benefit the bank. That is to say, Goldman Sachs’ financial interest has been put before that of its customers. In some cases, Goldman’s employees refused clients’ requests for shorts related to the housing market so Goldman’s own profits in shorting the market  could be preserved. Sen. Susan Collins (R-ME) said, “There is something unseemly about Goldman betting against the housing market as it is selling housing-related products to its customers.” Sen. Conrad, a more conservative Republican, echoed this sentiment.  The fact that Republicans on the subcommittee joined with Democrats rather than joined in Goldman’s paradigm points to a major disconnect between Wall Street “speak” and the discourse of the general public.  In other words, the financial managers and the politicians were largely talking past each other.  Even so, the two “worlds” can be translated into a common language that nonetheless finds Goldman culpable, while acknowledging some of the managers’ points.  In what follows, I discuss a number of the points raised in the hearing to bear out my contentions here.

Broker dealers do not have a legal fiduciary obligation to their clients in the US. This, Sen. Collins argued, is the root cause of the conflict of interest at Goldman (i.e., pitching toxic investments to its clients while betting against them).  Goldman bankers view their obligation being to be market makers.  A duty to serve the clients or act in their best interest?   Goldman’s managers tended to affirm the former because where the bank is making markets, similarly to an exchange, it is not in an advising capacity. According to one of the managers, market-makers do not have an obligation to tell clients of the market-maker’s position in the market.  The manager contended that how Goldman is positioned may not affect how the instrument performs.  So long as clients understand what they are investing it, the position of the market-maker is not relevant to the client.

Paulson (of the hedge fund, Paulson & Co) had a role in picking the securities in the Abacus CDO. The rating agency said that if the rating analyst had known this, the rating would have been far different.  Torre, the manager at Goldman who oversaw the deal, claimed in testimony that he had told ACA (the major long buyer) that Paulson was going short, but in a memo from ACA afterward refers to Paulson going long. Paulson was involved in the selection of the securities, according to Torre, though ACA left off more than half of the securities that Paulson had recommended. Even so, Paulson was in the room as the securities were being selected, and he had selected the criteria of their removal. Goldman employees did not indicate in the Abacus CDO that Paulson, whose intent it was to short, had been involved in the selection of the securities (which were subprime mortgages from 2006—presumably the stated-income-only variety).

In replying to Sen. Levin’s questions regarding whether it is correct that Goldman made money on its net short position in 2007, two of the Goldman managers replied, “I didn’t write that.” A third replied, “I can only comment on what I did.” Although such non-answers could have been directed by lawyers or the answers could be due to the difference in general paradigms between Wall Street and the general public, I submit that the managers’ underlying attitude is particularly troubling because it involves some cognitive warping.  Because Chairman Levin (D-MI) was not asking  whether they wrote the Goldman document he was referring to, the reply “I didn’t write it” simply doesn’t apply.  At the very least, the managers were adding assumptions into Levin’s question that simply were not there. My question is this: what, cognitively or affectively speaking, would prompt such “value-added addendums”? After a similar answer to one of his questions, Sen. Colburn (R-OK) replied, “Mr Burnbaum, you didn’t hear what I said.”  Similarly frustrated after a question, Sen. Levin gave up with the witness, saying, “I think you’ve not answered the question as best you can.” At one point, Sen. Colburn asked Mr. Burnbaum whether he had any knowledge of whether his firm had a short position on an issue, he replied that he didn’t take the position.  “I don’t speak for the firm; I speak only for my position.” But Sen. Colburn didn’t ask him to speak for his firm; rather, he asked him whether he knew anything about something regarding the firm.  What could prompt such mistaken assumptions?  I don’t think it is entirely a subterfuge; rather, I suspect that the managers’ cognitive processes had been distorted by a particular organizational or industry culture. Such cognitive warping could be part of the reason why Goldman’s managers have blind-spots concerning the institutional conflicts of interest.

