Tag Archives: goldman sachs

Goldman Sachs Concedes Existence Of Too Big To Fail

By Simon Johnson

Global megabanks and their friends are pushing back hard against the idea that additional reforms are needed – beyond what is supposed to be implemented as part of the Dodd-Frank 2010 financial legislation.  The latest salvo comes from Goldman Sachs which, in a recent report, “Measuring the TBTF effect on bond pricing,” denied there is any such thing as downside protection provided by the official sector to creditors of “too big to fail” financial conglomerates.

The Goldman document appears hot on the heels of similar arguments in papers by such organizations as Davis Polk (a leading law firm for big banks), the Bipartisan Policy Center (where the writing is done by a committee comprised mostly of people who work closely with big banks), and JP Morgan Chase (a big bank).  This is not any kind of conspiracy but rather parallel messages expressed by people with convergent interests, perhaps with the thought that a steady drumbeat will help sway the consensus back towards the banks’ point of view.  But the Goldman Sachs team actually concedes, point blank, that too big to fail does exist — punching a big hole in the case painstakingly built by its allies.  Continue reading

Could Goldman Sachs Fail?

By Simon Johnson.  This link to MIT Sloan’s website provides a partial transcript and video covering the points made below.

If Goldman Sachs were to hit a hypothetical financial rock, would they be allowed to fail – to go bankrupt as did Lehman – or would they and their creditors be bailed out?

I asked this question on Sunday to four leading experts (Erik Berglof, Claudio Borio, Garry Schinasi, and Andrew Sheng) from various parts of the official sector at the Institute for New Economic Thinking (INET) Conference in Bretton Woods – and to a room full of people who are close to policy thinking both in the United States and in Europe.  In both the public interactions (for which you can review video here) and private conversations later, my interpretation of what was said and not said was unambiguous: Goldman Sachs would be bailed out (again).

This is very bad news – although admittedly not at all surprising.  Continue reading

Goldman Sachs: “We Consider Our Size An Asset That We Try Hard To Preserve”

By Simon Johnson

To great fanfare, this week Goldman Sachs unveiled the report of its Business Standards Committee, which makes recommendations regarding changes for the internal structure of what is currently the 5th largest bank holding company in the United States.  Some of the recommended changes are long overdue – particularly as they address perceived conflicts of interest between Goldman and its clients.  

What is most notable about the report, however, is what it does not say.  There is, in fact, no mention of any issues that are of first order importance regarding how Goldman (and other banks of its size and with its leverage) can have big negative effects on the overall economy.   The entire 67 page report reads like an exercise in misdirection.

Goldman Sachs is ignoring the main point of the debate made by – among others – Mervyn King, governor of the Bank of England, regarding why big banks need to be much more financed by equity (and therefore have much less leverage, meaning lower debt relative to equity).  On p.10 of his Bagehot Lecture in October 2010, for example, King was quite blunt: Continue reading

Why Is The US Taxpayer Subsidizing Facebook – And The Next Bubble?

By Simon Johnson

Goldman Sachs is investing $450 million of its own money in Facebook, at a valuation that implies the social networking company is now worth $50 billion.  Goldman is also apparently launching a fund that will bring its own high net worth clients in as investors for Facebook.

On the face of it, this might just seem like the financial sector doing what it is supposed to – channeling funds into productive enterprise.  The SEC is apparently looking at the way private investors will be involved, but there are some more deeply unsettling factors at work here.

Remember that Goldman Sachs is now a bank holding company – a status it received in September 2008, at the height of the financial crisis, in order to avoid collapse (for the details, see Andrew Ross Sorkin’s blow-by-blow account in Too Big To Fail.)  This means that it has essentially unfettered access to the Federal Reserve’s discount window, i.e., it can borrow against all kinds of assets in its portfolio, effective ensuring it has government-provided liquidity at any time.

Any financial institution with such access to such government support is likely to take on excessive risk – this is the heart of what is commonly referred to as the problem of “moral hazard.”  If you are fully insured against adverse events, you will be less careful. Continue reading

Thoughts On The Macroeconomic Impact of Goldman Sachs

By Peter Boone and Simon Johnson

The influential Goldman Sachs economist Jan Hatzius has a new research note out (with Sven Jari Stehn), “Thoughts on the Macroeconomic Impact of Basel III,” arguing that the move to raise capital standards for banks will put a serious crimp in growth in the United States – knocking 1.5 to 2 percent off gross domestic product in the next few years. Their findings are questionable, but in any case we should broaden the discussion to consider exactly how banks like Goldman Sachs affect our macroeconomic dynamics going forward – particularly if they are able to effectively lobby against higher capital. Growth based on risky banking has a tendency to prove illusory.

