The Shadow Boys

Yond’ Cassius has a lean and hungry look;
He thinks too much: such men are dangerous.
— Julius Caesar

There will be plenty of both academic and journalistic research done trying to figure out what went woefully wrong with finance markets in the first decade of this century. I’ve just co-authored a paper that will be out shortly in a peer reviewed journal on how the bubble in the mortgage market probably passed into the market for Real Estate Investment Trust funds (REITS) that were once considered one of the safest and least volatile investments on the planet.  They used to have good patterns of fairly consistent returns too.  However, that was then and this is now.  Now is a different reality and the three scoundrels in the picture above are part of the reason.  These three are part and parcel of how the vampire squid came to rule the world of finance.  You’re looking at a young Ex-Treasury secretary Hank Paulson, Steve Friedman, and Jon–was Governor of New Jersey–Corzine. Take a good long look at that trio of dangerous, lean and hungry men.

Their exploits are outlined in the latest who-did-this-to-us book “Money and Power: How Goldman Sachs Came to Rule the World” By William Cohan.  I don’t have the book yet but the reviews and articles that its release is spawning are everywhere.   The firm started out as man named Goldman who was a simple dealer in commercial paper at the onset of the switch from mercantilism with its emphasis on natural resources and people to capitalism with its emphasis on money. For years, the company was a partnership (the start of IPO move started around 1996 and happened in 1999) and its reputation was that of a firm committed to teamwork  and a laser-like focus on serving clientele despite a past riddled with scandals.  How this situation went from that corporate identity to a group of hot shot sales egos selling toxic mortgages and derivatives to customers is the focus of the book.  Oh, and the most important part is that they did all that selling while having offsetting bets to what they were pushing to customers during the financial crisis that paid of hugely.   The Economist’s review of the book explains why Cohan’s book stands out in the recent flurry of Goldman Sachs psychodrama financial novels.  Cohan has some fresh material which seems even more revealing given Carl Levin’s latest pronouncement.  Basically, Levin argues that Goldman Sachs bet against the stuff they sold clients (Credit Default Obligations)  and then lied to congress about it.

Much of the blame for the 2008 market collapse belongs to banks that earned billions of dollars in profits creating and selling financial products that imploded along with the housing market, according to the report. The Levin-Coburn panel levied its harshest criticism at investment banks, in particular accusing Goldman Sachs and Deutsche Bank AG (DB) of peddling collateralized debt obligations backed by risky loans that the banks’ own traders believed were likely to lose value.

In a statement, New York-based Goldman Sachs denied that it had misled anyone about its activities. “The testimony we gave was truthful and accurate and this is confirmed by the subcommittee’s own report,” Goldman Sachs spokesman Lucas van Praag said.

“The report references testimony from Goldman Sachs witnesses who repeatedly and consistently acknowledged that we were intermittently net short during 2007. We did not have a massive net short position because our short positions were largely offset by our long positions, and our financial results clearly demonstrate this point,” van Praag said.

It remains to be seen if the Obama DOJ will pursue any legal action against the firm.  The Economist article has a more succinct explanation albeit it with a bit of finance jargon thrown in.  Are the actions of the shadow banking behemoth illegal or just maleficent?   Given the horrible state of regulatory framework and the abysmal performance of the SEC under Christopher Cox,  it appears to be walking both sides of that line that’s frequently called the Chinese Wall.  We could also say that the District has not had an active interest in translucent, standardized, and information symmetric-financial markets for decades.  Eliot Spitzer–who knows about Wall Street wrongdoing–thinks Holder should prosecute GS or quit. The Economist states that:

Goldman has pushed this envelope further than other investment banks, believing it had the skill to manage the resulting conflicts. It insists that the Chinese walls separating its traders and bankers are always impermeable.

But outsiders are less inclined to trust it these days. Using client information to increase its trading edge—if that is what Goldman does—may not be against the law, but it is hardly honourable. As the author puts it, the scandal may not be what’s illegal but what’s legal.