To potential customers who asked how Goldman got comfortable with Anderson securities, which were put together by New Century (a mortgage servicer), the sales people at Goldman did not say that the bank was comfortable because it was betting against them by buying 51% of the shorts.  Did Goldman have an obligation to disclose the fact that the bank had bought shorts (i.e., that Goldman had an adverse interest to the client)?   Goldman’s bankers point to the potential buyers’ ability to investigate the securities themselves. The Anderson was downgraded from AAA to junk in seven months.

“Boy, that Timberwolf was one shitty deal.”  This is from an internal Goldman email from the head of a division prior to the bank selling hundreds of millions from that deal to customers. Sales people were told that that deal was their top priority. “Should Goldman be trying to sell a shitty deal?”, Sen. Levin repeatedly asked throughout the hearing.  Seventeen of the people at Graywolf’s research group were Golden alums. Was that why the sales people were told to make the deal a priority?

In general terms, some of the managers at Goldman liked the risk involved in securitizing stated-income mortgages because clients wanted to buy them.  As a market-maker, Goldman’s managers believe that there is a price for any risk, so they would sell a deal they believed to be bad because some clients would like the price. In one case, 90% of the mortgages from an originator were stated-income.  In spite of the high number of stated-income mortgages, the rating agency involved gave some of the securities the AAA rating. Did the Goldman sales people tell their clients of the extent of the stated-income mortgages in the securities? Or did the sales people assume that the clients could investigate the securities in spite of there being the AAA rating on at least some of them?  Goldman claims that it investigated the due diligence of originators, like Long Beach.   So why did the investment bank not cut off that originator?

When asked about the bonuses paid out even as the clients lost money, the Goldman managers said that the compensation incentives were or are in line with ethical behavior.  Even if Goldman lost money, its executives didn’t. So it is reasonable to ask whether the incentives are in line with “performing.”

Goldman magnified the rise and fall of the housing market. Lloyd Blankfein, Goldman’s Chairman and CEO (which is itself a conflict of interest) admitted that the bank had played a role, as did the other investment banks, in the system that included too loose lending criteria. The managers at Goldman said the bank was a market-maker for instruments that reflected those low standards. Sparks, who headed the mortgage securities unit at Goldman, said he didn’t think Goldman did anything wrong; rather, some of the deals it put together did not “perform”—meaning that they were downgraded to junk.  “Goldman made some bad business decisions.”  In a business sense, “bad” does not mean “wrong” in the sense of “ought not” (i.e., unethical).  Rather, “bad” refers to making an error in business calculations.   Similarly, David Vinair, Goldman’s executive VP, said he didn’t think there is a conflict of interest in Goldman selling a security long while shorting it on its own books.  The client buying the security long may have a different stance toward risk as well as a different time horizon than the bank.  Also, the bank may change its short to a long depending on factors that are different from those impacting a given client.  Sen. Levin countered that the conflict of interest is at the moment of sale (hence the bank’s changing preferences are irrelevant). The customer, Levin said, has a right to expect that the bank selling the security wants it to do well.  “In what sense do you mean well?”, Vinair countered.  More semantics ensued. In spite of using vague terms like “perform” (which is actually relevant to acting), Vinair wanted a definition of “doing well” from the chairman. Blankfein also said that there is no conflict of interest; he likened Goldman’s market-making function to that of a stock exchange. Investors don’t ask what positions the exchange has in given stock.  But unlike the NYSE, Goldman Sachs is not limited to its market-making function; the bank takes proprietary in the markets, or instruments, that it “creates” not only to protect its positions in the market-making transactions, but to make a profit by trading on its own books. Hence Goldman, unlike the NYSE, has financial interests other than simply making a market and such interests can warp its market-making function in ways that are not transparent to Goldman’s clients.

