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Alan Schram

Alan Schram

Posted: May 9, 2010 11:28 PM

Goldman Was Wrong, Despite the Excuses

What's Your Reaction:

Berkshire Hathaway Chairman Warren Buffett and his Vice Chairman Charlie Munger defend Goldman Sachs by saying the hapless Goldman clients have only themselves to blame.

I still think Goldman Sachs' conduct was revolting.

Yes, every synthetic derivative transaction by definition must have a buyer and a seller. It can't be a surprise to anyone that someone is selling the product they are buying.

And yes, the objective of Wall Street is to get an edge. That should not surprise anyone either. It was ACA's job as the selection agent to assess the credit of those mortgages, regardless of the identity of the seller.

And of course banks who take on asinine risks are virtually guaranteed to lose money.

But Goldman Sachs (much like every other large investment bank) has an inherent conflict of interest in that it serves both its proprietary capital and its customers. When those interests are competing, the firm faces a moral dilemma. And given the incentives, it is no wonder Goldman chooses its own interests rather than watching out for the client.

Incidentally, this is also a business dilemma, because Goldman cannot remain in business if its clients do not trust the firm.

In that context, they have crossed the line.

They crossed it by collecting information from all of the ABACUS deal counterparties and using it to the detriment of the client, and for Goldman's own benefit: they reduced Goldman's own exposure to mortgages by selling their positions to clients. Goldman calls this "market making", but it is prima facie wrong and unethical.

Moreover, I believe one of the roles of investment bankers is to decide which securities should not be sold and which transactions make no sense. If a trade is clearly not in the client's best interest, a decent broker would say so.

In that, Goldman Sachs was negligent.

The firm can afford to turn down some business even if it is legal, rather than rely on technicalities such as who picked the underlying securities, and whether or not disclosure was made on page 65 of the deal memo. There is a difference between being ethical and following the letter of the law.

Their self-righteousness notwithstanding, does Goldman really want to deal with its clients in a manner that is technically legal?

To be clear, I do not think all derivatives should be discarded. Derivatives serve a useful economic purpose. They allow market participants to reduce their risks by taking positions that offset any systematic risk in their own portfolios.

More importantly, people should be able to have contracts and freely engage in trades with each other, so long as there is no government guarantee that they can't fail, and subject to prudent regulation. For example, no one should be able to buy insurance unless they had an insurable interest (otherwise, if you can buy insurance on the life of any company, you would be much more inclined to take steps that lead to its demise).

I do not think Goldman Sachs created the real estate bubble. They did not force individual homeowners to over-leverage, cheat on their loan documents or default on their mortgages. But they structured a disastrous trade and prodded their client into it, ignoring their duty to behave as a responsible gate keeper. I cannot understand why Berkshire Hathaway is willing to put its stellar reputation at risk for such callous practices.

As Michael Lewis so aptly put it, there was a time when people could smoke on airplanes, but we don't do that anymore. Similarly, there was a time when Wall Street traders could work with a short seller, create a bond designed to fail, inveigle the rating agencies and sell the bonds to a dim-witted customer without having to worry about the consequences. But we just evolved.


Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com.