Controversy also swirls around Goldman’s “marks”, or the prices at which it valued its mortgage holdings during the crisis. These were much lower than those of its rivals, drawing accusations that it was trying to force them to mark their portfolios down to the same level so that it could pick up assets on the cheap in the ensuing wave of firesales.

Goldman’s aggressive stance certainly caused massive pain, speeding the demise of Bear Stearns and AIG. But as mortgage delinquencies ballooned, Goldman’s marks were shown to be more accurate than those of the other big houses. Its longstanding “mark-to-market” discipline meant it was better placed to face the truth. There is no evidence of a conspiracy to post unreasonably low valuations. There was, in fact, a vigorous debate within Goldman about the right level, just as there was over the firm’s overall risk levels. Angry at being reined in by its powerful risk managers, traders dubbed them the “VAR police”, a reference to the value-at-risk models they used to measure how much was on the line.

My late night relaxing in the tub reading of all this started with the book’s adaptation in Vanity Fair.  There’s an interview with author William Cohan on its website.  I suppose I should mention that Cohan worked at GS.  His excerpt in the May issue characterize GS of the 1990s as the stage for an Alpha War.  I have to say from what I’ve read to date,  John Corzine is the one that comes off the worst for exposure.  I pity poor New Jersey.  Corzine’s trading positions in fixed income sound like something out of Bonfire of the Vanities and The Black Swan simultaneously.  Corzine appears to be the type who won’t stop doubling down, even when he’s losing big time.  Cohan’s VF article focuses on the period of around 1994 when Friedman was trying to deal with the loss of Robert Rubin who had headed of to the Clinton Administration to be Secretary of the Treasury.  One of the big things that I realized when reading all of this was how many Secretaries of the Treasury over a huge number of years have connections to GS.  It makes you believe in secret banking cabals.

Popular at the firm for his genial manner, Corzine also had his critics. “He is charming,” says one partner. “He’s got a really nice style. He comes in an attractive package, so although he has got a huge ego and huge ambition—which far exceeds his ability in both those things—he comes across in a laid-back, low-key, disarming style.”

The partner explains the origin of Corzine’s Goldman nickname: “Fuzzy.” It derived not only from his beard, but also because he was “a fuzzy thinker. He wasn’t crisp and wasn’t black and white. He fuzzed things when he communicated.”

The VF article is a veritable soap opera of tension and struggles between Corzine and Paulson.   The one pervasive criticism that I’ve seen of the book as of right now is that the drama still didn’t stop or explain how GS manages to make so much money.  Perhaps the Levin Report and its supporting documents have more information that would interest a financial economist.  The narrative in this book is from former employees, clients, and just about any one else that would dish the conflicts to Cohan. Many of these remain “unnamed sources”.  Goldman’s sketchy history was also fascinating to me.

After all, this is a firm that periodically eviscerates those who trust it most. In the 1920s, Goldman ran a Ponzi-like scheme involving investment trusts. In the 1970s, it peddled soon-to-be-worthless commercial paper for the soon-to-be-bust Penn Central Railroad. And, in 2007, the firm that prided itself on being “long-term greedy” sold gullible clients on the merits of mortgage-backed securities while simultaneously shorting some of those same debt obligations. The firm has succeeded, in part, by ignoring these nastier aspects of its past. In fact, Goldman never misses an opportunity to celebrate the holier-than-thou principles laid down by former senior partner John Whitehead. Rule No. 1: Our client’s interests always come first.

Money and Power suggests the bank does possess a few special powers, starting with its remarkable ability to convince some of the world’s smartest young people that touting stocks, sniffing out arbitrage opportunities, and shaking down corporate clients amount to a noble calling. One illuminating anecdote in Money and Power concerns Robert Rubin, the former Goldman head who would go on to become Treasury Secretary under Bill Clinton. During his third year at the firm, back in 1969, Rubin’s career path may have hit a rough patch. Sandy Lewis, who at the time ran the arbitrage department for a rival bank, tells Cohan that Rubin approached him regarding a job opportunity. Lewis explains that Rubin had grown disgusted with the Goldman way. “It’s a dishonest mess,” Lewis recalls Rubin saying to him, “that’s making honest people dishonest.”