There are three issues. First, what is the short-term impact of raising capital requirements? Second, how should capital be increased? And third, and perhaps most important, do we really need global banks like Goldman Sachs to operate in their recent “high risk – highly variable returns” mode?

In their note, which is not in the public domain, Mr. Hatzius and Mr. Stehn are willing to acknowledge that raising capital standards can help make banks safer and that this is good for sustained growth over a sufficiently long period of time (think a decade or more), as the Bank for International Settlements suggests. But they make the case that raising capital – at least in the form that this is likely to take place – can slow growth over the next several years. Continue reading

What Is Goldman Sachs Thinking?

By Simon Johnson

The next financial boom seems likely to be centered on lending to emerging markets.  Sam Finkelstein, head of emerging markets debt at Goldman Sachs Asset Management, summed up the prevailing market view – and no doubt talked up his own positions – with a prominent quote in Monday’s Financial Times (p.13, front of the Companies and Markets section):

“Debt-to-GDP ratios in the developed world are about double those in emerging markets and they’re growing.  This makes emerging markets interesting because you’re pick up incremental spread [higher interest rates compared with developed world rates], and in return you’re actually taking less macroeconomic risk.”

This is a dangerous view for three reasons. Continue reading

Update on ABACUS

Read the “synthetic, synthetic CDO” post first if you haven’t already.

The reasonable counterargument, for example here, is that because these are derivatives, there logically speaking must have been someone on the other side of the trade from the buyers, and the buyers should have known that — who that is doesn’t need to be disclosed. I think this is true to a degree, but not to the degree that Goldman needs it to be true.

Take an ordinary synthetic CDO. Back in 2005-2006, a bank might create one of these because it knows there is demand on the buy side for higher-yielding (than Treasuries) AAA assets. To do this, the CDO has to sell CDS protection on its reference portfolio to someone. That someone could in the first instance be the bank. But then the bank’s “short” position goes into its huge portfolio of CDS, which may overall be long or short the class of securities (say, subprime mortgage-backed securities) involved.The bank is constantly hedging that portfolio via individual transactions with other clients or other dealers, so there’s no one-to-one correspondence between the long side of the new CDO and any specific party or parties on the short side.

Let’s say for the sake of argument that the bank, prior to the new CDO, was exactly neutral on this market. The new CDO makes it a little bit short. So the bank will go out and hedge its position by finding someone else to lay the short position onto. But first of all, there’s a good chance it will divide up the short position and hedge pieces of it with different people. Those people may be buying the short position not because they want the subprime market to collapse; they might be partially hedging their own long positions in that market. Second, there’s an even better chance that it won’t sell off exactly the short position it just picked up from the CDO; it will buy CDS protection on a bunch of RMBS that are similar to the ones it just sold CDS protection on (which ones will depend on what the market is interested in), so in aggregate it comes out more or less the same.

So ultimately the “short” side of the CDO gets dispersed between the bank’s existing CDS portfolio and the broader market. So yes, there must be a short interest out there that is exactly equivalent to the long interest. But there doesn’t have to be a party or even an identifiable set of parties who have exactly the short side of the new CDO and want it to collapse, let alone a party that helped structure the CDO because it wanted to be on the short side. There’s a big difference between the market as a whole and one hedge fund.

Now, are things different with a synthetic synthetic CDO, as I have called it? Maybe. The pro-Goldman argument would be that ABACUS was so highly structured — basically, each tranche was a single complex derivative with a long side and a short side — that the long investors must have realized that there was a single party, or a small number of parties, on the other side. But that doesn’t necessarily hold. Just like a synthetic CDO, Goldman could have whipped this thing together because it thought it could sell it, and Goldman could have planned to hedge it the usual way — partially with its inventory and partially through a lot of small transactions dispersed throughout the market.

As always, I draw on Steve Randy Waldman.

ABACUS: A Synthetic, Synthetic CDO

By James Kwak

I actually suspected this, but I haven’t had the time to look at the marketing documents. But thankfully Steve Randy Waldman did. I don’t think I can improve on his description — these things take hundreds of words — but here’s a quick summary.