It seems to me that the major conflict of interest at Goldman manifests when Goldman managers suspect that a security won’t “perform” (hence the desire to short it) without telling the potential buyers of this belief.  The Goldman managers want to make money not only off its shorts, but also off the client, whom the Goldman sales staff have given a misconception of the security’s soundness either by omission or lying).  The conflict of interest deepens if Goldman managers actually know that a derivative has been put together to fail, and because the bank (or a favored client) will profit from its failure (having bought shorts), the relevant manager does not disclose what he or she knows to the client so the latter will purchase the security.  Goldman would profit both from trading the security (shorting it) on its own books aside from being a counter-party to clients taking long positions, and from being such a counter-party.  That is, profiting from Goldman’s books entails transactions beyond the counter-party transactions prompted by a client wanting to buy or sell. Not recognizing this as a conflict of interest, Sparks limited conflicts of interest at Goldman to picking between two customers, or between one of its customers and Goldman’s proprietary bank. The problem with such a narrow reading of the bank’s conflicts of interest is that it omits the impact of Goldman’s proprietary transactions based on profiting on its own capital. I wonder if this narrowness of perception isn’t related to the “cognitive warping” that was evinced in many of the non-answers of the managers testifying before Congress. “I didn’t write that” is irrelevant; so too are the bank’s proprietary transactions geared to profiting from the bank’s own books aside from being a counter-party to a client in the bank’s market-making function.

I believe that even Lloyd Blankfein viewed all of Goldman’s transactions as market-making.  But he was correct, then every single economic transaction by any party constitutes market-making; every business is making a market.  At Goldman, there was still the conflict of interest regarding the bank’s profiting on its own books not from being a counter-party to a client as part of serving the client versus from serving a buyer or seller client by being the counter-party if necessary.  Goldman can be understood to profit as a broker (a fee in putting a buyer and seller together), as well as from how it does as a counter-party in such a transaction. In addition, Goldman can profit from trading on its own books irrespective of being such a counter-party. I contend that if Goldman is to do the first function, then either of the latter two—and especially the third—constitutes a structural or institutional conflict of interest.  The second function would not be a conflict of interest were Goldman’s counter-party profits (and losses) passed on to the client.  Perhaps even the third function would not constitute a structural conflict of interest were the profits distributed to the bank’s clients.  However, to the extent that there could be an interest in currying favor with particular clients who would benefit differentially in either the second or third function, there could still be a conflict of interest for Goldman.

In general terms, a conflict of interest can be seen as involving lying (or duplicity) in order to benefit “both ways” from having two conflicting interests.  The solution is to reduce the number of interests that a party has such that he or she has no interests that could or do conflict.  This is a different question than asking what legislation is needed, for the field of business ethics ought not be conflated with the field of business & government (i.e., institutional political economy) or even with that of business & society.

Societal norms are not justifying regarding whether a given practice is or is not a conflict of interest.  Theoretically, a firm could deviate from the norms of a society in order to avoid structural conflicts of interest, or a society could simply be blind to such conflicts and a firm act to avoid them anyway.  In other words, business ethics need not involve “social responsibility”  (and the latter need not involve the former).   In the case of Goldman, the social norms regarding such conflicts of interest (i.e., structural) are in their infancy, at least in the US.  Hence, this discussion of business ethics is a distinct project.  Business & Society would investigate the disjointedness of the paradigms of the bankers and the general public–that is, how and why they differ. Business & Government would investigate legislative and/or regulatory matters concerning the conflicts of interest as evinced by Goldman.

While the three fields are related, so too are medical ethics, sociology and biology. You don’t find schools putting these three in one class because it would be cheaper.  So part of the problem concerning business ethics might be how it is treated by business schools; it (as well as CSR and business & goverment) is essentially relegated to one third of a course in most undergraduate and MBA curriculi.  Among the lessons that we ought to have learned from the financial crisis of 2008 is that of the value, or importance, of the fields of business ethics, business & society, and business & government in business schools.  Sadly, even in educating their respective scholars, these fields are conflated–hence the scholars are not apt to study sufficiently in the basic discipline of their particular field.  That is, they tend to skim along the surface in order to cover three rather than one field. Perhaps business schools have a conflict of interest of their own whereby they have an interest in cost-saving expediency and in covering all of the fields of business. The three fields being discussed here have been willingly mitigated (or enervated) into “one” such that business schools could appear to have it both ways.  The problem is when something happens like the financial crisis of 2008, which shows just how vital each of the three fields are–meaning worthy of courses of their own.