I  skipped into this interesting bit of hearsay quoted by the NYT.  As you know, GS has friends in high high places so I find this a bit ominous.  This is where the book lends credence to the recent Levin pronouncement.

About Goldman Sachs’s present-day business practices, one “private equity investor” says this: “They view information gathered from their client businesses as free for them to trade on … it’s as simple as that. If they are in a client situation, working on a deal, and they’re learning everything there is to know about that business, they take all that information, pass it up through their organization, and use that information to trade against the client, against other clients, et cetera, et cetera.” The speaker stops short of labeling this as insider trading, but only barely, saying, “I don’t understand how that’s legal.”

Mr. Cohan raises the same question as he writes that the firm’s onetime dedication to its clients has evolved into something more ruthlessly self-serving. “Its primary source of profit has shifted from banking to trading,” he writes, “and the firm is intentionally quite vague about how, and precisely where, those trades are made or, equally relevant, from whom the profits are coming.”

Indeed, the GS Big Short” may have been more responsible for the meltdown than any one thought previously and hearing about these behind-the-scene alpha male wars doesn’t enhance the firm’s supposed client-centric claim or its testimony that fell back on its mantel as the  role of  market-maker.  I watched the hearing completely and was appalled at how little Levin’s panel knew of the world it was supposed to regulate.  There were few intelligent questions and even fewer cogent responses.

But the key players in enacting the strategy were Dan Sparks, head of the mortgage division, and his most senior traders, Josh Birnbaum and Michael Swenson.

All three were key witnesses called by Levin’s committee a year ago. The trio were quizzed alongside the now notorious trader Fabrice Tourre, who is still defending himself in the American courts against a separate claim by the Securities and Exchange Commission that he duped investors into buying mortgage assets that he expected to collapse in value.

That trade was in fact a sideshow to the wider strategy set in motion by that momentous meeting in December 2006. From that point onwards Goldmans began to cut its exposure to American mortgages and set up a series of short positions to gamble on a housing market crash.

At the same time it began publicly marking down the value of those mortgage securities it held, forcing other banks to do the same. But unlike Goldmans, the others had not taken out short positions and when the crisis came they could not offset the huge losses these markdowns involved.

Within eight months of the December meeting, the storm had broken. Credit was drying up in financial markets, rumours of banks in crisis swept through the world’s financial capitals and by September the squeeze on banks led, in Britain, to the emergency loans to Northern Rock and eventually its collapse into State ownership.

Cohan, who interviewed Birnbaum and many others for his book, claims that in 2007 Goldmans’ mortgage desk made a profit of $4 billion from its shorting, helping the bank turn a total profit for the year of $13.5 billion – $9 billion of which ended up as bonuses for staff. Birnbaum, Cohan claims, had wanted to be even more aggressive but the risk department at Goldmans was frightened of going too far in case the gambles went wrong.

In the end, this saga may well play itself out in the world of researchers outside of the beltway who get access to the Levin committee’s documents.  We can always hope that Holder will investigate his boss’s biggest campaign contributor during a campaign cycle in the way that children hope that Santa Claus is real.  The White House could make Carl Levin into an old man who tilts at Windmills.  What is worrisome is how interconnected the alpha males on Wall Street are with the ones that strut around Pennsylvania Avenue.  It’s hard to miss the co-dependency of campaign-fund addict with drug dealer who needs special favors when you read so many sources with similar themes.  It makes a mere mortal like me want to put my money some place out of their reach. I don’t think I’d want a stake in anything near New Jersey either.  My greatest fear, however, is that we know so much about how all this happens and yet we do nothing.  The evidence is out there.  There’s no real change afoot.  Who will the ghost of Caesar haunt?