An ordinary CDO is a new entity that raises money by issuing bonds in tranches, uses the money to buy some other bonds (say, residential mortgage-backed securities) and uses the cash flows from those bonds to pay off its own bonds.

A synthetic CDO is similar except instead of buying the underlying bonds, it sells credit default swap protection on those bonds (the reference portfolio) and uses the premiums from the CDS to pay off its own bonds. (The money it raises by selling those bonds is usually parked in low-risk securities so it is available to pay off the CDS if necessary.)

ABACUS was different. There was a reference portfolio. But instead of selling CDS protection on all of those bonds, Goldman said (to paraphrase), “Imagine we sold CDS protection on all of those bonds. Then imagine we used those CDS premiums to issue bonds in tranches A-1, A-2, B, C, D, and FL. The derivative I’m selling you is one that will behave exactly as if it were an A-1  (or A-2) bond in that scenario — even though we’re not actually selling all of the tranches.”

Continue reading

The Best Thing I Have Read on SEC-Goldman (So Far)

By James Kwak

Actually, two things, both by Steve Randy Waldman.

Part of Goldman’s defense is that it was in the nature of CDOs for there to be a long side and a short side, and the investors on the long side (the ones who bought the bonds issued by the CDO) must have known that there was a short side, and hence there was no need to disclose Paulson’s involvement. Waldman completely dismantles this argument, starting with a point so simple that most of us missed it: a CDO is just a way of repackaging other bonds (residential mortgage-backed securities, in this sense), so it doesn’t necessarily have a short investor any more than a simple corporate bond or a share of stock does. Since a synthetic CDO by construction mimics the characteristics of a non-synthetic CDO, the same thing holds. (While the credit default swaps that go into constructing the synthetic CDO have long and short sides, the CDO itself doesn’t have to.) Here’s the conclusion:

“Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO. They no more thought they were trading ‘against’ short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio. Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors.”

Waldman follows this up with an analysis of the premium that Goldman extracted from the buy-side investors and transferred to Paulson (in exchange for its own fee). The point here is that Goldman could have simply put Paulson and the buy-side investors together and had Paulson buy CDS on RMBS directly — but that would have affected the price of the deal, because Paulson wanted to take a big short position. So instead, they created the CDO (a new entity) and then drummed up buyers for it, in order to avoid moving the market against Paulson. The advantage of thinking about it this way is it shows what the function of a market maker is and how that differs from the role Goldman played in this transaction.

The posts are long, so sit back and enjoy.

Update: Nemo points out that I misinterpreted Waldman’s post, and Nemo is right, although I think I got the substance of Waldman’s point right. Here is what Waldman says:

“There is always a payer and a payee, and the payee is ‘long’ certain states of the world while the payer is short. When you buy a share of IBM, you are long IBM and the firm itself has a short position. Does that mean, when you purchase IBM, you are taking sides in a disagreement with IBM, with IBM betting that it will collapse and never pay a dividend while you bet it will succeed and be forced to pay? No, of course not. There are many, many occasions when the interests of long investors and the interests of short investors are fully aligned. When IBM issues new shares, all of its stakeholders — preexisting shareholders, managers, employees — hope that IBM will succeed, and may have no disagreement whatsoever on its prospects. . . . The existence of a long side and a short side need imply no disagreement whatsoever.”

So I was clearly wrong when I said, “a CDO is just a way of repackaging other bonds (residential mortgage-backed securities, in this sense), so it doesn’t necessarily have a short investor any more than a simple corporate bond or a share of stock does.”

But — and I don’t think I’m engaging in sophistry here — Waldman’s underlying point is that even though there is a short position, that doesn’t mean that the long and short investors have diametrically opposed interests. That’s true of stocks, and it’s also true of CDOs. And so it’s disingenuous of Goldman to imply that buyers of any CDO always know that there is someone who is actively betting on it to go down in value.

Break Up The Banks

By Simon Johnson, co-author of 13 Bankers, as discussed on the Today show this morning with Matt Lauer and Erin Burnett

The biggest banks in the United States have become too big – from a social perspective.  There are obviously private benefits to running banks with between $1 trillion and $2.5 trillion in total assets (as reflected in today’s earnings report), but there are three major social costs that the case of Goldman Sachs now makes quite clear.