Goldman Sachs’ settlement with the SEC in July, 2010 amounts to just two weeks of profits for the bank—hardly even a slap on the wrist.  However, the bankers had to concede that they had not had “full and complete disclosure in their marketing materials.”  Even so, few if any clients left the bank in the wake of the settlement. To be sure, since the impropriety had come to light in Sen. Karl Levin’s investigations subcommittee, Goldman had slipped in the pecking order of top underwriters of stocks and bonds to eighth. There is reason to think this was the extent of the damage.  Oklahoma’s Teachers Retirement System, for example, was unlikely to terminate Goldman even though the system’s general director said he was disappointed in the admission.

In general terms, the US Government was having trouble holding bankers accountable for the financial crisis of 2008. Wall Street’s defense that the bankers had simply made mistakes does not explain the liars’ loans or Goldman’s knowingly misleading clients who went long on subprime derivative securities. The government’s difficulty could itself give Wall Street an incentive to keep up the deceit.  That the market mechanism does not reflect the fraud by removing the offenders suggests a second major drawback—the first being internal volitility from irrational exuberance.  On the government side, even with regulations on the books and a willingness to enforce them, it may simply be too difficult for anyone to prove fraud when Wall Street is hanging together rather than turning each other in. That is to say, both the market mechanism and regulation may not be able to correct for the risk involved in the existence of banks too big to fail. In a way, we all enable the presumptiveness of fraud by refusing to break up the big banks both organizationally and in terms of ownership.  A lesson available from the financial crisis of 2008 might be that we can ill-afford to continue to enable giants who could fall on us any day.

Sources: Thomas Catan and Kara Scannell, “Convictions From Crisis Hard,” Wall Street Journal (July 17-18, 2010), B2; Susanne Craig and Randall Smithy, “For Goldman, Reputation Reclamation Project,” Wall Street Journal (July 17-18, 2010), B1-2.

While creating and selling mortgage-based securities to some of its clients, Deutsche Bank AG was not only advising other clients to bet the other way, but also sometimes doing it itself, according to the Wall Street Journal. A trader at the bank would help create an index that made it easy for the bank to bet against housing even as sales people at the bank were selling the securities as if there were no downside to the American housing market. Then some of the tax-payer money was paid by the US Government to AIG to reimburse Deutsche’s hedge-fund clients who had bought the mortgage securities. American regulators looked at whether there were misrepresentations made to the hedge fund managers who bought the mortgage-backed securities even as Deutsche Bank was betting against the housing market.

The structural conflict of interest wherein a bank’s interest is antipodal to that of its clients raises the spector of misrepresentation. A spokesperson for Deutsche said, "We served clients whatever their investment objective, but only after being satisfied that they had arrived at their view after thorough consideration.” Furthermore, although Deutsche made tens of millions of dollars betting against the housing market, overall it “maintained a net long position in the housing market and ultimately suffered billions in losses, even after factoring in our hedges and offsetting positions.”  The more even proprietary position would relieve the bank of the conflict of interest; it is where the bank’s own position is skewed dramatically in one direction while it sells to clients in the other that at the very least the appearance of a conflict of interest arises.  The way out of this is to severely limit proprietary trades to those that are needed for clients (i.e., to manufacture a counter-party for a transaction desired by a client rather than the bank itself).  A second way out may have been illustrated by Deutsche. That is, a bank can hold a relatively balanced proprietary position such that the bank itself does not have an interest in the market going one way or the other. However, even with a balanced position, bankers can believe that a market will go down and lie to potential clients in order to sell long. 

