While one part of Goldman Sachs was doing the equivalent of passing off cubic zirconium trinkets as diamond rings in Tiffany boxes, another part was betting against the first set of suckers. It is old news that Goldman turned an unexpected profit in the last quarter of 2008, while the market teetered on the brink of utter collapse, because the profit from their bets against mortgage-backed securities in one operation outstripped the loss from packaging and selling those securities in another.
Admirers of the firm, including your humble blogger, assumed that it was a case of the right hand not knowing what the left hand was doing - typical behavior in every large organization. However, according to a recent SEC action, in at least one set of transactions, the same brain was directing both hands. And therein lies the singular importance of this case, because that is where Goldman violated the most important tenet of business, but of banking in particular: keep trust with the clients.
I leave it to other columns and blogs discuss how this case impacts the debate on the financial reform legislation now pending in Congress. But to the general public, this case provides the "smoking gun" for the growing belief that Wall Street is not just a casino, but a crooked and fixed casino. And that perception does Wall Street more harm than Washington regulations could ever do.
Public unease with Wall Street grew over the last twelve years. The great bull market that started in 1982 came to a halt in 1998. Since then, the Dow engaged in stomach-churning see-saws, but the time-weighted average has been stuck around 10,000. If the market had instead made its 100-year average return of 8%, the Dow would be at 25,000 today instead of 11,000. Put starkly, the average investor has seen no net new wealth creation in twelve years. Yes, some have done extraordinarily well. But others have done poorly. Most have done no better than tread water.
Investors searched frantically for a better return - no, make that any return. And the investment banks did their best to oblige.
First, there was the Internet bubble. At least, we got some lasting benefits: a few great new companies like Google, a profound transformation in how we live and work, and grist for plenty of blog posts.
Then there was the housing boom. At first, low interest rates made bigger houses affordable to more people. With no long term return and nauseating volatility in the stock market, real estate looked to many to be their most attractive investment. On a 100-year basis, real estate returns were about 5%, not as good as the 8% from the stock market. But there are times when real estate outperforms equities, and the period from 1998 to 2006 was one of them.
Wall Street helped by creating packages of loans that the originating institution could sell to others. With those liabilities off the balance sheet, the originating bank could issue even more loans, because the assets, liabilities, and risks now belonged to someone else. Then Wall Street helped the intermediaries transact ever more business by creating derivative products to pass the portfolio risks off to other someones else. Then they even created derivatives of the derivatives.
It was a load of fun, and very profitable. Why? Because the leverage in the loans, derivatives, and second-order derivatives amplified the profit in the underlying housing market - so much that it sucked capital away from more traditional investments like commercial loans or start-up venture capital, which contributed to the last decade of poor or no growth in small business and real wages.
Of course, on the down side, leverage would later amplify the losses. As Salvor Hardin, Isaac Asimov's Foundation Trilogy mayor of Terminus observed, "It's a poor atom blaster than doesn't point both ways."
As a nation and a society, we decided not to take the risk of letting the banking system collapse under the weight of leveraged losses. While debate about the merits, hazards, and ultimate costs of the bail-out continues, the undeniable fact is that Wall Street further lost trust with the public.
Goldman Sachs and, by extension, Wall Street need to mend their reputation. When the public regains trust in financial markets and institutions, the path to 25,000 and more is set; until then it is blocked. Goldman would certainly make more profit in an economy where the Dow is at 25,000 than 11,000. The Bard of Avon said it best:
Good name in man and woman, dear my lord,
Is the immediate jewel of their souls.
Who steals my purse steals trash; 'tis something, nothing;
'Twas mine, 'tis his, and has been slave to thousands;
But he that filches from me my good name
Robs me of that which not enriches him,
And makes me poor indeed.
- Othello, Act 3 Scene 3
That, Mr. Blankfein, is the real banker's credo. Ignore it at your peril.