1)      The megabanks have little incentive to behave well, in terms of obeying the law.  There is fraud at the heart of Wall Street, but these banks have deep pockets and suing them is a daunting task – as the SEC is about to find out.  The complexity of their transactions serves as an effective shield; good luck explaining to a jury exactly how fraud was perpetrated.  These banks have powerful friends in high places – including President Obama who still apparently thinks Lloyd Blankfein is a “savvy businessman”; and Treasury Secretary Geithner, who is ever deferential.

2)      The people who run big banks brutally crush regular people and their families on a routine basis.  You can see this in two dimensions

A. They are not inclined to treat their customers properly.  They have market power in particular segments (e.g., new issues or specific over-the-counter derivatives) and there are significant barriers to entry, so while behaving badly undermines the value of the franchise, it does not destroy the business.  Talk to some Goldman customers (off-the-record; they don’t want to bite the hand that hurts them).  Lloyd Blankfein still claims that the client comes first for Goldman; most of their clients are surprised to hear that.

B. Small investors also lose out.  Who do you think really bears the losses when John Paulson is allowed to (secretly, according to the SEC) design securities that will fail – and then pockets the gains?

3)      Underpinning all this power is the ultimate threat: Too Big To Fail.  If a big bank is pushed too hard, its failure can bring down the financial system.  This usually means protection when the system looks shaky, but it can also protect big banks from serious prosecution – if their defenders, like Jamie Dimon, can make the case that this would undermine system stability and slow the creation fo credit.  (This is startlingly parallel to the arguments made by Nicolas Biddle against Andrew Jackson during the 1830s; see chapter 1 of 13 Bankers).

In turn, this puts competitors at a major disadvantage, because the bigger banks can borrow on better terms.  The extent of protection provided to management and boards in 2008-09 was excessive, but what really matters is the protection perceived and expected by creditors going forward.  And this is all about whether you can credibly threaten the creditors with losses.  This, in turn, is about a simple calculus – if a firm is in trouble, will it be saved?

There are simply no social benefits to having banks with over $100 billion in total assets.  Think clearly about this – and if you dispute this point, read 13 Bankers; it was written for you.

Goldman Sachs: Too Big To Obey The Law

 By Simon Johnson, co-author of 13 Bankers.

On a short-term tactical basis, Goldman Sachs clearly has little to fear.  It has relatively deep pockets and will fight the securities “Fab” allegations tooth and nail; resolving that case, through all the appeals stages, will take many years.  Friday’s announcement had a significant negative impact on the market perception of Goldman’s franchise value – partly because what they are accused of doing to unsuspecting customers is so disgusting.  But, as a Bank of America analyst (Guy Mozkowski) points out this morning, the dollar amount of this specific allegation is small relative to Goldman’s overall business and – frankly – Goldman’s market position is so strong that most customers feel a lack of plausible alternatives.

The main action, obviously, is in the potential widening of the investigation (good articles in the WSJ today, but behind their paywall).  This is likely to include more Goldman deals as well as other major banks, most of which are generally presumed to have engaged in at least roughly parallel activities – although the precise degree of nondisclosure for adverse material information presumably varied.  Two congressmen have reasonably already drawn the link to the AIG bailout (how much of that was made necessary by fundamentally fraudulent transactions?), Gordon Brown is piling on (a regulatory sheep trying to squeeze into wolf’s clothing for election day on May 6), and the German government would dearly love to blame the governance problems in its own banks (e.g., IKB) on someone else.

But as the White House surveys the battlefield this morning and considers how best to press home the advantage, one major fact dominates.  Any pursuit of Goldman and others through our legal system increases uncertainty and could even cause a political run on the bank – through politicians and class action lawsuits piling on.

And, as no doubt Jamie Dimon (the articulate and very well connected head of JP Morgan Chase) already told Treasury Secretary Tim Geithner over the weekend, if we “demonize” our big banks in this fashion, it will undermine our economic recovery and could weaken financial stability around the world.

Dimon’s points are valid, given our financial structure – this is exactly what makes him so very dangerous. Our biggest banks, in effect, have become too big to be held accountable before the law. Continue reading

SEC Charges Goldman with Fraud

By James Kwak

Press release here. Complaint here. The allegation is that Goldman failed to disclose the role that John Paulson’s hedge fund played in selecting residential mortgage-backed securities that went into a CDO created by Goldman. Here’s paragraph 3 of the complaint:

“In sum, GS&Co arranged a transaction at Paulson’s request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson’s role in the portfolio selection process or its adverse economic interests.”