For example, The Wall Street Journal reports that Deutsche trader Greg Lippmann encouraged an investor to go short against subprime bonds, telling him, “you should get some [courage] and do some shorts” because “these bonds are ging much lower.” Deutsche, however, continued to market new mortgage-bond deals predicated on the mortgage-securities market staying strong. The next day, M&T Bank of Buffallo, NY paid $82 million into a Deutsche deal known as Gemstone 7. Within ten months, the company had lost 98% of its investment.  A Deutsche spokesperson claims that employees bearish on the housing market had spoke at client meetings to make their views known and there is no indication that Lippmann was among those in sales urging clients to buy.  Even so, it would be odd were M&T managers willing to sink so much money into mortgage bonds after being told that the bonds would go much further down. Even if the bank’s proprietary interest was balanced, the information it had on the housing market went against its profit-motive in sales, so there may have been a conflict of interest even without a proprietary position to back it up.  Telling M&T managers that the “underlying structures in these bonds are built to withstand” adverse conditions shortly before the value of M&T’s holdings go from $82 million to $1.9 million strongly suggests that Deutsche’s bankers were at the very least incompetent. Given Lippmann’s email, there is evidence that Deutsche bankers knew that the bond’s underlying structures were vulnerable.  Withholding information in order to lie in order to profit is of course fraud. My point is that it can be looked at as a structural conflict of interest between one’s belief in one’s opinion and one’s profit-motive that can exist even where there is no (or a balanced) proprietary financial interest.

Carrick Mollenkamp and Serena Ng, “Dual Role in Housing Deals Puts Spotlight on Deutsche,” The Wall Street Journal (August 3, 2010), pp. A1.

Neil Kashkari wrote up the U.S. Treasury department’s Break the Glass Bank Recapitalization Plan in April, 2008—months before the financial crisis—as a “just in case.” It was essentially the TARP program.  Karshkari states in his plan that governmental purchases of toxic mortgage-based assets would do “nothing to help homeowners without [there being] a complimentary program.” He notes that should there be a crisis, “there would be enormous political pressure” for relief going to homeowners in trouble.  Considering the noted downside to his plan, he may have viewed any such pressure from “the masses” as a problem to be ignored rather than even assuaged.  He also admits in his plan that it would provide “no guarantee banks [would] resume lending.”  It is odd that his was made explicit yet not dealt with.  He does gloss an alternative option (C) that would involve refinancing the troubled mortgages, though he assumes a (needlessly cumbersome) case by case basis and that the servicers would determine which loans to put into the program.  The culprits could opt out to insist on the higher payments. In other words, Kashkari was assuming that the government shouldn’t or couldn’t force the banks to take write-downs.  As a former Goldman Sachs man himself (like his boss at the time, Henry Paulson), Kashkari probably didn’t want to propose anything that the bankers wouldn’t view as being in their interest.

In December of 2009, a spokesperson at Bank of America announced that the bank would pay back its $45 billion in US Government aid. The government is all in favor of such repayments.  “As banks replace Treasury investments with private capital, confidence in the financial system increases, taxpayers are made whole, and government’s unprecedented involvement in the private sector lessens,” said Andrew Williams, a spokesman for the Treasury.  The Obama administration had already begun talking with lawmakers about using unspent money from the financial bailout program to help offset the costs of spending to create jobs.

As laudable as efforts to reduce unemployment are, the government is essentially skipping stones over the homeowners in trouble and facing foreclosure.  It could be argued that a “bottom up” approach to TARP—using it to help with mortgage payments (while enabling the government to impose refinancing on the adjustable-rate sub-prime mortgages) would have obviated the foreclosures while prompting further bank lending.  To skip over such a use as banks repay the government suggests that the government officials are not willing to put our money where their mouths are—such as in “pressing” banks to do better in refinancing.  In other words, it is telling that a use that is closer-related to the purpose of TARP was being (yet again) skipped over—only that time so that a purpose further from the mission of the TARP program could be funded.  Sometimes it is worth noting what people decide not to do…