The problem is that the marketing documents claimed that the securities were selected by ACA Management, a third-party CDO manager, when in fact the selection decisions were influenced by Paulson’s fund. Goldman had a duty to disclose that influence, especially since Paulson was simultaneously shorting the CDO. (According to paragraph 2 of the complain, he bought the credit default swaps from Goldman itself. I used to wonder about this; if he bought the CDS from another bank, then Goldman could claim it didn’t know he was shorting the CDO, implausible as that claim might be. But in this case Goldman must have known.)

Continue reading

Lloyd Blankfein: Time Man Of The Year

By Simon Johnson, co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown

In a surprise announcement earlier this morning, Time Magazine brought forward its annual “Man of the Year” award – and conferred this honor on Lloyd Blankfein, CEO of Goldman Sachs.  April 1st apparently is at least 7 months earlier than anyone else has ever won this award, since it began in 1927.

As the award has previously been conferred on controversial figures (including Joseph Stalin in 1942 and Mrs. Simpson in 1936), Time also saw fit to issue a statement clarifying Mr. Blankfein’s merits,

“[Goldman is] very important.  [They] help companies to grow by helping them to raise capital. Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. It’s a virtuous cycle.  [They] have a social purpose.”

A spokesperson for Goldman responded quickly,

“It was always clear to us that had [Lloyd not won], it would have been quite disruptive to the world’s financial markets. We would have had to spend money, other people would have had to replace transactions as well. Generally for us, volatility is good for our trading business, however it would not have been good for the financial markets as a whole, so it would not have been good for our business…We would not have been affected directly by our exposure to [him], but the world’s financial system would have been affected…there would have been no losses vis a vis our credit exposure.”

Now it seems the Nobel Peace Prize Committee feels pressed to follow suit.  Their statement just released in Oslo begins, Continue reading

Geely Buys Volvo: Goldman Gets The Upside, You Get The Downside

By Simon Johnson

Geely Automotive has acquired Volvo from Ford.  This is a risky bet that may or may pay off for the Chinese auto maker – after first requiring a great deal of investment.

Goldman Sachs’ private equity owns a significant stake in Geely, with the explicit goal of helping that company expand internationally.  Remember what Goldman is – or rather what Goldman became when it was saved from collapse by being allowed to transform into a Bank Holding Company in September 2008 (which allowed access to the Federal Reserve’s discount window, among other advantages).  Goldman’s funding is cheaper on all dimensions because it is perceived to be Too Big To Fail, i.e., supported by the US taxpayer; this allows Goldman to provide more support to Geely (and others).

Our Too Big To Fail banks stand today at the heart of global capital flows.  People around the world – including from China – park their funds in the biggest US banks because everyone concerned believes these banks cannot fail; they were, after all, saved by the Bush administration and put completely – gently and unconditionally – back on their feet under President Obama.  These same banks now spearhead lending to risky projects around the world.

What is the likely outcome? Continue reading

Senator Kaufman: Fraud Still At The Heart Of Wall Street

By Simon Johnson

Last week, Senator Ted Kaufman (D., DE) gave a devastating speech in the Senate on “too big to fail” and all it entails.  A long public silence from our political class was broken – and to great effect.  Today’s Dodd reform proposals stand in pale comparison to the principles outlined by Senator Kaufman.  And yes, DE stands for Delaware – corporate America has finally decided that its largest financial offspring are way out of line and must be reined in.

Today, the Senator has gone one better, putting many private criticisms of the financial sector – the kind you hear whispered with conviction on the Upper East Side and in Midtown – firmly and articulately on the public record in a Senate floor speech to be delivered (this link is to the press release; the speech is in a pdf attached to that – update: direct link to speech, which will be given tomorrow).  He pulls no punches:

“fraud and potential criminal conduct were at the heart of the financial crisis”

He goes after Lehman – with its infamous Repo 105 – as well as the other entities potentially implicated in those transactions, including Ernst and Young (Lehman’s auditors).  This is the low hanging fruit – but have you heard even a squeak from the White House or anyone else in the country’s putative leadership on this issue?

And then he goes for the twin jugulars of Wall Street as it still stands: The idea that we saved something, at great expense in 2008-09, that was actually worth saving; and Goldman Sachs. Continue reading